Since the tech crash, it has been increasingly popular to purchase variable annuities with “guaranteed living benefit” riders to help protect retirement income against the risk of a market catastrophe. The basic premise of the contracts is rather straightforward: for a modest cost, the insured can transfer the risk of a severe market decline to the insurance company, and remain assured that guaranteed retirement income will be available for life, undiminished by the market decline. In the meantime, the annuity owner has the opportunity to stay invested in the market, with the hopes of generating an ever greater upside (albeit reduced by the costs of the annuity).
The problem, however, is that unlike most types of insurance – where the law of large numbers allows the insurance company to have relative certainty about the timing and magnitude of potential claims – in the case of annuities with income guarantees against a market decline, the insurance company faces virtually no risk exposure for any of its policyowners, until a major market decline actually occurs… and then, suddenly, the insurance company must set aside reserves for everyone, all at once. The end result is that market volatility can end out creating drastic volatility in the required reserves and profitability of the insurance company – to such an extent that in the past several years, many major insurers have decided to stop offering the guarantees altogether.
In the aggregate, the problem is that having a large group of prospective policyowners transfer their exposure to market risk to the insurance company may seem like the risk is being transferred from the policyowner’s perspective, but the risk is actually being concentrated from the insurance company’s perspective, in a remarkably undiversified manner. As a result, the policyowners actually face the danger of turning what was a systemic risk exposure to overall markets into a very specific, undiversified, unsystematic risk exposure to the credit quality of a particular (insurance) company instead. And for those who fear the danger of a “black swan” event, the reality suddenly becomes clear that the kinds of black swans that could be a blow to markets may actually be an even more severe blow to the insurance companies trying to guarantee against them, as was evidenced by the need of at least one annuity provider to access Federal TARP funds for liquidity in the immediate aftermath of the financial crisis.
Ironically, it turns out the best alternative may simply be the solution that advisors recommended before such annuity contracts were available in the first place: to invest more conservatively, and spend more conservatively, and simply stay the course and weather the storm. After all, conservative spenders following a safe withdrawal rate approach have largely recovered their declines since the financial crisis, while many insurance companies have left for good; similarly, while the safe withdrawal rate weathered the Great Depression, many insurance companies did not. Of course, in today’s marketplace, the annuity companies have finally figured out how to proper structure, constrain, and price annuity guarantees to manage their risk exposures and make the products economically feasible to be offered; yet the outcome of such pricing may be leading to the point where their floor-with-upside guarantees are no longer an appealing trade-off for the (new) cost.