#292 | Dispatches from Annuityland – Part 1

person putting a passport on bag

In my experience, most folks carry a passport from one of two countries – life insurance or annuities. These passports give the holder access to the unique ecosystem built around the product. Imagine someone with an annuity passport walking into a Forum 400 or even a Finseca meeting. They won’t know anyone, won’t understand the relevance of much of the content and may not even recognize some of the insurers sponsoring the most extravagant booths. The same experience would happen if someone with a life insurance passport showed up to an Insured Retirement Institute (IRI) or National Association of Fixed Annuities (NAFA) meeting. There are very, very few people who carry both passports and travel fluidly in both worlds.

I’m not yet one of them – but I’m getting there. I have both passports courtesy of my time at the helm of Brighthouse’s life insurance and annuity product development areas and subsequent work with Life Innovators on annuity product development, but my life insurance passport is chock full of stamps and my annuity passport has just a few. I’ve traveled enough around what I’ll affectionately call Annuityland to see the stark differences and surprising similarities between the two worlds, where they intersect and where they are truly worlds apart.

But more than anything else, I’ve come to believe that the two products move at different paces. Things that have been long known in life insurance are just becoming known in annuities and vice versa. I used to say that if you want to know what is going to happen in life insurance in 10 years, just look at the annuity business. I still think that’s true, but I’ve come to believe that the inverse is also true – if you want to see what’s going to happen with annuities in 10 years, just look at life insurance. There’s a saying that there’s no education like travel and that certainly holds true when it comes to the worlds of life insurance and annuities.

If you were to poll any consumer about these two products do, they’d say that life insurance charges a premium to provide a death benefit and an annuity takes a premium to pay an income stream. That’s certainly true in the purest sense, but it’s hardly the full story. Below is a table that breaks down (from my view) the different variants of both products and their analogies on each side. Insurance Benefits refers to the provision of the core death benefit or annuity benefit and earnings refers to the method of growth of the cash value in the contract.

Insurance BenefitsCash ValueEarningsAnnuityLife
GuaranteedYesGuaranteedWhole Life
GuaranteedYesFixedFDA with LBUL with SG
GuaranteedYesIndexedFIA with LBIUL with SG
NonguaranteedYesInvestment ReturnsVAVUL
GuaranteedYesInvestment ReturnsVA with LBVUL with SG

SPIA = Single Premium Immediate Annuity

DIA = Deferred Income Annuity

MYGA = Multi-Year Guarantee Annuity

FDA = Fixed Deferred Annuity

LB = Living Benefits (Income Riders)

SG = Secondary Guarantee

FIA = Fixed Index Annuity

These variants represent something like 99.5% of the flows going into each product type with the remainder scattered among minor product variants, such as SPIAs with cash liquidity, variable deferred annuities and income annuities with participation or credits. For both products, the variants that are the most focused on simply providing the insurance protection – SPIA/DIA and Term – constitute a relatively small percentage of the overall market. For annuities, SPIA/DIA makes up less than 5% of premium. For life insurance, Term accounts for about 20% of overall recurring premium and a much smaller portion of total premium. For both life insurance and annuities, the vast majority of the action is happening in products with cash value.

Perhaps the easiest comparison between life insurance and annuity products with cash value is on the variable side between Variable Annuities and Variable Universal Life. Both products offer a broad range of insurance-dedicated mutual funds inside of an insurance product wrapper. For companies that offer both a VA and a VUL, the fund lineups are often identical or subsets of one another, meaning that the actual investment characteristics of the two products are identical.

Where they differ is in the policy charge structure. With Variable Annuities, the fee for the wrapper is strictly quoted as a percentage of assets and the pitch for a VA is that the fee is worth the benefits of tax deferral. With Variable UL, the fees are generally not based on assets but, rather, are fixed dollar amounts or Cost of Insurance related. The pitch is the same – that the fees of the Variable UL are worth the benefits of tax-free income and death benefit. The investments and the pitch are the same for both products. The only difference is the structure of the fees.

This is true for any comparison of annuities and life insurance for their accumulation characteristics. I would make the argument that, when it comes to accumulation, life insurance and annuities are actually the same product, just organized differently. If the same life insurer investment portfolio was used to support a life insurance and an annuity product, the only difference (from an accumulation standpoint) would be that the life policy has explicit charges and a higher rate and the annuity has implicit charges and a lower rate. One wouldn’t be better than the other one. The choice – strictly on the merits of accumulation – would be about optics.

However, the two products are not the same. Annuities are priced based on new money rates, life insurance is priced (generally) off of portfolio rates. For annuities, you can imagine the life insurer literally taking the client’s money and buying a basket of assets with the same expected maturity as the contract. For life insurance, the life insurer pools the client’s premium with all of the other policies and premium across the block and pays a single yield on all cash values. Hence, the reason why MYGA rates respond quickly to changes in interest rates but dividend interest rates in Whole Life move very slowly. Fixed annuities reflect today’s market rates. Fixed life insurance reflects last decade’s, last year’s, last month’s, last week’s and today’s market rates, all in one number.

