If you’re familiar with the 4 Buckets Income Strategy then you’ve heard us discuss the importance of guarantees for added security on retirement income. Now we need to know how good those guarantees are.
Insurance companies back their contracts based on their “full faith and credit.” Let’s break that down. “Full faith” means that they’ll operate their company responsibly so that you can put your faith or trust in them. Or in other words, they’ll carry out their duty as a company faithfully. Well, who doesn’t do that? And even if a company doesn’t, wouldn’t they say they did anyway? It’s one thing for me to say that to you – “we conduct our business honorably and faithfully.” We have a reputation on the line and you “know where we live” so to speak. When you work with someone face to face there’s accountability that’s just not there when you’re a dollar liability on a billion-dollar balance sheet. With large, faceless companies the faith element of a guarantee can be a difficult thing to lean on.
So, if you have no ability to hold a large business accountable, then who does?
That’s one positive of a capitalist economy. Businesses are driven by their desire for profit and competition creates an environment where those companies most attractive to their consumer typically win. This is the essence of market forces and you play a part in that. Companies that don’t operate with innovation and efficiency will produce less profit, lose value on their share price, employees will get paid less and employees will leave. At this juncture, a company’s management decides to right the ship or surrender (get bought) to some other company more willing and able. As a consumer you control where your dollar goes and those companies most attractive to you are the ones that get it.
Now, let’s talk about the “Credit” element behind these full faith and credit guarantees. A company’s credit refers to their financial health. As a contract holder with an annuity company, you are a liability on the company balance sheet and companies must be positioned to meet your obligations.
There are several financial ratios to measure the health of an annuity company, but a helpful figure is the Comdex rating which is a composite of the four major rating agencies: A.M. Best, Fitch, Moody’s, and Standard & Poor’s (S&P). Each rating agency evaluates insurance companies based on their financial strength, claims-paying ability, and other factors that indicate their ability to meet their obligations to policyholders. The Comdex score is expressed as a percentile ranking, with 100 being the highest possible score. If you don’t want to dig into spreadsheets, then this is a helpful reference.
Now, whether ratings agency are doing their job on evaluating companies is another topic. Hopefully they learned their lesson from the defaults within MBS and CDOs during the Great Financial Crisis.
Insurance Industry Regulation
In addition to accessible financial data and ratings agencies, annuity companies are regulated through state guarantee commissions and in conjunction with the National Association of Insurance Commissioners (NAIC). These overseers establish thresholds for financial and contractual standards in the industry. Similar FDIC-type insurance is also in place to serve as a stop-gap to contact-holders in the event of insolvency. In our home state of Virginia, annuity holders are protected through the Virginia Life, Accident, and Sickness Insurance Guaranty Association (VLASIGA). Under Virginia law, the protections offered by VLASIGA include coverage for up to $250,000 in withdrawal and cash per contract up to a total of $350,00 of protection per individual. The existence of this coverage is not a reason to utilize an annuity no more than FDIC coverage is a reason to have a savings account at a bank. These institutions provide a product/service that you need but you should also know what protections exist should they fail.
Insurance Company Operations
It’s also important to understand how annuities companies operate. Why? Because as you implement the 4 Buckets Income Strategy, you are relying on an insurance company in Bucket 3 to pay you for the rest of your life. And your lifetime, as we reiterate time and again, is an unknown. You may live to 95 or 125. An insurance company needs to be positioned to pay you regardless of how long or short your specific life span.
Creating an Annuity Contract
Many insurance providers will offer both life and annuity products because in many ways these both hinge on the same statistical dataset – human mortality. Here we’ll focus on the management of insurance company’s annuity book of business.
Insurance companies use a process called underwriting to evaluate the risk associated with issuing annuities and to determine the appropriate pricing of the product. Here are the steps involved in underwriting an annuity pool:
Gather data: The insurance company doesn’t know who will be a part of the pool but they can accurately guess their profile. Therefore, they collect data on the profile of these individuals. This data may include age, gender, health status, and other relevant factors that may affect the life expectancy of the pool.
