The Dynamics of Annuity Bailouts

Bailout!

How long will the high rates on deferred annuities last? With some current market rates as high as 10 times the guaranteed rates on annuity contracts, advisors and consumers are basking in the glow of these promising numbers. Many likely expect that the rug will be pulled out from underneath them on renewal, but are they really prepared for that? An attractive feature to provide assurance in the event of declining interest rates is a bailout feature, let’s dive into how they work.

A bailout feature, also known as a waiver of withdrawal charge provision, provides a level of protection for annuity policyholders who fear they may become trapped by surrender charges while holding an annuity with a credited rate below the market average. The bailout provision typically permits a penalty-free surrender if the credited rate falls below the bailout rate specified bailout rate defined in the contract.

Bailout features are most prevalent today with fixed index annuities. The gold standard Fixed Index Annuity (FIA) index strategy is S&P 500— the market leading bailout comes from Ibexis, which offers a 5.25% bailout rate, Delaware Life and Aspida have a 5.15% bailout rate. Although these figures may seem modest compared to current cap rates, which range from 10.5-11.5%, they provide a degree of assurance over the cap rate guarantees, which tend to be 1%. In a scenario where cap rates fall below the bailout rate, policyholders can withdraw their funds without penalties, giving them the freedom to explore alternative investment options.

Reserving for Bailouts

The Actuarial secret sauce that explains why bailout rates hover around 5% lies in the requirements for actuarial reserves. Back in the 1990s, bailout provisions became popular for fixed deferred annuity contracts. There was some confusion about whether the Commissioners’ Annuity Reserve Valuation Method (CARVM) required the reserve to ignore surrender charges that might be waived under a bailout provision. NAIC Actuarial Guideline 13 (AG13 NAIC, 1998) provided some clarity on this topic by requiring the reserve to exclude surrender charges only if the bailout is deemed significant. The term ‘significant’ is not explicitly used in the guideline, but it refers to a situation where there is a likelihood that the bailout clause will come into effect. According to the standard interpretation of the guideline, the bailout is deemed to be significant when the bailout rate surpasses the long-life rate. The long-life rate is the standard valuation interest rate used for life insurance policies with a guaranteed duration of more than 20 years.

To summarize, if the bailout rate is lower than the valuation rate, the waiver of surrender charges does not need to be considered for reserve calculations. The current long-life rate stands at 3.00% and that rate is currently projected to rise to 3.5% in 2025. This means companies currently can offer a 3.00% bailout rate on fixed annuities without posting any additional reserve capital. If the company were to lower the current rate below the bailout rate, they would immediately have to reserve as if it were significant.

An interesting aspect of the long-life valuation rate is that it is based on the lower of the rolling 12-month and 36-month Moody’s aggregate rate published by the NAIC.  By using this ‘lower of’ approach, it will have a bias to respond quickly to a decreasing rate environment and respond slowly to an increasing rate environment.  That leaves it pre-disposed to stay at a low rate.  Thus, bailout rates will have a bias to also stay low.

What is a Significant Bailout for a Fixed Index Annuity?

How do we get from a 3.00% bailout rate to a bailout rate more than 5% on S&P cap? The answer is that the significance test is applied to the option budget rather than the credited rate. When determining their bailout rates, companies determine what cap rate they could set if they spent 3.00% of premium on options, in today’s market we project that rate to be around 5.25%. Looking ahead to 2025, the valuation rate for long duration annuities is likely to increase to 3.5%. In that scenario, we project that bailout rates could soon exceed 6%.

Can You Take Bailouts Higher?

The industry seems to have settled for the maximum insignificant bailout rate.  It’s theoretically possible for a company to set a higher bailout rate but that would necessitate an additional 5-10% of the initial premium to be held in reserve to account for the waiver in surrender charges. This would represent a significant capital injection from the annuity provider. However, companies such as Mass Mutual Ascend already provide guaranteed cap rates for the S&P 500 index on their 5- and 7-year FIAs. A bailout rate equal to their guaranteed cap rate may be a cheaper solution.

A critical market psychological aspect needs to be considered: What exactly is the difference between a 10% bailout and a 10% guaranteed cap? A 10% guaranteed cap represents an unbreakable limit. A 10% bailout might be viewed as a “trust me” provision. In a declining rate environment, a company could lower rates below the bailout, banking on the belief that policyholders will stay put. Even if rates fall below the bailout some policyholders could be negligent or indifferent, some may stick around because competitor rates aren’t any better than their current policy, however, producers have incentives to move business, especially if it results in better outcomes for the customer. This is a risky proposition, and it remains unlikely that we will see any company risk setting a bailout above where they expect rates to go in a worse case scenario.

The fundamental reality of bailout rates is that while they do not absolutely guarantee a rate that exceeds bailout rate, they guarantee the company’s commitment to providing rates higher than the bailout whenever feasible, and even if circumstances make it challenging, the company remains dedicated to offering the most competitive rates possible.

Bonus Material

Bailout provisions on bonus products present an enticing opportunity for individuals wary of potential future rate drops by companies. Typically, carriers reduce their cap rates by 3-4% to accommodate the bonus cost, while the bailout rate may decrease by 1% or less. Consequently, there’s a narrower margin between current rates and bailout rates, implying a stronger implicit guarantee. Furthermore, the bonus amount serves as an additional safeguard for policyholders who retain their policy until the end of the vesting period. This combination makes high bonus, high bailout products particularly appealing in the Accumulation Fixed Index Annuity (FIA) sector for those concerned that today’s rates may be temporary.

Conclusion

Companies are unlikely to lower rates below the bailout rate based on today’s practices, making these rates similar but not equivalent to a guarantee. This is because activating the bailout provision would result in additional reserving costs. The industry has generally steered away from offering bailout rates that require additional reserves, which creates a sort of implicit guarantee.

As option budgets continue to outpace increases in the valuation rate, this perspective might shift. If companies cannot entice attention with their current bailout rate strategy, they may be persuaded to put up the additional capital required to offer higher bailout rates in hopes of alleviating consumer concerns about rate decreases. A higher bailout rate is likely to cost less than guaranteeing the cap rate for the full surrender charge period.

In this ever-evolving landscape of annuities, one thing is clear: the question of how long these favorable rates will last continues to drive innovation and adaptation in the industry. The path forward for annuity providers is likely to be shaped not only by financial considerations but also by the psychological dynamics that underpin the delicate balance between guarantees and trust in the world of annuity products.