This core difference between life insurance and annuities plays out in any fixed variant of either product. MYGAs, Fixed Deferred and Fixed Index annuities tend to get hot when interest rates pop because the product rates respond quickly. Whole Life, Universal Life and Indexed UL tend to get hot when interest rates drop because product rates respond slowly. In general, folks selling fixed annuities generally want interest rates to go up. That’s when their products are going to show better rates and make a more compelling case against bonds, which lose value when interest rates go up. Life insurance folks, on the other hand, generally want rates to drop or stay low, because that’s what makes their products look more attractive and allows for things like “arbitrage” in premium financing arrangements. The great irony, of course, is that in the long-run, the average rate for either method will be identical. The difference is simply a matter of timing.

Even if both life insurance and annuity products were priced off of new money rates, there would still be another key difference – maturity. On your first visit to Annuityland, you’ll notice that products usually have a number after them. These numbers signify the surrender charge period of the contract. Longer surrender charge periods typically mean higher rates and higher commissions. In the MYGA space, the hottest maturities are 3, 5 and 7 years. In FIAs, the most common maturities are 10, 7 and 5.

The assumption in Annuityland is that policyholders are efficient. Once the surrender charge period ends, they’ll go on the prowl for a new annuity contract that pays a better yield (and a new commission to the agent). It’s a self-fulfilling prophecy – life insurers assume that clients will lapse, which means they invest only at a very short duration after the surrender charge period, which leads to lackluster rates. And why do policyholders leave? Because of lackluster rates. Accumulation annuities are products with a defined lifecycle determined by the surrender charge period. And, of course, the life insurer invests accordingly.

Life insurance, however, is a different animal. Paradoxically, life insurance doesn’t price with so-called “shock lapses” once the surrender charges burn off. Instead, it assumes relatively stable lapse rates throughout the life of the contract. And then there’s also mortality, which plays a role for both products but, because life insurance is assumed without shock lapses, mortality plays into pricing much more strongly. Take a look at the weighted average “maturity” of a permanent life insurance policy under various lapse assumptions for a 45 year old male:

Lapse Rate0%2%4%6%8%10%
Years In-Force39.026.619.214.611.69.6

Companies with very low lapse rates can theoretically invest longer – and at higher yields – than companies with higher lapse rates. Recall that my analysis of Guardian’s bond purchases in 2020 revealed an average maturity of a little more than 17 years, which shouldn’t come as a surprise for a company predominately selling Whole Life with low lapse rates. Therefore, all else being equal, we would expect life insurance to have slightly higher yields on assets supporting the policies if for no other reason than longer reasonably assumed policy maturities.

I once asked an Englishman where he learned to speak French so well. He looked at me over the top of his glasses and said, in a quintessentially British way, that “French is simply English pronounced badly.” After he made that comment to me, I started to listen to French differently and I can say with absolute certainty that he was making a joke – but a joke with some element of truth in it. There is something to learn about French by looking at it through the lens of English and vice versa. The same goes for annuities and life insurance.

Nowhere is that more evident than in FIA and IUL. In the wake of the Financial Crisis, both products were the right story for the time – protection from market losses with the ability to participate in market upside. But as market interest rates dropped over the ensuing years, FIA had nowhere to hide. FIA caps fell precipitously, which posed a threat to the core value proposition of the product. Downside protection is certainly worth something, but is it worth giving up the vast majority of market upside? That’s the situation that FIAs were in at the beginning of the 2010s. There was no conventional way to escape the trap, so what did FIA writers do?

They started using proprietary indices, which I’ve written extensively about elsewhere. These indices gave insurers the ability to offer mouthwatering participation rates – sometimes 100% or higher – and jaw-dropping performance, at least in terms of backtested results, all with the benefit of cheap and stable option prices. FIA products with these indices began to sell hand-over-fist. But, fortunately, interest rates began to climb in the late 2010s and equity volatility froze, which meant that life insurers could once again offer attractive S&P 500 rates and that staunched the flow into proprietary indices.

Then something else happened. Life insurers began to use illustrations to market FIA products. We need illustrations in life insurance to show how the policy charges interact with the expected premium flows and earned interest in the product. But for FIA, which doesn’t have explicit policy charges and is often a single-premium product, there is no need for an illustration, so why are they now so prevalent? Because illustrations for FIA are focused entirely on the worst, most cancerous part of life insurance illustrations – the illustrated “performance” of the crediting strategy. FIA products show backtested earnings being applied to the premium over the best, worst and most recent 10-year periods based on calendar-year returns. Little wonder that the products with the highest backtested returns are also earning the most sales. And those products are all using proprietary indices, which are often engineered explicitly for the purpose of maximizing backtested performance. It’s a very nasty, very vicious, very problematic cycle.

And one that, of course, we’ve seen in Indexed UL for over a decade. Indexed UL had the benefit – yes, benefit – of falling interest rates because it could use portfolio rates to buy options priced using market interest rates. That allowed IUL caps to stay resiliently high throughout most of the 2010s. Illustrated rates on IUL pre-AG 49 were commonly 7% or higher. Anything below that was considered “unrealistically conservative,” to paraphrase the comments I would regularly receive when I advocated for lower illustrated rates. AG 49 put an end to some of the shenanigans, but opened the door to multipliers and illustrated cash value IRRs north of 10%. Then came AG 49-A to squelch that, only to be met by the proliferation of proprietary indices paired with fixed interest bonuses, which is surely going to result in AG 49-B.

