The Retirement Conundrum
With more employers phasing out defined benefit pension plans, retirees will continue to have significantly greater responsibility for maintaining their retirement nest egg in later years, whether through 401(k) plans, IRAs, or general savings. Historically, retirees took a conservative approach to investing during retirement. However, because retirees live longer (20-30 years typically spent in retirement), nest egg distributions need to last longer. With retirees' increased life expectancy and their inability to rely on the guaranteed cash flow from defined benefit plans, financial planners often recommend greater allocations to equity investments. With greater equity allocations, though, comes the risk that a significant investment loss in the early years of retirement distributions will permanently scramble the nest egg. Once a nest egg enters the distribution phase, early investment losses are difficult to make up.
The industry created product solutions to address this problem during the last decade in the form of guaranteed living benefit riders attached to variable annuities. Because these riders provide a safety net in the event of sub-par investment returns within a variable annuity, retirees and near- retirees can more confidently allocate more of their nest egg to equity investments. The two most common forms of guaranteed living benefits have been the Guaranteed Minimum Income Benefit (GMIB) and the Guaranteed Lifetime Withdrawal Benefit (GLWB). Brief descriptions follow.
In the GMIB design, the insurer creates a 'phantom account' called a Benefit Base. On the effective date of the Benefit Base, the Benefit Base equals the variable annuity account value. Typically, the Benefit Base will have two components: a 'Roll-Up' component and a 'Maximum Anniversary Value' (MAV) component. The Roll Up component increases each year by a contractually promised rate for a pre-determined period. In a typical MAV component design, the insurer reviews the annuity's account value on each contract anniversary. If the account value is higher on the current contract anniversary than the initial account value or previous contract anniversary, the MAV component is adjusted to equal the account value on the current contract anniversary. The Benefit Base is then adjusted to equal the greater of the Roll Up component or the MAV component. If the MAV component is higher than the Roll Up component, many GMIBs allows the contractowner to elect to 'reset' the Roll Up component to equal the MAV component.
After a waiting period usually of 10 years, the contractowner may elect to annuitize the contract under the GMIB. The insurer calculates the monthly benefit produced by annuitizing the contract's then account value. The insurer then calculates the monthly benefit produced by annuitizing the Benefit Base. The contractowner receives the higher of these two amounts. Importantly, however, the annuity purchase rate factors used in determining the monthly benefit produced under the GMIB are more conservative than the annuity purchase rate factors used in determining the monthly benefit produced by annuitizing the account value. Conceivably, a Benefit Base of $110,000 could produce a monthly benefit that is less than the monthly benefit produced by an account value of $100,000.
In the GLWB design, the insurer likewise creates the phantom account Benefit Base. On the effective date of the Benefit Base, the Benefit Base equals the variable annuity account value. The Benefit Base will typically increase in a manner similar to a GMIB design, but a number of variations exist. Beginning at a specified age, the contractowner may withdraw from the account value up to a fixed percentage of the Benefit Base (e.g. 5%) each year. Until very recently, the fixed percentage was purely age-based, usually determined either by the owner's age on the GLWB effective date or by the owner's age at the time of first withdrawal. As long as the withdrawals do not exceed the fixed percentage limit (so-called 'compliant withdrawals'), withdrawals will continue for the life of the owner (or in the event joint life coverage is elected, for the lives of both owners) even if the cash value is fully depleted.
The charge for these riders -- typically ranging from 0.75% to 1.30% of the Benefit Base annually -- is subtracted from the account value. These riders have many moving parts, adding to their complexity. Consider:
1. In both GMIB and GLWB riders, there may be restrictions on the kinds of underlying funds in which the contractowner may invest.
2. Under most GLWB riders, withdrawals in excess of the fixed percentage limit or made before the specified age will reduce the Benefit Base on a proportional basis.1
3. Under most GMIB riders, withdrawals will typically reduce the MAV component on a proportional basis and withdrawals in excess of a GMIB Roll Up rate will reduce the Roll Up component on a proportional basis.
4. Under GLWB riders the specified age to begin making 'compliant withdrawals' typically begins at around age 60. If joint life coverage is elected, the specified age is determined by the age of the younger joint life.
5. Resets to Roll Up components under a GMIB rider usually result in a new waiting period before the GMIB may be annuitized, and may permit the insurer to increase the rider charge prospectively.
State Insurance Regulatory Issues
Although variable annuity guaranteed living benefits provide significant protection to consumers, their complexity makes variable annuities with living benefits ripe for customer complaints and regulatory actions.
