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Over the past 15 years, the variable annuity industry has experienced a tremendous amount of change - from the explosive rise of variable annuities with guaranteed living benefit riders for retirement income leading up to the fall of 2008, to the dramatic pullback of many insurers away such offerings in the aftermath of the financial crisis. While ultimately many annuity owners who purchased contracts prior to 2008 have been happy with their contracts and the guarantees, the same has not been true of the annuity companies who offer them, as a rising number of insurers have been offering buybacks to annuity owners that offer contract value increases or outright cash in exchange for releasing the company from their guarantees in order to reduce exposure. 

In a disturbing new trend, though, several annuity companies have begun to make changes to the investment offerings, ostensibly to simply change the lineup of funds being offered, but done in a way that increasingly appears to change the rules of the game for existing annuity holders after the fact. The first shot across the bow came earlier this spring from AXA, who in the process of rotating investment offerings in a 'routine' prospectus change indirectly defaulted a large number of annuity holders into more conservative investments than they may have originally selected (and often into their own affiliate-managed funds to boot). In a more concerning shift, now Hartford has decided to change its investment offerings as well, and actually require policyowners to voluntarily adopt the new investment offerings or lose their annuity guarantees! In other words, a number of contract owners with what were purported to be lifetime guarantees are now renewed to complete a "renewal" process by October 4th or permanently lose their lifetime income protection!

While such a move is certainly not popular, the reality is that because several companies making recent changes - including Hartford - are not in the business of offering variable annuities anymore, the potential fallout to the companies in damage to their brands is arguably limited. Nonetheless, this emerging trend to alter annuity contracts after the fact by changing the prospectus and attaching requirements to continue the guarantees puts new pressure on advisors to monitor on behalf of clients, and arguably even advisors who didn't originally sell the annuity could still be liable if they're engaged for ongoing monitoring of the client's comprehensive financial plan and miss a crucial change to the guarantee! As a result, advisors will need to be increasingly diligent in reviewing client annuity contracts, or look to outsource to due diligence services that can help to support the process.

Variable Annuities Over The Past 15 Years

Although the first Guaranteed Minimum Income Benefit (GMIB) riders on variable annuities came out in the late 1990s, the offers really gained popularity in the early 2000s, a combination of early baby boomers getting within striking distance of retirement, and the aftermath of the 2000-2002 tech crash that reminded investors that markets can go down as well as up. A few years after the crash, the first Guaranteed Minimum Withdrawal Benefit (GMWB) riders were released - generally viewed as an improvement or at least a simpler and more palatable alternative of their complex GMIB cousins - and the marketplace took off even further. By the financial crisis in 2008, nearly 90% of all variable annuities being issued had some for of Guaranteed Lifetime Benefit (GLB).

However, the reality that became apparent when the financial crisis hit was that some annuity companies were engaging in hedging strategies to manage their exposure to their guarantees, while others were not. Even companies that were seeking to protect themselves had not anticipated the extent and magnitude of the crisis that hit; with more than $500 billion of new variable annuity sales in just the 2003-2008 time frame, just a small amount of hedging leakage still had significant financial ramifications. Furthermore, in the aftermath of the crisis, it has become clear that many companies misjudged how many consumers would keep their contracts. As a result of the sometimes incomplete hedging and unexpectedly low lapse rates, some companies were forced to make tremendous allocations to reserves to back their guarantees after the market fell, resulting in a significant multi-year hit to profits. Variable annuity leader The Hartford was ultimately forced to seek liquidity from the Federal government to help manage its exposure, and overall the market capitalization of the 10 largest insurers fell by over 50% through the financial crisis.

In the wake of the 2008-2009 market crash, variable annuity companies have significantly shifted in their offerings of guarantees to new investors. Many companies have deliberately adjusted the offerings on their new contracts, with higher costs and lower guarantees, in an effort to stem the amount of flows coming in by making them less appealing. In some cases, the goal was to expand the profit margin - and therefore, the padding against uncertainty - of the products, while in other cases the rising costs and restrictions are simply reflective of the increased cost to manage and hedge risk in the post-2008 environment. In addition, most offerings also restrict the available investment options, forcing asset allocation portfolios that limit the risk exposure of the insurance company by limiting the exposure to equities and other risky assets in the annuity. And many annuity companies - including the prior market leader Hartford itself - have simply decided to stop offering variable annuities with living benefit riders altogether.