As crazy as this sounds, nothing – and I mean nothing – on the life insurance side is as wild as what is going on right now in FIA illustrations. Recall that the debates surrounding AG 49 and AG 49-A landed on a 50% annual option profit* as the guardrail for Indexed UL illustrations, meaning that a 4% option budget could illustrate no higher than 6%. In FIAs, right now, there are products with option budgets in the 2% range illustrating returns over 10 years in excess of 8%, implying something like a 300% annual option profit. And the race is on. New FIA products are purportedly about to be released with double-digit illustrated returns for the same roughly 2% option budget. And just like with life insurance, the entire market is reorienting itself away from the core value proposition of the product and towards the illustrated performance. It’s a recipe for disaster.

Anyone on the life insurance side would look at what’s happening in annuities and go pale, knowing that the hard hand of regulation is coming. But that’s probably not the case. On the life insurance side, Whole Life and Indexed UL writers are natural counterweights and, in broad strokes, the few but very large Whole Life writers carry as much sway as the many but smaller Indexed UL writers. The two keep each other in check. If things get too out of hand, you can count on the Whole Life writers to step in and inform the regulators of how the game works. Not so on the annuity side. There is no counterweight to the FIA sellers. Virtually every insurer in the annuity space has an FIA and virtually all of those FIAs use proprietary indices. No company has an incentive to rat out another company – at least not yet.

At the heart of the problems with both Indexed UL and FIA lies the same malfunctioning part – the use of hypothetical historical lookbacks that combine today’s currently declared rates with past historical (or just backtested) index performance. This method has the distinction of being simultaneously misleading and ripe for abuse. It incentivizes bad behavior and that is exactly what it has bred. But, fortunately, that means the solution to what ails both FIA and IUL illustrations is simple – remove the malfunctioning part. Replace the HHLM with a more realistic view of illustrated performance based on fair-market fundamentals, not speculation about future performance based on real or fabricated past results.

Over the past decade, companies have successfully pioneered two new product categories in annuities – so-called Investment Oriented Variable Annuities (IOVAs) and Registered Index-Linked Annuities (RILAs). IOVA is simply a rebrand for a traditional VA without a suite of living benefits, but it has hit the mark. IOVA products are now reaping billions in new flows. The irony, of course, is that VUL does it better. If given the choice between an IOVA with a 1.25% M&E and a VUL with expenses that, in the long run, tally up to about 1.25%, it would be a no-contest knock-out in favor of VUL. If you’re going to pay the same fees, then why not get tax free income rather than tax-deferred income? The fact that IOVA has been such a smash success augurs very well for VUL.

RILA products were introduced in the annuity space in 2010 and have exploded in growth over the past few years, becoming the fastest growing annuity product category by a country mile. The concept behind a RILA is extremely simple – it’s an index-linked annuity with greater downside risk and greater upside potential than a traditional FIA, which is why it requires SEC registration. Actually creating a RILA is more complex than it first appears because it lives in the gray area in terms of filing standards, requires the creation of a non-unitized, non-insulated separate account and entails an S-1 filing. But once that infrastructure is created, it can be ported into a VUL chassis, potentially opening the door for VUL products that piggyback on the success of RILA.

Finally, there is much we can learn from the dramatic rise and spectacular fall of guaranteed living benefits in annuities. Like guaranteed death benefits in Universal Life, guaranteed living benefits in annuities are features bolted on to the base deferred annuity chassis. Guaranteed UL represents a pure an unadulterated bet on policyholder behavior, mortality experience and, more than anything else, interest rates. As Guaranteed UL has waned, we’ve seen the rise of Guaranteed VUL, which injects equity risk into the mix by allowing policyholders to layer a secondary guarantee on separate account investments.

That’s exactly what a Variable Annuity with Living Benefits (VALB) does. In the early 2000s, there was a massive run-up in the VALB market kicked off by Hartford and culminating in MetLife’s $28 billion of deposits in 2011 into its GMIB Max product. This period of time is sometimes referred to as the “Rider Wars.” Years later, it’s patently obvious that the Rider Wars were toxic, loading up life insurers with mispriced products that have resulted in companies and blocks being cordoned off and sold to white-knight PE firms. It is foolish to think that the same won’t happen to Guaranteed UL and Guaranteed VUL. The forces are the same – and the outcome will very likely be as well.

In the next Dispatch from Annuityland, we’ll cover distribution, carriers, disruptors and the future prospects for each product and the industry as a whole.

*I’ve made this technical distinction before – AG 49 has an allowable option profit of 45% (quoted as a 1.45 factor), but it is applied to the raw Net Investment Earned Rate. Accounting for the fact that the NIER discounts the AV for calculation of indexed credits, the 45% gross rate produces results like a 50% net option profit.