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The variable annuity industry has a long history of criticism, generally stemming from the relatively high cost of their guarantees relative to less expensive investment alternatives. To burnish their value, in the past 15 years variable annuities have stepped up the guarantees that they provide, delivering a far wider range of income and death benefit features. However, in the face of wild market fluctuations – especially the 2008 financial crisis – many critics now also point out that the new guarantees of variable annuities pose new risks about whether the company will even be able to make good on its guarantees when the time comes. Yet the reality is that suggesting that variable annuities are risky and that the companies might not be able to pay on their guarantees would suggest that they’re not charging enough – implying that actually, variable annuities are too cheap, not too expensive! Alternatively, if the reality is that the current world of variable annuity guarantees really are too expensive, then there should be no risk at all, as the companies would have more than enough excess profits to handle the risks. So which is it at the end of the day? Are annuities really too expensive, or are they actually too cheap? 

The inspiration for today’s blog post was a recent column by Reuters personal finance writer Linda Stern, looking at the current marketplace for variable annuities with living benefit riders. The article notes two of the most common concerns regarding variable annuity guarantees: they are too expensive, and there’s too much risk about whether the companies will be able to pay on those guarantees when the time comes.

These concerns are familiar ones. During research for the latest update to my book "The Advisor's Guide to Annuities" I heard many financial planners express similar worries about the high cost of variable annuity guarantees, along with fears that the annuity companies may not be able to make good on their guarantees down the road.

There’s just one problem: it’s actually impossible for annuities to be too expensive and too risky!

What Does It Mean When Annuity Guarantees Are Too Risky?

To understand why variable annuity guarantees can be risky, it’s important to understand what’s at risk in the first place, and how such guarantees operate.

In the case life insurance death benefits, the actuarial process is relatively straightforward – with a large enough number of people, the frequency of death for a group of individuals is quite easy to predict, and the companies simply pool together a large number of insureds, and let the math work for them. For instance, if 100,000 people own life insurance, it’s fairly easy to predict the amount of money that will be paid out in death benefits every year; although it’s difficult to know if any one person will pass away or not, on average the people who are still alive (and still paying premiums) support the people who died (and need to receive a death benefit), and thanks to the so-called “law of large numbers” the results average out quite reliably. Thus, in the aggregate, the insurer gathers money in the form of premiums from those who are alive each year, invests it, subtracts a small amount for expenses and the profit margins of the insurer, and pays out the remainder as a series of death benefits as people die (predictably from large numbers) each year. If mortality or investment experience are slightly better than anticipated (or expenses are lower), there is a little more money left over at the end of the year, and the insurer shows a greater profit; similarly, if investment or mortality (or expense) results are unfavorable, profits are lower. The process of annuitization operates the exact same way, but in reverse; instead of collecting premiums during life and making a payment at death, payments are made during life and cease at death.

Unlike traditional immediate annuities or even life insurance, variable annuities income guarantees do not simply operate by pooling risk and letting the law of large numbers work for them, because the relevance of the variable annuity guarantees is determined by unpredictable market fluctuations, not large-numbers-predictable mortality. Although it is true that the death of a variable annuity owner lets the company “off the hook” for future income guarantees, the company is only “on the hook” if the market performs poorly, causing the guarantees to be relied upon. But because all annuitants may be invested substantively the same, the numbers don’t just average out en masse. In fact, a significant market decline is likely to simultaneously put the insurance company at risk for income guarantee payments to nearly all annuity owners at once; similarly, a strong market rally simultaneously relieves the insurance company of its obligations to most of its annuity owners at the same time.

Because the risk isn’t simply pooled – where those who live a long time support the benefits for those who die early, or vice versa – the insurance company has to manage its risk by charging a separate expense fee for the privilege of the income guarantee. If the insurance company sets an appropriate price, the ongoing reserves generated by the fees accumulate sufficiently to pay the income guarantees if/when/as they come due. If the pricing is wrong, however, then the annuity owners are at risk, as the insurance company doesn’t have enough money to pay the guarantee obligations.

