Introduction: The Promise and the Pitfalls of Annuities
Suppose you held an AIG annuity in 2007 while it was being downgraded. Since it was illiquid, you could not sell it or get out, even at 80 cents on the dollar. You were trapped in a death spiral,l having to ride it all the way down to 0, powerless to get out at 90,80,70 as you could with a downgraded bond. A downgrade clause could allow you to exit at the current book value or even 90%. Instead, this combination of credit and liquidity risk creates a doomsday scenario that was only stopped in the case of AIG by a huge government intervention.
Annuities are attractive to retirement plans because they offer guaranteed lifetime income, insulate participants from longevity risk, and provide what many see as the “floor” beneath volatile investments with fixed rates. Indeed, in its recent LawFlash, Morgan Lewis celebrates a new DOL Advisory Opinion allowing certain managed-account lifetime income strategies (in which annuities are used) to qualify as QDIAs for defined contribution plans. Morgan Lewis
But the enthusiasm for annuities often understates the structural conflicts of interest baked into many products—and the absence of meaningful exit protections for prudent plan fiduciaries. That is why downgrade clauses (sometimes called “step-down,” “de-risking,” or “soft-exit” clauses) are essential guardrails. Without them, annuity allocations can morph into locked boxes with undisclosed spread profits and catastrophic losses for participants.
Below, I explain:
- What a “downgrade clause” is (and why it’s needed)
- Common annuity-friendly counterarguments (and why they fail)
- Why annuities lacking downgrade clauses violate the Impartial Conduct Standards and thus cannot qualify for safe harbor exemptions
- How fiduciaries (and litigants) should press for these clauses in plan contracts
What Is a Downgrade Clause — and Why It’s Critical
A downgrade clause is contractual language that enables a plan fiduciary (or, in some frameworks, participants) to move assets out of or adjust exposure to an annuity product under specified conditions, without incurring prohibitive penalties or lockups. Examples of showing a downgrade clause:
- Permitting partial or full redemptions (or transfers) from the annuity segment, subject only to limited and predictable constraints
- Requiring the insurer to step down crediting rates only prospectively (i.e. not clawing back past promised rates)
- Forcing the insurer to accept commuted value payments if certain benchmarks (e.g., credit rating, liquidity, or interest rate changes) are triggered
- Embedding automatic de-risking triggers (e.g. when spreads widen excessively, or when performance deviates materially) that allow rollback to a safer investment option
Why is this so vital?
- Exit optionality is intrinsic to fiduciary prudence. Without it, fiduciaries cannot respond to a deteriorating contractual or market environment.
- It constrains insurer opportunism—knowing they may face forced reallocation discourages excessive spread extraction or imprudent investment risk.
- It mitigates the risk that an annuity becomes a “golden cage” locking in stale rates while underlying economics deteriorate.
In short, a downgrade clause helps transform an annuity from a one-way bet into a managed liability asset that preserves fiduciary flexibility and accountability.
Responding to Annuity-Friendly Arguments
“Downgrade clauses are unavailable; insurers won’t agree because they cut into excessive hidden spreads.”
This is a common refrain by annuity-industry lawyers. But it fails under scrutiny:
- Market comparables exist. Some insurer contracts already embed exit rights or de-risking provisions (especially in separate account or institutional annuity offerings). The argument that all insurers refuse downgrade clauses is overbroad.
- Contract negotiation is part of fiduciary process. Fiduciaries routinely negotiate plan and service agreements. Refusing to demand a downgrade clause is inconsistent with fiduciary duty.
- Excess spread is not a free lunch. If insurers fear downgrade clauses will cut into “excess” profits, that signals the margins are already inflated. In fact, the need for a downgrade clause is strongest when spread profits are opaque and outsized.
- Better for insurer certainty than litigation risk. An insurer may prefer a known downgrade formula to the uncertainty and reputational risk of litigation over hidden spread provisions.
- Absence of downgrade clauses is a red flag—not a justification. If every insurer refuses, that underscores the structural conflict. Fiduciaries should regard that as a warning, not a safe harbor.
In short: the reluctance of insurers is a symptom, not a defense. It underscores the need for downgrade language, not the futility of it.
Why Annuities Without Downgrade Clauses Fail the Impartial Conduct Standards (and Cannot Rely on Exemptions)
PTE 2020-02 conditions safe harbor relief on compliance with the Impartial Conduct Standards: (1) best interest, (2) reasonable compensation, (3) best execution, and (4) no materially misleading statements. Reish, Neri, and Waldbeser rightly emphasize that failure to satisfy any of these disqualifies the practice from exemption relief.
Here’s how annuities lacking downgrade clauses systematically violate each:
| Impartial Conduct Standard | Requirement | How Non-Downgrade Annuities Fail |
| Best Interest (Prudence & Loyalty) | Fiduciary must evaluate costs, risks, returns, and act loyally | Without downgrade rights, fiduciaries cannot prudently assess downside risk of lock-in. Discretionary crediting rates and opaque spread extraction further prevent any meaningful comparability or loyalty. |
| Reasonable Compensation | Fees and spread must be reasonable for services rendered | Hidden spreads devoid of market benchmarking—and lacking pressure from downgrade clauses—render reasonableness unverifiable, if not implausible. |
| Best Execution | Investments must be executed in a way to achieve the best net result | Opaque internal pricing and lack of exit rights prevents comparisons or competitive bidding; participants can’t “shop around” or demand better options. |
| No Materially Misleading Statements | Must fully disclose costs, conflicts, compensation arrangements | Withholding general account yields, internal rates of return, or spread margins—plus the very absence of downgrade protections—amounts to a material omission. |
Because annuities absent downgrade clauses fail all four standards, they cannot qualify for PTE 2020-02. Investors and fiduciaries relying on such annuities remain exposed to ERISA §406 prohibited transaction risk—and accompanying excise taxes and fiduciary liability.
