No Time for Guarantees

The concept is seductive: a financial product that provides upside exposure in the event that equity markets trend up and to the right while also providing a floor of protection in case the bottom falls-out from under markets again.

Sort of like having your cake and eating it too. Very tempting in light of the massive financial uncertainty that has existed for the past several years.

Products playing into this “upside plus protection” theme include (but are not limited to) variable annuities with guaranteed living benefits, standalone living benefits (SALBs) and, to a certain extent, indexed annuities.

However difficult it might be, financial services consumers must try to look at guarantees with ruthless objectivity because there are some strong currents pushing against the value proposition of these products.

Some factors to consider:

1) Equity Exposure: many carriers have been limiting the level of equity allocation in an attempt to limit their own volatility exposure. From a consumer’s perspective, the value of a guaranteed lifetime income benefit (GLIB) or a standalone living benefit (SALB) is directly related to the percentage of their portfolio that can be allocated to equities. As Moshe Milevsky explains so brilliantly, guarantees such as GLIBs or SALBs are essentially equity put options, and “the value of this put option and the embedded income protection it provides depends primarily on the volatility of the underlying subaccounts. The more equity in the subaccounts, the more valuable is the put option. Likewise, the greater the asset allocation restrictions, the less valuable is the put.”

2) Cost: products and guarantees are simply more expensive than they were before the financial crisis. Carriers have been leaving the markets and those that remain have the ability to raise prices in what is already a very concentrated market.

3) Benefit: carriers have been dialing-down guaranteed rates.

4) Asset Prices: there is certainly a case to be made for more equity exposure--particularly in light of the potential returns and risks in the fixed income markets. The reality, though, is that equity markets are now back to pre-financial crisis highs. Many informed observers such as Bill Gross of PIMCO believe that future asset returns will be in the low single digits. The drag of high expenses is an enormous hurdle in a low return world.

5) Inflation: equities are not necessarily an inflation hedge, and the real value of any guarantee may erode in an inflationary environment unless it is adjusted for inflation.

6) Tail Risk: if the purveyors of armageddon economics prove correct and the financial world comes to an end, there is the issue of credit or counterparty risk--the guarantee is only as good as the company behind it. Second, high quality fixed income is where people will want to be if the bottom does fall-out, so why not use fixed income exposure or a deferred income annuity (a longevity annuity) as a tail risk hedge rather than paying-up for the expensive equity put.