If AA Was the Reason You Bought It, You Need the Right to Leave When It Isn’t AA
The insurance industry wants lifetime-income annuities in 401(k) plans.
A 401(k) fiduciary buys a lifetime-income annuity in large part because the insurance company is AA-rated.
Five years later the insurer gets downgraded.
AA becomes A. Maybe A eventually becomes BBB.
Now what?
If the fiduciary would not buy the annuity from that insurer today, why should participants be trapped in the annuity purchased five years ago?
They shouldn’t be.
The Answer Is a Downgrade Clause
Every 401(k) lifetime-income annuity should have a contractual downgrade provision.
If the insurer falls below a predetermined financial-strength standard, the plan should be able to move the participant’s money or guarantee to another qualified insurer without a surrender charge, market-value adjustment or other financial penalty.
It is a remarkably simple concept:
If AA was the reason the fiduciary bought the annuity, losing AA should give the fiduciary the right to leave.
Otherwise the fiduciary has purchased a 30- or 40-year credit risk with no meaningful exit door.
That is especially troubling as insurers increasingly reach for yield through private credit and other less-liquid investments, an issue I discussed in The Coming AI Bailout—and Why the Annuity Bailout Could Be Much Bigger and New York vs. Iowa: Where Does the Extra Annuity Spread Come From?.
Vanguard RST synthetic based stable value fund had 6 synthetic GIC Providers. Each had a step-up clause that if one was downgraded that GIC would elapse with no loss and split among the remaining 5 insurers. When AIG was downgraded in 2008 they were able to do this, way before the Federal Bailout.
We Already Have Multi-Insurer Lifetime Income
And here’s the important part: the retirement industry has already demonstrated that lifetime income doesn’t necessarily have to depend upon one insurance company.
AllianceBernstein developed a multi-insurer lifetime-income platform.
An earlier version used three insurers:
ING Life
AXA Equitable
Nationwide
The insurers split responsibility for the lifetime-income guarantees.
Voya subsequently described the AB Lifetime Income Strategy as using multiple insurers, specifically explaining that several insurance companies split responsibility under the contracts to diversify risk.
So the concept isn’t theoretical is just needs a step up clause to deal with a downgrade of one of the issuers.
Now Add a Step-Up Provision
Suppose a lifetime-income product has three AA insurers:
Insurer A — 33%
Insurer B — 33%
Insurer C — 34%
Insurer A gets downgraded below the plan’s predetermined credit standard.
Under a properly designed contract, A’s share could be transferred or replaced by B, C or another qualifying AA insurer—without imposing a surrender loss on participants.
That’s the lifetime-income version of counterparty diversification.
And it solves one of the biggest fiduciary problems with annuities.
But It Won’t Solve a Systemic Insurance Crisis
There is an important limitation.
This works beautifully when one insurer screws up.
It works much less well if everybody screws up together.
Suppose A, B and C all loaded their general accounts with similar private-credit loans, private-equity-related investments, commercial real estate and AI/data-center financing.
A gets downgraded.
Its exposure moves toward B and C.
Then B gets downgraded.
Then C.
Now the diversification wasn’t really diversification.
It was three different insurance-company names sitting on substantially correlated risks.
That is why fiduciaries need to examine what’s actually inside insurers—not merely their current ratings.
I’ve written repeatedly about this problem, including Who Regulates Your 401(k) CIT?, Annuities: Who Is Your Regulator? and Annuities Cherry-Pick the Weakest State Regulator.
A multi-insurer structure helps diversify company risk.
It doesn’t eliminate systemic risk.
Here’s Why Insurers Will Fight Downgrade Clauses
Downgrade protection isn’t merely about credit risk.
It attacks one of the most profitable parts of the traditional annuity business:
Captive money.
Once an insurer gets retirement money into its general account under a long-duration contract, getting it back can be difficult or expensive.
That captivity has enormous economic value.
I believe some general-account annuity economics can produce effective spreads in the neighborhood of 300–400 basis points between what the insurer earns on its assets and what participants ultimately receive.
Give fiduciaries a real exit right and suddenly the insurer has to worry about losing the money.
Competition comes back.
An insurer with deteriorating credit can’t simply say:
“Yes, we’ve been downgraded—but read page 137 of your contract. It will cost participants millions to leave.”
With a real downgrade clause, the answer becomes:
“You no longer meet our credit standard. We’re moving to another AA insurer.”
That could potentially compress a 300–400 basis-point spread toward perhaps 100–200 basis points.
Still plenty of money for the insurer.
But potentially a much better deal for participants.
Solve Two Problems With One Clause
This is what makes the downgrade clause so powerful.
It addresses two major annuity problems simultaneously.
Problem #1: Fiduciary Risk
The fiduciary can respond when the credit quality that justified purchasing the annuity disappears.
Problem #2: Excessive Spreads
The insurer loses some of the economic value of holding participants captive for decades.
The threat of losing billions of dollars creates something the annuity marketplace badly needs:
Competition after the contract is signed.
The ERISA Safe Harbor Should Require It
Congress has given fiduciaries substantial protection for selecting lifetime-income providers.
That protection should come with strings attached.
A lifetime-income annuity receiving favorable ERISA treatment should have, at minimum:
- a clearly defined financial-strength requirement;
- automatic review following a ratings downgrade;
- CDS, bond-spread and capital-deterioration monitoring;
- a contractual right to terminate or transfer after specified deterioration;
- no surrender charge or market-value adjustment following the trigger;
- a mechanism for replacing the downgraded insurer;
- multiple insurers where economically practical; and
- disclosure of the insurer’s actual spread and compensation.
I raised many of these issues in my ERISA Fixed Annuity Due Diligence Checklist.
And this becomes even more important as Washington pushes lifetime income deeper into defined-contribution plans. As I argued in Lifetime Income: The Gateway Drug for Insurance Products in 401(k) Plans, once insurance products become embedded in the retirement-plan infrastructure, getting them out may be much harder than getting them in.
The CommonSense Test
Forget 100 pages of actuarial jargon.
A 401(k) committee should ask its insurance company one question:
“If you get downgraded below the rating that caused us to select you, can we move every dollar to another highly rated insurer tomorrow without losing participant money?”
If the answer is yes, show us the contract provision.
If the answer is no, why is an ERISA fiduciary buying the product?
Lifetime income may have a legitimate place in 401(k) plans.
But a lifetime guarantee shouldn’t mean a lifetime hostage situation.
Require downgrade clauses.
Use multiple insurers.
Give fiduciaries an exit door.
And make insurance companies compete to keep retirement money rather than writing contracts designed to prevent fiduciaries from taking it away.
Fix the fiduciary-risk problem and you may cut the excessive-spread problem in half at the same time.
The CommonSense 401k Project 