Handling Pre-Crisis Annuities In A Post-Crisis World

While the shifting variable annuity landscape has forced new buyers to assess their potential contracts and guarantees more carefully, the focal point for many companies has been not on how to handle the new contracts they offer, but what to do about all the existing contracts issued prior to 2008, many of which are still either "in the money" (where the contract is underwater relative to the guarantees) or at the least are offering more generous benefits at lower costs with fewer restrictions than what companies are willing to issue today.

For the past several years, annuity companies such as AXA, Hartford, Transamerica, and more, have sought to reduce their exposure to pre-2008 contacts by offering "buybacks" where annuity holders are credited with a lump sum that increases their current cash value, in exchange for agreeing to walk away from the prior guarantee. Consumers whose contracts weren't very far in the money, or whose needs may have changed since the contract was originally issued, could decide for themselves whether it was now more desirable to simply walk away. Unfortunately, though - at least from the annuity companies' perspective - buybacks have not reduced the exposure of the companies as much as was hoped for (although in the 4th quarter of 2012 variable annuities had a net outflow driven by buybacks), and contract persistency remains high; not surprisingly, many of the contracts with previously generous guarantees, that are now in the money, were contracts that the annuity owners have decided they want to hold on to, resulting in unexpectedly low lapse rates.

As a result, variable annuity companies are now exercising their rights in a more aggressive manner to manage their risk exposures. For instance, many contracts - especially those issued in the last few years leading up to the financial crisis - had options to increase the cost of the annuity riders "just in case" and companies are now exercising those options to increase the annuity costs. Similarly, some contracts had asset allocation restrictions that were not previously enforced against policyowners, but are now being applied, requiring the annuity owners to shift their investments to more conservative options, whether they wanted to or not.

Still not reduced risk exposure enough, though, some companies have taken to even more concerning steps in recent months. This spring, AXA Equitable started a new trend in announcing that the company had filed for updates to its prospectus that would change its investment line-up and impact about 500,000 annuity policies; while nominally the purpose of the change was to eliminate some old fund options and offer new "better" ones, in many cases the replacement funds were more conservative than the original ones, indirectly defaulting (or sometimes forcing) annuity holders to become more conservative, even if they didn't want to. In addition, some of the default replacement funds also offered a new "volatility management" feature that would essentially allow the company to change the allocations of its investors at the fund level since many older contracts didn't otherwise have provisions to allow the company to change the allocations at the contract level. Furthermore, it was notable that many of the prior third-party investment offerings were outright swapped out for AXA's own funds or those of its affiliate companies. In other words, since AXA's risk exposure couldn't be managed by forcing annuity owners to make allocation changes, it forced the result indirectly by altering its prospectus to limit the investment offerings.

And unfortunately, it turns out that AXA's decision to change its prospectus as a way to alter the contract offerings after the fact may have been the tip of the iceberg. In recent weeks, Hartford - which has stated on the record that "we are determined to reduce the size and volatility of our legacy annuity liabilities" announced its own prospectus-driven changes, which are even more severe than AXA's. Not only will the company be applying investment restrictions to its allocations, force annuitization for older policyowners who reach the required starting date, and eliminate many favorable features - which were permissible under the original contract as issued - but the Hartford also announced that it will change its investment options as well. And in perhaps the most shocking step, Hartford announced that policyowners who don't voluntarily opt in to the new investment choices by October 4th, and move at least 40% of their holdings into bond funds, will lose their existing variable annuity guarantees; in other words, through prospectus changes, Hartford just created a requirement to renew what was previously supposed to be a guaranteed lifetime income rider! An estimated 60,000 clients will be affected by at least some of the proposed changes.

Annuity Outlook And Concerns From Here

The shifting environment for annuities has placed a new series of burdens and risks on the shoulders of financial planners, including those who have sold annuities in the past and those who have not. The issue - especially in the case of the latest change by Hartford - is that the failure of a policyowner to act can result in the permanent loss of their lifetime guarantee, and if such a lapse occurs, there's a risk that the current advisor may be blamed for the failure. In fact, several broker-dealer executives have been pushing back against the Hartford, concerned about the burden placed on the financial advisor to reach every policyowner by October 4th to avoid the lapse of their guarantees, or risk a lawsuit from the policyowner in the future if the rider lapses accidentally.

