Regular readers of this column know I have no love affair with variable annuities, an investment “product” dreamed up by insurance companies.
Recently, a colleague told me his wife had put most of her retirement savings in an investment suggested by an insurance agent we’ll call “Mr. X.” The agent told her the investment would generate stock market-like returns but, in the worst case, would guarantee a life-long withdrawal rate of 7 percent. What did I think?
My immediate reply was, “That’s impossible.”
What my colleague’s wife purchased was a variable annuity with a “guaranteed minimum withdrawal benefit.” This product, brought to market by insurance giant Hartford in 2002, has proven to be very popular. Indeed, other insurance companies have leapt into the market, leading to an arms race of sorts to offer more generous guaranteed withdrawals at lower prices.
Here’s how these guarantees work. Suppose you invested $100,000 in a variable annuity issued by an insurance company in 2007. The issuer placed your money in a “separate account” for you, meaning the funds weren’t pooled with the issuer’s general funds. You then allocated your separate account among the various mutual fund-like investments offered by the insurer.
Now it’s 2009, and after a tough couple of years in the market, the value of your separate account has declined to $70,000. No worries. You’re still entitled to the guaranteed withdrawal benefit of 7 percent of your original principal, or $7,000 per year withdrawal when you elect to convert your variable annuity to a fixed lifetime payout. But if you do that now, the $70,000 in your separate account is not enough to purchase a $7,000 annual lifetime payout, so the insurance company has to make up the difference.
There’s the rub. The insurance company must cover that difference, not just for you but for the bulk of its annuity buyers, whose separate accounts are all down in value. The more the markets decline, the more the guarantees are worth to the annuitants and the more likely they’ll exercise their right to convert to guaranteed annual payouts.
The normal practice of the insurance company issuing the annuity is to cover its minimum withdrawal guarantees using put options. A put option is a financial derivative that gives the holder the right, but not the obligation, to sell a security at a predetermined price for a specified period. In seeking to avoid having to dip into its capital to fund your withdrawal guarantees, the issuer purchased a put option on a broad stock market index such as the S&P 500.
In our example, let’s assume that when you bought the variable annuity, the insurance company bought an S&P 500 put option with a strike price equal to the value of the index at the time of purchase. For simplicity’s sake, let’s assume it costs the issuer 1 percent annually of the amount insured ($100,000) to maintain that option position. Variable annuities aren’t free, of course—the issuer typically charges your account somewhere between 2 percent and 3 percent of your original investment annually. And put options aren’t free, either, so the issuer tacks on the 1 percent annually as an additional fee to cover the cost of the guarantee.
Those who trade in options know that market volatility is a key element in how options are priced. The more volatile a market, the more it costs to maintain a position using options. As market volatility has skyrocketed over the past year, so too has the cost of maintaining option positions to cover withdrawal guarantees.
The annuity issuer now faces a difficult choice. It can pass the increased cost of the guarantee on to you, further eroding the value of your separate account and increasing the likelihood you’ll convert your variable annuity to a lifetime guaranteed payout. Or it can reduce the volume of options it purchases, increasing the risk the issuer will have to dip into its capital reserves to pay the guarantees.
Exposure to growing risk from variable annuity guarantees has led rating agencies to lower the credit ratings of many insurance companies that have been most active in peddling these products. On February 6, Moody’s lowered Hartford’s senior unsecured debt rating to “Baa1,” or low investment grade, down two rating levels from where it was just last October. AIG, the second most active firm in this area, which once proudly advertised its AAA credit rating, was downgraded by Standard & Poor’s to A- in October, with further downgrades likely.
Declining credit ratings are a serious problem for an insurance company. Astute agents will advise their life insurance clients to switch their policies to a financially stronger company, if possible. Those who, for health reasons, are no longer insurable will remain with the lower-rated company, increasing the likelihood of death benefit claims and further jeopardizing the credit rating.
This downward quality cycle has devastated the stock prices of many life insurance firms once considered to be of the highest quality. The Hartford, for example, has seen its stock price decline more than 90 percent from a peak of about $105 a share in May 2007 to around $10 (Hartford traded as low as $4.16 a share last November). Other examples are Principal, whose stock is down 85 percent since December 2007, and Lincoln National, which has seen its shares plunge 82 percent since May 2007.
Investors should look at guaranteed minimum withdrawal benefits and any other guarantees available from variable annuity issuers the same way they do life insurance. That is, you’re ultimately dependent on the creditworthiness of the insurance company to get paid. You should diversify your holdings among several insurance companies chosen from among only those with the highest credit ratings. Variable annuities usually come with surrender penalties, making you weigh paying a penalty equal to a few percentage points of the value of your separate account against the possibility that the issuer of your annuity will be unable to honor its guarantees.