Most states have promulgated some form of annuity suitability regulation usually patterned after the NAIC Suitability In Annuity Transactions Model Regulation, originally adopted in 2003, and revised in 2006 and 2010 ('Model Regulation'). The 2010 Model Regulation iteration significantly strengthened consumer protections. It provides in part that in recommending to a consumer the purchase or exchange of an annuity, the producer, or the insurer where no producer is involved, must have reasonable grounds for believing that the recommendation is suitable for the consumer as to his or her financial situation and needs, and that there is a reasonable basis to believe, among other things:
∙ The consumer has been reasonably informed of the various features of the annuity, potential charges for and features of riders, insurance and investment components, and market risk;
∙ The consumer would benefit from certain features of the annuity, such as tax-deferred growth, annuitization, or death or living benefits;
∙ The particular annuity as a whole, and riders and similar product enhancements, if any, are suitable for the particular consumer; and
∙ In the case of an exchange or replacement of an annuity, the exchange or replacement is suitable taking into account whether the consumer will lose existing benefits (such as death, living or other contractual benefits under the old annuity), be subject to increased fees or charges for riders and similar product enhancements in the new annuity, and actually benefit from any product enhancements in the new annuity.
Under the 2010 Model Regulation, the consumer's actual understanding of living benefit riders plays a large role in determining whether the sale is suitable. Because of the complexity of these riders, it is not uncommon for consumers to misunderstand the features, leading to customer complaints. Typical complaint allegations include:
∙ 'I thought my account value was guaranteed to grow by 5% each year.'
∙ 'I have a GMIB rider. When I annuitized my contract, the Benefit Base was $200,000 and the Account Value was $180,000. I don't understand how it is possible for $200,000 to produce a smaller monthly annuity benefit than $180,000.'
∙ 'I have a GMIB rider. On my 7th contract anniversary strong stock market performance caused my account value to increase by 30%, and my roll up component was reset to equal the account value. Since that time, in the past 2 years, the stock market has reversed and my account value is down 35%. I need to annuitize my contract now, but I'm told I have to wait 8 more years before I can annuitize under the terms of the GMIB. Where's my downside protection?'
Not only can the complexity fool the consumer, it may also fool the producer or the insurer. Assume a variable annuity with a GLWB rider is purchased within a qualified retirement account such as an IRA, and the specified age to begin taking compliant 5% benefit base withdrawals is 60. The owner is age 69 at the time of purchase and elects joint life coverage with a spouse age 53. Unless the retirement account is a Roth retirement account, required minimum distributions will need to be taken from the account by April 1 of the year following the year in which the owner hits age 70 ½. In this situation, unless the owner can satisfy the RMD from some other retirement account, RMD withdrawals will need to be taken from the annuity, and since the specified age will have not yet been met by the younger spouse, each RMD mandatory withdrawal (until the younger spouse reaches age 60) will reduce the benefit base on a proportional basis. Such a situation would appear to be on its face an unsuitable sale for this particular consumer.
Impact of Financial Crisis On Variable Annuity Writers
Notwithstanding the potential for customer complaints, consumers who purchased variable annuities with a guaranteed living benefit before the financial crisis took hold in 2008 were well protected, as the riders performed as promised. Not so well protected, however, were many insurers who provided these benefits and were in the midst of an 'arms race' to determine which insurers could create the most popular (usually most generous) living benefit. In the immediate aftermath of the financial crisis, significant numbers of contractowners were 'in the money,' i.e., their benefit bases significantly exceeded their account values. Insurers, on the other hand, were forced to increase reserves in their general accounts to make up for the shortfall, and, due to the generally very low interest rate environment, the hedging costs to provide these benefits soared.
As a result, beginning in 2009 insurers providing guaranteed living benefits conducted a quick 'triage' approach to product design by reducing the richness of these benefits and charging more for them. In addition, greater asset allocation restrictions were imposed to curtail the ability of contractowners to invest heavily in equity funds. Among the ways insurers adjusted benefits on the triage basis for new sales included:
∙ Reducing the annuity purchase rate under the GMIB
∙ Reducing Roll Up rates and Roll Up periods
∙ Reducing GLWB compliant withdrawal rates by at least 1%
Recommendations to exchange or replace an existing variable annuity containing a pre-financial crisis living benefit with a new variable annuity containing a 'triage-revised' living benefit may be more likely to be found unsuitable since the new product as a whole would appear to have inferior features and higher costs compared to the existing annuity. Broker-dealers supervising these sales and insurers monitoring these sales should carefully review such transactions.