What Does It Mean When Annuity Guarantees Are Too Expensive?

As noted earlier, in order to pay out annuity income (and other) guarantees, annuities must charge a fee, and often the expense can be substantial. In today’s marketplace, it’s not uncommon for annuities to have total Mortality & Expense and other income guarantee rider fees of 2% to 3% per year, before adding in the costs of the underlying investment subaccounts (roughly analogous to mutual fund fees). This is a striking total cost in a world where index mutual funds and ETFs can often be had for less than 0.20% of expenses, and even more actively managed funds might only carry a 0.75% to 1.5% expense ratio.

Of course, it’s a bit apples-to-oranges to compare mutual fund or ETF fees to the expenses of a variable annuity on a head-to-head basis, because they don’t really provide the same thing. The cost of mutual funds or ETFs simply provides access to an investment (and, perhaps, an active investment manager); variable annuities expenses, on the other hand, pay for guarantees regarding death and/or income benefits that traditional investments simply don’t offer. So it should not be surprising that separate, additional guarantees entail a separate, additional cost.

Nonetheless, anchored to the typical expenses associated with standalone investments, the cost of variable annuity guarantees often ‘feels’ high, in a world where the expenses of the latter could literally double or triple (or more!) the cost of a mutual fund or ETF. As a result, notwithstanding the fact that the offerings aren’t quite the same, the variable annuity is often perceived to have a “too high” and therefore unreasonable cost, implying that the annuity company (and perhaps the annuity agent as well) must be unjustly enriched by excessive expenses.

The Problem With Too Expense And Too Risky

So far, the criticisms of annuities seem relatively straightforward. The insurance companies are heavily reliant on making accurate estimates of the cost of the income guarantees that they provide; failure to estimate these costs accurately could mean, in the face of a severe bear market where suddenly the income guarantees become ‘in the money’ for almost all policyowners at once, that the annuity company simply will be unable to pay on its promises. Similarly, at a cost that may be 2 to 3 times (or more!?) the expense of a standalone mutual fund or ETF, it’s hard for many to rationalize the expense of variable annuity guarantees, even if the head-to-head comparison with traditional investments is a bit apples-to-oranges.

The fundamental problem, however, is that almost by definition, if the annuity’s expenses and fees are “too expensive”, the company should be raking in profits hand over fist… which means it should be so wildly profitable that it cannot possibly be at risk for failing to pay on its guarantees! After all, an annuity being too expense implies that the costs too high relative to the benefits that are offered, which directly contravenes the “riskiness” of annuity company guarantees which emerge when the company doesn’t charge enough for what it offers to policy owners! 

Viewed conversely, if the greatest concern for a variable annuity owner is that the company may not be able to make good on its income or death benefit guarantees, the implicit suggestion is that the company needs to raise its expenses to bring in more money to ensure that it can pay its contractual obligations. Which means if the greatest fear is that the annuity company might be at risk for failing to pay on its income guarantees, the company should be raising its fees further to compensate, because the current expenses would be too low!

Bad Anchors And Short Time Horizons

So how do we account for the common viewpoint that variable annuity guarantees are both too expensive and too risky, when in reality too much of one by definition means the opposite cannot be true as well? The culprit appears to be a combination of behavioral finance biases: bad anchors, and an excessive focus on recent (and short) time horizons.

The bad anchor problem is that, even though we may acknowledge the comparison is apples-to-oranges, we are still judging the cost of annuities with guarantees by contrasting them with investment alternatives that don’t have those guarantees, such as variable annuities versus traditional mutual funds and ETFs. Sure, compared to an index fund with a cost of less than 0.20%, the cost of a 2%+ annuity seems quite high. Yet when readjusted to the proper anchor – is the fee appropriate for the guarantees provided, the irony is that a large number of investors and planners actually seem to think the fee is too low, such that the annuity company is at risk and might not be able to make good on its contractual obligations! Which means, simply put, the appropriateness of the fee really needs to be judged relative to the annuity guarantees provided, and not referenced back to non-guaranteed alternatives; when we use the right anchor, sometimes we come to the opposite conclusion!

