Over two and a half years ago, in the pages of this fine magazine, I described my Road-to-Damascus like conversion from a Variable Annuity (VA) critic to mild advocate. These products had become personal pensions in an era of declining corporate pensions. However, in the same piece, I also expressed bewilderment at the extra fees associated with VA benefits that promised a generous lifetime of income. While the conventional wisdom with all things VA related was that these products were expensive and overpriced, my “stochastic” analysis indicated that quite the opposite was the case. The so-called mortality and expense (M&E) fees were unreasonably low, compared to the cost of acquiring the economically equivalent “pension put options” in the open market.
And alas, as the last tumultuous year has illustrated, there was a clear disconnect in the design of these products. They were never meant to live through “Black Swans.” Indeed, the same annuity wholesalers who incessantly questioned financial advisors about their clients’ exposure to sequence-of-returns risk should have asked the risk management and folks within their companies the exact same question.
So, we are now experiencing a reverse arms-race of sorts. Insurance companies who aggressively competed with each other to offer more frequent step-ups or larger bonuses are now falling over each other to decrease their risk exposure. Only time will tell whether this new product equilibrium will contain enough value for the consumer to be worth the undoubtedly higher fees.
In my mind, though, it is a shame that the insurance and annuity industry have not taken advantage of the unprecedented turmoil, to make fundamental and structural changes – as opposed to piecemeal claw backs – to the entire product line.
With that in mind, here are my suggestions for structural changes to the “personal pension” business. I am not talking about miniscule changes to guaranteed interest rates, frequency of step-ups or nursing home waivers. I offer five ideas in increasing level of difficulty, which is a wish-list of sorts:
[1.] You are not Alone: Encourage a Product Allocation Approach, by Design.
As I have stated, I believe that everyone approaching retirement without a Defined Benefit pension, which provides the majority of retirement income needs, should seriously consider allocating wealth to an annuity with a lifetime income guarantee. But, at the same time, even under the most optimistic assumptions regarding annuities as a product class, issuers don’t advocate allocating more than 70% to 80% of a client’s liquid investable assets. So, why not start off and accept this premise in the product design phase? Offer a package that already combines mutual funds, basic income annuities and VAs, in one platform. The good news is that I am starting to see some insurance companies accept the “product allocation” approach by offering guidance that pre-exists the assumptions of other asset and product classes.
The take away here is not that some of your clients should have their money in a variable annuity, but rather that all of your clients should have some of their money in an annuity. The question is how much? And this is where the insurance industry must do a better job of explaining how their partial solution fits with many other solutions in the market place. This is the equivalent of the manager of a gold industry mutual fund acknowledging that the typical client should have around 5% in commodities, or the life insurance industry developing rules of thumb for how much life insurance a client needs. Right now variable annuity products are being designed as one-stop shops for diversified asset allocation, IRA rollovers, etc., when in fact they are a small part of a structured product allocation.
[2.] If you can’t beat ‘em, join ‘em: Offer a Full Menu of Passive Investment Funds
While I obviously don’t want to get ensnared in the active versus passive debate, or whether index funds outperform mutual funds, I think it is important to acknowledge that a very large segment of the investing public is growing increasingly skeptical of active management. The few managers who have managed to beat the SP500 over a statistically meaningful time period, fail remarkably in subsequent years. So, the underlying sub accounts must be…
[3.] A la carte buffet: Completely Disentangle Living and Death Benefits.
I understand the desire for life insurance and certainly understand the need for longevity insurance. I also accept the historical role of death benefits and its association with insurance companies. However, I strongly question the need to offer any sort of life insurance, especially if its elimination will save the consumer an extra 50 or 100 basis points in fees. In fact, even if the unbundled saving is lower, I think that the absence of a death benefit (other than the account value itself) sends a powerful behavioral signal to the advisor and the client this product is not about dying, but about living.
[4.] Sell Insurance: Offer Sequence-of-Returns Protection without Money Management
As it stands right now, investors and consumer who like the idea of protection and guarantees against adverse market conditions, must purchase this insurance together with the money management services of the insurance company and its asset managers. If you want the privilege of withdrawing 5% of your $100,000 nest egg for life, you have to hand over your $100,000 to the insurance company as well. But why must these two services be intertwined? Why not sell the insurance separate from the money management? With a bit of a stretch of the imagination, this is akin to the difference between buying a whole life insurance policy, or a UL policy — where the insurance company invests your premiums – versus term life insurance in which pure insurance is provided. Why not have the same with Guaranteed Living Income Benefits?
The way I see it, this type of product would unfold in a two step process. First, we would need a new index, perhaps called the SP500 withdrawal index that keeps track of portfolio withdrawals. Then, the insurance company would offer income annuities that start paying when this index hits a trigger value.
[5.] Spread it around: Have a Consortium of Insurance Companies Syndicate the Guarantee
My final recommendation might be the most difficult to implement but yet is motivated by the single most vocal concern from consumers and clients today: will the company be around to honor its guarantees in 20 or 30 years? The often heard question is usually followed with an (improper) reference to AIG, declining stock prices and increasing reserve requirements. The prudent advisor’s response explaining state guarantee associations, credit ratings and 150 year histories does little to alleviate irrational fears.
Think of the syndicated loan market. Large and rival banks – often archrivals — band together to spread the risk of making large loans, by breaking them up into little pieces which are parceled out to members of the syndicate. If the lender runs into financial distress or defaults, all members of the syndicate share in the exposure. Financial institutions understand and manage credit risk (for the most part), why shouldn’t consumers be allowed the same? It’s time for a syndicated annuity market.
Mr. and Mrs. Consumer would buy a generic variable annuity from a syndicate of 3-5 highly rated insurance companies. A guaranteed income stream would be determined at the time of purchase…Each company would agree to make a fraction of the payment, where the fraction is determined by the number of companies in the consortium. Alas, and this is the key part, if any one of the insurance companies defaulted, the other ones would step in to continue the remaining payments. The consumer is thus …
AN OPPORTUNITY TO FUNDAMENTALLY RETHINK
There it is: my wish list. In fact, I pledge here that the first company to design and market these types of products can use me as their poster boy for advertising, gratis. I’ll be the first in line to buy.
Critical readers might note that my wish list has been very careful to stay away from compensation issues. It would have been easy for me to follow the crowd and slip in some gratuitous comment about lowering fees, reducing surrender charges and slashing compensation. You don’t need me to remind you that in a zero interest Treasury Bill environment, every basis point counts. These are not economic product design issues. They are between ethical you and your knowledgeable client. This is not legislated or mandated…
From a big picture perspective, there are three participants in this relationship: the insurance company, the advisor and the client. Everyone has to eat right and everyone has to sleep tight. The risks and rewards must be allocated amongst these three parties. I call this a constant (as opposed to zero) sum game. If the insurance company withdraws a feature to reduce their risk profile, they are reducing the value to the consumer even if the new level of prudence ultimately …
With the above in mind, I have therefore decided to my restart my dormant monthly column in Research, to both help advisors better understand many of the complex aspects of VAs, and to advocate for some change in the industry. Feel free to comment. Stay tuned.
(This is a longer version of a condensed article that appeared on ThinkAdvisor.)