By Chris Tobe, CFA, CAIA
Annuities issued by a single insurance company are a Fiduciary Breach. They can be called guaranteed income, they can be called GIC’s or fixed accounts, or index annuities. I am focused on the institutional annuity products mostly used in 401(k)s. There are many more fiduciary breaches in retail and variable annuities, as noted by attorney James Watkins in his recent article.
There are breaches in institutional annuities for 4 basic reasons
- Single Entity Credit Risk
- Single Entity Liquidity Risk
- Hidden fees spread and expenses
- Structure -weak cherry-picked state regulated contracts not securities and useless reserves
A 1992 Federal Reserve paper notes that the so-called insurance safety net is much weaker than most realize. [i]
Annuities are in the news as insurance companies are pouring millions of dollars into lobbying and PR and advertising trying to trick people into buying them.
The insurance industry spends millions of dollars trying to abolish and weaken fiduciary standards because they do not come close to meeting them.
Insurance companies are especially frustrated with 401(k) plans because they have not only the strongest fiduciary standards, but an enforcement mechanism in 401(k) litigation. While they have lobbied the US Department of Labor to ignore most of their enforcement duties on excessive fees on 401(k), they have not been able to block court action, and the latest Supreme Court ruling has reinforced this.
Annuities in 401(k) plans have traditionally been in 401(k) plans though a stable value of fixed annuity option. [ii] In recent years they are trying to expand into hiding annuities in target date funds,[iii] mostly under the guise of Lifetime Income.[iv]
The Insurance industry’s huge push into 401(k) has even had some plan fiduciary consultants sounding words of caution. A commentary in Benefits Pro by Mitch Shames is titled “Annuities: The Straw That Breaks the Back of Retirement Plan Fiduciaries.”[v]
Annuity contracts, however, are not investment securities. Instead, they are individually negotiated contracts entered into between an insurance company and the annuity-holder. …… the fiduciary will also need to be a prudent expert in the selection of the annuity. That is a pretty tall order. Retirement plan fiduciaries are on notice. Annuity contracts may be the straw that breaks the back of the fragile fiduciary infrastructure employed by plan sponsors under ERISA.[vi]
Single Entity Credit Risk
Single Entity Credit Risk – Diversification is one of the most basic Fiduciary duty and annuities totally ignore this. Like a single stock or a single bond is a clear fiduciary breach so is an investment 100% reliant on one entities credit like an insurance contract.
For over 20 years fiduciaries in the know, like large 401(k) plans, fled fixed annuity products backed by the general account of a single insurance company. This was due to concerns about single entity credit and liquidity risk. Many attribute this to the 1992 and 1993 defaults by Executive and Confederation Life, as documented by the Federal Reserve Bank 1992 article. [vii]
In 2005 AIG was AAA rated and some in the trade press said that AIG was as safe as the Government by 2008 it was in default. In 2008 Federal Reserve Chairman Ben Bernanke said that “workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable-value funds would decline in value would have seen that insurance disappear.” [viii] Many investment professionals believe that a plan sponsor is taking a severe fiduciary risk by having a single contract with any one entity, such as AIG. It can be argued that a plan is taking less risk by assuming that the single insurance company backing the stable value option is too big to fail and has an implied government guarantee.
The Federal reserve for several decades bought fixed annuities in their stable value option in there 401(k) option for their employees. They limited credit exposure to 5% per insurance company. In the late 2000’s there were not the 20 issuers needed for diversification so they shut the fund down. Even the few diversified annuity structures still have 25% or 33% single entity exposure which is considered high by fiduciary diversification norms.
Taking 100 perentsingle entity credit risk is a clear breach of fiduciary duty.
Single Entity Liquidity Risk
Single Entity Liquidity Risk – A fiduciary managing a bond portfolio sells a bond when it is downgraded to a level allowed in the investment policy. Most Annuities are not allowed to be sold when they are downgraded. They have no liquidity if the firm is downgraded multiplying the credit risk as a participant has to ride it down to default.