The short time horizon problem is the tendency to extrapolate whatever is going on recently into the indefinite future, and making decisions accordingly. Thus, as markets swing from bull to bear, annuities are varyingly judged to be too expensive (during a bull market when the declines that the annuity is protecting against seem remote, suggesting the fee is too expensive) or that the guarantee is too risky (during a bear market when the declines that the annuity is protecting against are so salient, it creates worry that the annuity company will not withstand the shock). In reality, the cost of the annuity should really be judged against the entire market cycle of bull and bear markets (at least, unless the investor is specifically trying to time the annuity purchase to the market cycle and buy in when the guarantee is undervalued), not just whether the market is in the midst of a short-term bull or bear cycle.

In any event, the bottom line is that annuities cannot simultaneously be too expensive and too cheap and underpriced; it’s either one or the other. As long as we compare them to inappropriate anchors and/or over unreasonably short (or recent) time horizons, though, we run the risk of coming up with these mutually exclusive conclusions and making poor decisions as a result. To make a proper decision, it’s crucial to really evaluate the value of the guarantees relative to what those guarantees provide – which ensures they’re not being evaluated in an apples-to-oranges comparison – and over a reasonable time horizon that acknowledges both the up and down cycles of the market.

So what do you think? Do you believe variable annuity guarantees are too expensive? Or that the companies are at risk and therefore that the annuities are too cheap and should have higher fees? How do you evaluate the costs of variable annuity guarantees? Over what time horizon? Do you have the same perspective on variable annuity guarantees and costs as your clients?

  • jeffe

    How about a third option? The expenses are enough to hedge against the risks in the products but the insurance companies misallocate funds to marketing and sales commissions. (I am not saying this is true. It is just another possibility.)

    • TFB

      I agree. It can be both when high expenses are paid to the distribution channel leaving the company with inadequate reserves.

  • Charlo Maurer

    Your reasoning does make sense, but it doesn’t make the annuities good investments. . I think the issue is that if a person is told that an annuity has a guaranteed return of 7%, with a fee of 3%, they don’t realize the effect of the fees on the performance. I have a client who had that exact offer in an annuity recently.

  • planner

    Respectfully Michael, I think we can eyeball VA expenses by running projections on income versus other means.

    We can also say it is too risky for the obvious reasons… companies dumped benefits and are looking to get these benefits off their books. They are telling us something by their actions. The risk to them is there; we shuold respond appropriately.

    Since we can’t know exactly what that is, we can guess. For example, with all the fancy ways of hedging an reinsuring coming under fire and possibly future regulation, the costs of these may skyrocket. There may be ways of heding that become so costly they can’t be used, or some may even be outlawed. You can say that projections for these products was appropriate at a time, but that it is risky.

    Risky actions can have a negative correlation with price, though I understand why annuities charge more of course. For example, I would want to pay less for a service that did not guarantee the outcome I wanted as much as an alternative. The poor use of the products to meet clients goals versus others makes them too risky and too expenses, though I again am not challenging your logic on the need to charge a high fees.

  • Robert Wasilewski

    Interesting. post. I tell my clients that VAs are expensive because they can be duplicated as you imply at a significantly lower cost but risky because the company can go out of business. It is important to stay under the state guarantee just as it is to be careful with the amount put into banks relative to FDIC guarantee . Because of the guarantee there is the usual moral hazard issue – consumers don’t do due diligence. My example is AIG.
    To me this isn’t an anomaly because insurance companies are in great position to exploit consumers lack of information. Show up with a $300,000 VA death benefit payout and you have an easy on-the-spot sale for a variable annuity.

  • Anonymous

    Think about a similar issue: The fact that a car company loses money on a model does not imply that the model is a good buy for the consumer. Similarly, the fact that a guarantee is expensive for the company does not make it a good value for the buyer.