More Sophisticated Product Design
More recently, many insurers have comprehensively altered the overall design of their living benefits to better manage their risk exposure. For example, some new GLWB riders vary the compliant withdrawal percentage rates based on a combination of age and an external interest rate index such as the 10-year Treasury rate. Other living benefit riders provide for automatic transfer of sub-account values from equity funds to more conservative fixed income or stable value funds based on a pre-determined formula that assesses the relationship between a contract's benefit base and its account value and the current direction of equity and fixed income markets. Such formulas tend to limit the upside potential of account value growth while continuing to provide account value downside protection. Similarly, some insurers achieve a comparable result by offering underlying funds with risk mitigation built into the funds themselves.
Lastly, some variable annuity insurers wishing to reduce their direct risk to guaranteed living benefits in their in-force block are providing 'buy out' offers to contractowners. Under one such offer, the insurer allows owners of variable annuities with a GMIB rider whose contract surrender value is 80% or less than the GMIB Benefit Base the option to surrender or exchange their annuity and receive an enhancement to their contract's surrender value of 80% of the Benefit Base less the surrender value. For example, assume the Benefit Base is $200,000 and the surrender value is $120,000. If the owner accepts the buy out, he would receive an enhancement to the surrender value of 80% of $200,000 [$160,000] minus $120,000; thus, $40,000. Total proceeds would be $160,000.
Several state insurance regulatory issues are raised. Most obvious is whether the transaction is suitable under applicable state insurance regulations. The 2010 iteration of the Model Regulation applies to recommendations to 'purchase, exchange, or replace' an annuity contract. If under a buy out scenario the contractowner will be exchanging the old annuity (enhanced by the buy out) for a new annuity, clearly the 2010 iteration of the Model Regulation would apply to the transaction, and the contract to contract comparison analysis described earlier would need to be conducted. Note, however, an outright surrender of the old annuity for cash would not be covered under the Model Regulation.2 In situations covered by the Model Regulation, insurers would be well-advised to provide as much disclosure as possible on the pros and cons of any buy out, so that contractowners can make informed decisions.
More subtle in the buy-out scenario is the potential applicability of state anti-discrimination and anti-rebating statutes. Section 4(G)(1) of the NAIC Model Unfair Trade Practices Act ('Model UTPA') defines unfair discrimination as 'making or permitting any unfair discrimination between individuals of the same class and equal expectation of life in the rates charged for any life insurance policy or annuity or in ¦ other benefits payable thereon, or in any other ¦ terms and conditions of such policy.' Whether the Model UTPA is violated depends on the determination of 'class' and whether members of the class are treated unfairly. The validity of the class of contractowners who receive the buy out offer is crucial. The broader the class, arguably the more likely the class will be found to be valid. However, if the class becomes too broad, it may create issues under the suitability model in connection with those contractowners who receive a buy out and elect to replace the existing (now enhanced) annuity with a new annuity. A careful examination of what the contractowner is giving up, and what the contractowner is getting in return, is critical. It would appear that buy outs can be appropriate in limited situations where the contractowner's financial situation has changed and the protections that the living benefits afforded are no longer needed.
Where a contractowner is offered and elects a buy out, receives an enhancement, and replaces the existing annuity with another issued by the same insurer, the insurer may have potential exposure for violating the anti-rebating statutes. Section 4(H)(1) of the Model UTPA defines rebating as 'knowingly permitting or offering to make or making any life insurance policy or annuity, ¦¦ or agreement as to such contract other than as plainly expressed in the policy issued thereon, or paying or allowing, or giving or offering to pay, ¦ directly or indirectly, as inducement to such policy, any rebate of premiums payable on the policy, or any special favor or advantage in the ¦. benefits thereon, or any valuable consideration or inducement whatever not specified in the policy; ¦.. or anything of value whatsoever not specified in the policy.' The rebate language is very broad. Here, a state insurance regulator could arguably assert that the insurer has provided a benefit (the enhancement) not specifically provided under the existing contract, and has provided that benefit to induce the contractowner to purchase the new contract issued by the same insurer.
The variable annuity landscape has changed considerably since the 2008 financial crisis. However, the need of retirees and near-retirees to have a vehicle available to invest a portion of their nest egg in equities, while maintaining a lifetime income safety net, will only continue to grow. It is likely insurers will continue to meet this demand by redesigning living benefit riders until an optimal balance between insurer risk mitigation and consumer benefit is achieved.