Noted Morningstar analyst John Reckenthalrer said in April 2022 that in selecting 401(k) investment options, “inappropriate are investments that don’t price daily.” [ix]
Annuities do not price or mark to market daily. There is a secondary market for retail annuities provided by firms like JG Wentworth and Peachtree, which many times only pay 80 percent on the dollar. So, if you bought an annuity and wanted to sell it the next day on the secondary market, you would take a 20 percent loss. There are annuity products that provide some limited liquidity, what they call benefit responsive, but is always a major fiduciary risk.
Hidden fees spread and expenses
Prudential in a 2013 conference documented by Bloomberg bragged that they had secret hidden spread fees of over 200 basis Points.[x]
This loophole allows insurance companies to hide as much 2% or 200 basis points (bps) in yearly spread profits. I was quoted in the Wall Street Journal’s Marketwatch, stating that
“These excessive profits, even if called spread, act like fees and are used like fees,” [xi]
In addition they continue to pay commissions out of the hidden spread which drive even more sales.
The National Association of Government Defined Contribution Administrators, Inc. (NAGDCA) in September 2010 created a brochure with this characterization of insurance company general account stable value that got beyond the high risks and right to fee disclosure.
Due to the fact that the plan sponsor does not own the underlying investments, the portfolio holdings, performance, risk, and management fees are generally not disclosed. This limits the ability of plan sponsors to compare returns with other SVFs [stable-value funds]. It also makes it nearly impossible for plan sponsors to know the fees (which can be increased without disclosure) paid by participants in these funds—a critical component of a fiduciary’s responsibility.[xii]
It is hard to comprehend why the DOL lets these products escape disclosure. However, there is already ERISA litigation in which spread fees have been important in settlement negotiations.
Structure -Weak Cherry-Picked State Regulated Contracts and Useless Reserves
When you purchase an annuity, you do not get to own any securities, you just get a piece of paper.
Whereas securities (and the firms issuing, offering or underwriting the instruments) are governed by the federal securities laws and regulated by the Securities and Exchange Commission, insurance companies and the contracts they enter into are governed by the States – 50 different regulators and bodies of law. Once again, the variety can be staggering. This is the world that retirement plan fiduciaries are being forced into. [xiii]
A 1992 Federal Reserve paper notes that the so-called insurance safety net is made of 50 different state regulators with a wide variety of regulations and is much weaker than most realize. This allows companies to shop for insurance regulation among the 50 states to find the ones that have the softest regulations. [xiv] In 2017, The European Union showed concern with the weakness of state regulators of insurance companies. [xv]
Investors are mostly unaware of this risk based on flimsy state guarantees which the Federal Reserve has said have little worth. [xvi] These guarantee fund balances are typically a joke with $0 as they pass the hat to other insurers if one goes under.
Required Fiduciary Questions
What should a fiduciary document and become comfortable with before investing in an annuity.
1.Which state issues the annuity, what is their record, do they have conflicts of interest with the insurance company?
2.What is their minimum capital requirement in basis points for this annuity product in the state your contract is issues in?
3.What is the current solvency of that states guarantee pool.
4. Get full fee disclosure all internal spreads (200+) before expenses and then with expenses and profits broken down?
5. Does the Annuity contract have a downgrade provision to get out if the company is downgraded?
All annuities flunk at least one of these fiduciary tests, most flunk all. By and large the Fortune 500 largest US Corporations have avoided these insurance company products in their 401(k) plans since 1992. This is not because of fear of regulators, but because of fear of lawsuits filed by employees under the Employee Retirement Income Security Act of 1974 (ERISA). Thus, many of these non-transparent insurance products are in smaller company plans which are not cost effective for plaintiff bars to litigate individually. However, as litigation goes downstream there are over 9 thousand plans from $100mm to $3 billion out of the top 500 many of which have annuity assets. It is these mid to large plans who need to resist the annuity marketing push into guaranteed income mostly hidden in target date funds.
[i] Pg. 6 Federal Reserve Bank of Minneapolis Summer 1992 Todd, Wallace SPDA’s and GIC’s
[xiv] Pg. 6 Federal Reserve Bank of Minneapolis Summer 1992 Todd, Wallace SPDA’s and GIC’s