Determine mortality risk: Using actuarial tables and statistical analysis, the insurance company estimates the mortality risk associated with the annuity pool. This helps to determine the amount of money that the insurance company will need to pay out in annuity payments.
Determine interest rate risk: Insurance companies also need to assess interest rate risk, as changes in interest rates can affect the value of the annuity pool. The insurance company will typically use financial models to evaluate the potential impact of interest rate fluctuations*.
*Did you catch that? Insurance companies also face interest rate risk just like you do if you’re a retiree holding bonds. This risk is the movement of rates up or down affecting the value of bond holdings and impacting distribution outcomes. It’s not hard to imagine that insurance companies are much better suited to manage this risk than a retired individual.
Set pricing: Based on the estimated mortality risk and interest rate risk, the insurance company will determine the pricing of the annuity product. This pricing will take into account the amount of money that the insurance company will need to pay out in annuity payments and the expected return on the pool’s investments.
Insurance Company Accounts
There are two primary accounts inside an insurance company – the general account and the separate account. The funds in the general account are used to support the insurer’s various obligations, such as paying out claims, providing policyholder benefits like fixed rate returns, and meeting its contractual obligations to annuity holders (lifetime income). An annuity company will use the assets in the general account to invest in a variety of financial instruments in order to generate returns, which help it meet its financial obligations to policyholders.
The separate account of an annuity company is a type of investment account that is established to support certain annuity products, such as variable annuities. Unlike the general account, which is a pool of assets that supports all of an insurer’s products, the separate account is essentially pass-through. The contract owner is the holder of the underlying investments in the separate account contributing to their “liquidity” feel.
The contract owner experiences the same gains, losses and fees as they would in a non-annuity investment account. The insurance company will charge their fees against the separate account. Variable annuities in their most suitable form have riders attached to them which provide lifetime income guarantees. And these guarantees are liabilities that are met by the general account. I know that’s confusing – you hold investments made available through the separate account but have an attached guarantee supported by the general account. What that all means, is that the general account and how it is managed is what really matters.
Managing the General Account
An insurance company will invest the funds received from contract-holders in a manner that they can remain profitable and meet their obligations. We’ve talked about how bonds are not an ideal asset class of a retiree. That is because of two key risks that present themselves to retirees in the income phase of their life – interest rate and longevity risk. On the flip side, bonds are the preferred investment for insurance companies.
The general account will typically consist of 75% or more in bonds and these bonds themselves are primarily corporate bonds. Corporate bonds range in quality and features that determine their yield.
But, retirees can invest in corporate bonds too? Yes and no. The corporate bonds that most retirees have access to are in the form of index funds. These provide ownership and diversification so in that sense, they do own corporate bonds. But the yield generated from a retiree’s corporate bond fund versus the direct issue owned by an insurance company doesn’t compare. Scale plays a huge role in bond markets and retirees aren’t suited to play this game.
To review, we have looked at the credibility of insurance company guarantees by going behind the scenes to understand how annuity contracts are created and how the pool of funds used to support them are managed. This all sounds a lot like another asset on a retiree’s balance sheet – social security.
Social security, as discussed in Bucket 2 of the 4 Buckets Income Strategy, is a key component to retirement income. It is a based on a guarantee backed by the full faith and credit of the United States of America. America, as an entity, has a long track record of paying their financial obligations as do many of the insurance companies we look at in Bucket 3.
How is social security created and managed? Well, this social insurance program has been funded since its creation by tax revenue. But, we know that social security has a funding issue which has become increasingly stated. It’s a management issue that we’ll not get into here, but the point is this: you likely rely on some form of guaranteed income to support your retirement lifestyle. That guarantee is based on the full faith and credit of your government. The financial credit of your government is clearly in question, but your faith in it still stands. How do we know that? I have yet to meet a retiree who has “opted out” from receiving their benefit check to help the program get on better financial footing. So, if your income strategy incorporates this sort of guarantee through Social Security, then you should be even more confident implementing other guaranteed elements.