    • Michael Kitces

      The issue of whether the value proposition is a good MATCH for the consumer is different than whether the product is overpriced.

      A Mercedes probably isn’t an affordable car for someone working at McDonalds. But that doesn’t mean the Mercedes manufacturers are overpricing the vehicle. It simply means that the Mercedes may offer features and benefits that the McDonalds employee cannot afford to pay for.

      Perhaps a better wording would have been “Annuities can’t be too risky AND too overpriced”?
      – Michael

  • Jason

    Michael – Your argument that VA guaranteed income riders are actually “cheap” if they turn out to be inadequate to support claims doesn’t make sense. If a VA owner pays for those riders for years only to be stiffed, doesn’t that make them expensive relative to what he ultimately receives! Do we pay those rider premiums for the warm fuzzy feeling along the way or for the income stream when we need it?

    I’d like to see more underwriting hisotry before buying these products. Not because the cost is too high today, but because I’m not confident that the model will work when we need it to.

    • Michael Kitces

      The point is, if you believe the VA owner is going to be “stiffed” you’re implying that the annuities riders should actually be MORE expensive (1.5%? 2%? 2.5%? 3%/year?).

      Of course people shouldn’t do business with companies that will be insolvent. But again, that’s the point. So to do business with companies that will NOT be insolvent, are you suggesting that people should only buy annuity riders that charge another 1% or 2%/year, “just in case”?
      – Michael

      • Jason

        Michael – My thought is that the law of averages can be applied to the longevity exposure associated with these guarantees. But what about the market risk? I think even the strongest P&C insurer would be in trouble if everyone’s house burned down in the same year. Even if their premiums were “expensive” relative to competitors.

        At the very least, I’d like to understand how the insurance companies offering GMIB can protect themselves from a prolonged period of bad equity returns in a low rate environment. I’m not saying it’s not possible, rather that I want to see how it works. Maybe they do it with complicated derivative hedging strategies and a team of mad scientists. If that’s the case sign me up! What could go wrong there?

        Great work on the website. Do you have a team helping you? You seem to be pumping out information at a super-human rate. Keep up the good work!

  • Jim

    “Of course people shouldn’t do business with companies that will be insolvent.”

    Michael, I think it was Mark Twain who said we should only buy stocks that are going to go up – and if they are not going to go up then we should not buy them! We do not know what will happen next month let alone in 30, 40, or 50 years.

    Like too many financial innovations, the risk/reward of these VA products is asymmetrical. First, many come with up-front commissions or back-end fees to the customer who has buyers’ remorse, so one reward – a big chunk of revenue – is going to the insurance company today for a promise in the [often very distant] future.

    A couple years ago I had to sit through a sales pitch for one of these VA products from a major firm. The salesman showed us a projection where my wife and I could roll over ALL our retirement savings into one of these products and if we never touched the money by the time we were in our late 90s we “could” “potentially” have ACUMULATED $3MM.

    Please note: we are not rich, and we have no children.

    This product was recently dropped by the offering company [like many other new products, for example many Long Term Care policies]. Current customers are being given another big sales pitch – no doubt for the next
    big new thing – and the company would really appreciate it if you would switch! Up-front fees are guaranteed. Everything else is risk.

    Annuity products of all types have not been so popular since the 1930s. Consumers afraid of stocks are buying anything else. There is a lot of fear that pensions or Social Security may not be around when it comes time to collect, so people are buying annuities [a non- company pension] that are “guaranteed” by states that are often in worse shape, financially, than the federal government.

    If we continue in this low interest rate environment – for example, like Japan – for a lot longer than most people expect, I think a lot of guarantees will turn out to be worthless.

    P.S. Very interesting thread! I was surprised by the very thoughtful replies on what is too often an emotional topic.

  • Robert Vogel

    Great post, Michael. This remind me of a great Seinfeld episode: You know how to make the guarantee, you just don’t know how to *hold* the guarantee and that’s really the most important part of the reservation, the holding. Anybody can just take them!