And even beyond PTE treatment, such annuities clash with the broader ERISA fiduciary principles as reflected in case law:
- In Brotherston v. Putnam, the First Circuit emphasized the burden on fiduciaries to justify the prudence of structural investment choices—something impossible when exit options are foreclosed.
- Cunningham v. Cornell confirmed liability where conflicted revenue arrangements taint fiduciary decisions, analogous to hidden spread practices.
- Tibble v. Edison (and later Hughes v. Northwestern) affirm a continuing duty to monitor, which requires visibility and flexibility—neither of which downgrade-less annuities offer.
Thus, in litigation or regulation, one can and should argue that annuities without downgrade clauses are per se disqualified from safe harbor protection and are inherently subject to prohibited transaction treatment.
Practical Blueprint: How Fiduciaries Should Demand Downgrade Clauses
- RFP and contract design: Include downgrade/step-down language as a mandatory negotiation point in insurer solicitations.
- Tie downgrade triggers to objective metrics: e.g., when spread > 80 bps over benchmark, when insurer credit rating falls, or when actual GA returns deviate materially from pricing assumptions.
- Require commutation or transferability options: At fair market or formula-based value, without surrender penalty.
- Ongoing monitoring and audit rights: Demand transparency in internal yields, expenses, and delta between GA returns and credited rates.
- Reserve right to “step out” administratively: Even absent a contract provision, fiduciaries must preserve documentation of why they declined an annuity lacking downgrade terms and be ready to demonstrate switching if needed.
If an insurer refuses all downgrade language, that refusal itself should be framed as evidence of structural conflict—and a basis to reject the product entirely.
Downgrade Protection and the IPS
I make the case above that any annuity without a downgrade clause is a trap—locking fiduciaries into an insurer’s opaque balance sheet while executives siphon off hidden spread profits. Let’s be blunt: without downgrade liquidity, these products are incompatible with ERISA, period.
The IPS Isn’t a Suggestion—it’s the Law of the Plan
An Investment Policy Statement (IPS) is not a fluffy consultant exercise; it is the governing playbook for fiduciaries. As I wrote in this earlier piece, the IPS codifies the process fiduciaries must follow to select, monitor, and—crucially—remove investments when they no longer meet standards of prudence.
So what happens when a plan’s IPS says “investments must meet minimum credit quality standards,” and the annuity provider’s general account gets downgraded? With no downgrade clause, the fiduciary is stuck—forced to keep participant money in a product the IPS says must be dumped. That’s not just bad optics. That’s a textbook breach of fiduciary duty.
The Stable Value World Already Gets It
Look at synthetic stable value funds like Vanguard RST or Fidelity MIPS. Their contracts include strict downgrade provisions. If a security in the portfolio gets downgraded below guidelines, it must be sold. That’s called discipline. That’s called fiduciary duty in practice.
Contrast that with insurance annuities: no downgrade clauses, no exit rights, no transparency. Just a locked box where the insurer pockets spread profits while participants are left holding the bag if credit quality deteriorates.
Liquidity in a Downgrade Isn’t Optional
Liquidity isn’t a luxury—it’s the lifeblood of fiduciary prudence. Without the ability to exit a failing investment, an IPS becomes a fig leaf. Fiduciaries can’t “monitor and remove” if the contract forbids removal. That’s why annuities without downgrade clauses don’t just flunk the Impartial Conduct Standards—they expose fiduciaries to prohibited transaction liability under ERISA §406.
Call It What It Is
When annuity industry lawyers claim downgrade clauses are “unavailable,” what they really mean is: they cut into our secret spread profits. Downgrade liquidity would force insurers to compete honestly, disclose their true economics, and give fiduciaries an actual choice. No wonder they fight it.
But ERISA doesn’t care about insurer margins. ERISA cares about participants. And until annuities come with downgrade clauses, fiduciaries should call these products what they are: fiduciary landmines hidden in an insurance contract.
Conclusion: The Downgrade Clause Is Not a Nice-to-Have — It’s an ERISA Necessity
Absent a downgrade clause, an annuity allocation is akin to handing over plan assets with no option for redemption and no clarity on internal yield. That structure invites hidden spread profiteering, foils market discipline, and violates the core fiduciary doctrines embedded in ERISA.
Downgrade clauses are not anti-insurer “gotchas” — they are the contractual oxygen that allows an annuity to breathe under fiduciary scrutiny. Annuity-friendly commentators who insist such clauses are unavailable are implicitly admitting that the underlying margins are too generous (and too opaque) to withstand rigorous fiduciary or litigation pressure.
By insisting on downgrade clauses, plan fiduciaries can align annuity allocations with transparency, accountability, and true participant protection—transforming what is often a “black box” into a manageable, contestable instrument.
SOURCES
The CommonSense 401k Project 