However, arguably even a current advisor who didn't sell the annuity could face liability for failing to advise the client to take the steps necessary to ensure the continuation of the guarantee, especially if the advisor is otherwise being paid for ongoing investment management and monitoring. In a world where these kinds of annuity changes may occur with increasing frequency - given Hartford's decision to implement prospectus changes after AXA, it may mark the beginning of a more aggressive trend by companies to reduce their annuity exposures through prospectus changes and scenarios where clients are defaulted out of their guarantees unless they act - even fee-only advisors may have to be more cautious than ever to do effective due diligence in reviewing existing variable annuities and crafting appropriate strategies. Alternatively, this rising liability exposure of advisors to oversee annuities - even potentially those they didn't sell originally - may increase the appeal of services like Annuity Review, which offers to become a Broker of Record of existing annuities to help the non-sales advisor monitor the contracts on an ongoing basis. Especially since the earliest announcements of the Hartford changes were made not to the policyowners, but the brokers of record on the contracts (in fact, the first notice of this issue came to my attention through Annuity Review expert Mark Cortazzo).

Beyond the risk that more insurance carriers will take aggressive stances in trying to change existing variable annuities through prospectus changes, the current environment provides an important reminder that due diligence on annuities and their guarantees are crucial, to ensure that the company is not overpromising on benefits that it cannot deliver. In today's environment, annuity companies are increasingly leaving themselves options in the contract provisions to change the terms, to avoid the risk to the company of being caught on the hook - but such changes also mean there is arguably an increased risk that companies may alter the rules of the game for today's annuity buyers after they purchase, potentially resulting in a scenario where the guarantees or returns don't turn out as favorable as originally anticipated (with little recourse for the investor). And in many cases, the best option for the client is specifically to not walk away - in fact, the whole point of this process from the annuity company's perspective is to encourage consumers to lapse what are otherwise very favorable guarantees on their behalf! To say the least, deciding what to do requires a thorough analysis of the available strategies for existing GMIB and GLWB riders (which often are to keep the contract and begin guaranteed withdrawals, not surrender them!).

The bottom line, though, is simply this - if you're dealing with clients and annuities at all, whether offering them new contracts or simply doing work with clients who have existing annuities, the pressure is on right now for an increasingly proactive monitoring process to ensure that clients don't accidentally lapse their guarantees, especially if more and more companies begin to alter their prospectuses in the coming years as they try to reduce their exposure to guarantees. On the plus side, it appears that regulators are finally starting to take notice of these prospectus changes that seem to be changing the rules of the game after the fact, in ways not originally anticipated. Nonetheless, the changes are happening, and while they are unpopular, in many cases - including with Hartford - the companies are no longer in the business of offering annuities anyway, which means they may be less concerned about making such unpopular decisions. In the meantime, though, expect to see a continued rise of "next generation" annuities focused on delivering benefits through alternative means - such as providing tax deferral for higher return alternative investments as an asset location tool - where annuity companies can generate a modest profit for insurance companies but without the risk exposures of significant living and death benefit guarantees!

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  • andrew peters

    Thanks for the thorough insight as usual.

    While companies like Hartford may no longer be in the “business” it sounds like the advisors are being hung out to dry on this one.

    If it becomes so time/cost prohibitive to proactively monitor a client’s VA, I wonder if holding one will cause advisors to increase their fees or avoid the client all together.

    Sounds like a good opportunity for a specialist service to enter the marketplace and focus on ongoing monitoring/notification for existing VA products. Maybe this would reduce the liability for advisors?

    In any event, it seems that with so much capital in play this is going to affect a lot of people and may leave the industry with yet another black eye.

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  • Brad Nichols

    Thanks for the article, Michael.
    Wouldn’t it go to say that, because a lot of these GMIBs require a contract holder to actually annuitize their contract, many of these guarantees have never been/will never be realized? That is based on the extremely low percentage of variable annuity contracts as a whole that ever annuitize.
    Why would a financial advisor sell something when they know that there is a distinct potential that the benefit, which they pay for, will never be realized?
    I think I know the answer.

    • Michael Kitces

      The point of these contracts it that they would be annuitized because the cash value has been depleted, and the individual has to rely on the GMIB guarantee. These contracts will not necessarily have any relationship whatsoever to the standalone annuitization rate for deferred annuities (which you correctly note is very low); this is an entirely different context. If your plan was to actually annuitize your cash value in the first place, you would never want to buy a GMIB anyway, as the guaranteed annuitization rates in a GMIB are generally worse than going market rates anyway.
      – Michael

  • Michael Kitces

    The Annuity Review service I mention in the blog post is actually partially doing that ongoing monitoring/notification service already. They become broker of record on the contracts so that they receive updates (which is how they got advance notice of the Hartford changes), and then notify the advisors so the advisors can decide how to proceed with their clients.

    I would imagine that for some advisors, these kinds of challenges will make them far less inclined to use annuities in the future, given the stress and challenges that decisions like Hartford’s are producing. Which I actually view as unfortunate, because they are some very positive virtues for variable annuities used in appropriate situations.
    – Michael

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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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