    It seems to me that when many advisors say that VA riders are too expensive, it is more a statement of value than the efficacy of the insurance companies’ business model. When they say it is too risky, then they are making a judgement about the business model. For me personally, no matter how cheap it was offered, I would not pay someone to mow my lawn. I mow it now for free, soon my son will be old enough to take it over, and when he is ready to leave the house I will be looking to downsize. Therefore incurring any cost for the benefit is too expensive to me. That doesn’t make any judgment about whether or not the lawn mowing company can actually operate on the fee they charging, it is a statement of value.

  • Anonymous

    Tell me what an alternative is for a retiree who needs a guaranteed income vehicle that has any chance to keep up with current and future inflation? That is the question and the problem.

    I am unaware of ANY fixed income vehicle on the street that currently has any more ability to achieve a guaranteed income stream function VA’s are offering. This is especially true when considering the monetary policy being implemented by the fed. Add to the fact that we aren’t just looking at market risk, interest rate risk, or inflation risk, BUT also LONGEVITY risk as well, and the options for retirees in the “investments” world become miniscule.

    Traditionally, retirement consisted of pensions, social security, and income producing fixed income investments such as bonds, CD’s, money markets, etc. Two of those legs on the stool have been sawed off, so again my question is WHAT IS THE ALTERNATIVE?

    Therefore, IMO, the RISKS associated to the investor of the VA becomes the only valid question on the subject IMO. The ability to deliver on the guarantee is underpinning question that must be answered by the person suggesting it, as well as the person purchasing the vehicle. The only way to know for sure is by conducting a due diligence of the VA provider company as well as any Parent Company it may fall under. That, IMO is what I would be looking for as an investor. What has my FA done in that regard, and what was the result?

    The critical and prudent items to determine, again IMO are:

    What is the overall health of the issuer? Credit Ratings are obvioulsy not enough, one needs to take a hard look at the balance sheets of the issuer (HOPING the books haven’t been “cooked,” but I digrees) and see what the situation looks like. Reserves, hedging strategy, questions about how other VA companies failed in their hedging and why ABC company is different, et all should be learned.

    What is the worst case scenario? That is the question I would propose to everyone from the wholesaler, regional VP, Senior VP, CFO, to the CEO. I would have their answerers documented if not recorded. Get a feel for the strategic planning involved their risk management from WITHIN the company as well as OUTSIDE. Research analyst reports on issuing companies are available, read them!

    State Guarantee programs. I would not take these at face value. Call your State Treasures office and ask for an “on the record” response on the health of these programs. If anyone hasn’t noticed, 3 major municipalities in CA have filed for bankruptcy….in the same month. The financial health of our States very well could be the shoe that drops, so I would want HEAVY confirmation on the balance of the fund that would cover a bankruptcy of the issuer. Know the limits of each State are different as well.

    Bankruptcy proceedings. What happens if ABC goes bankrupt? How can that happen? Would there be a like purchaser (usually is to prevent systemic risk in that industry with big carriers)? Would purchaser honor the outstanding debt obigations? What if it was the Parent Co. that went under (ex: AIG therefore Sun America – you are welcome btw, signed Joe Q. Public and The Fed)?

    These are all things one must consider, the fee argument is a joke! The S&P over the last 10 years has been FLAT 0%. The 10 year treasury is almost 0%. Inflation is guestimated to be around 3% (and if you believe it is that low you probably haven’t read this far anyway). Where else does the blue collar worker who retires with 300-500k in his/her 401k go? You tell me?

    The point of this semi-rant/advise is to quit wasting time pointing out problems in the world (one of the many problems in today’s society) and start providing solutions. That’s all I got, take it or leave it.

    God Speed!

  • Michael Kitces

    Except the costs of the rider have nothing to do with the compensation to the distribution channel (that comes from the base M&E, not the rider cost).

    And there are companies offering these guarantees that pay no commissions at all.

    The distribution channel discussion looks very much like a red herring to me.
    – Michael

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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