The financial industry is currently in the very expensive process of restoring integrity to markets where risks were ignored. Seemingly fortress institutions have collapsed and ceased to exist.

In light of the sub-prime implosion and the auction-rate securities mess, promises from the industry that it can properly calculate risk/liquidity exposure have to be seriously discounted. The industry chose to ignore the risk because of the immediate profit to be made.

The industry knew the ARS market, based on cash alternatives with 30-year maturities, would work — unless it didn’t, and then it wouldn’t, big time! But until that moment, there was profit to be made. The losses have far exceeded the profits; millions of investors have been devastated. Hindsight suggests these were not black-swan events, but the logical conclusion of illogical design.

The living-benefit guarantees being offered by the annuity industry seem to me to be more of the same.

The greatest risk to market-based fixed dollar distribution portfolios is sequence of returns. The basic premise of guaranteed minimum-withdrawal benefits is that investors can be immunized from this volatility. This is a wonderful concept; but is it realistic? Is this an ARS-like design that will work until it doesn’t? How do we insulate an entire investor base from the market?

These guaranteed-withdrawal benefits all come with step-ups based on portfolio highs — some annual, some daily. This means all contract owners believe they have downside-market protection. Strong market returns don’t reduce future annuity-company exposure, because that exposure is raised with the step-up. With the insurance companies providing a floor during poor market performance and investors locking in increased benefits during strong market performance, investors have incentives to take as much risk as possible; especially in light of the need to overcome the extra 250 basis points of fees.

Five-percent annual minimum withdrawal benefits become 7.5% draws against market performance. Monte Carlo analysis suggests less than a 50% probability of a 7.5% draw-down from a moderate portfolio lasting 20 years (without potential step-ups). This 50% probability affects 100% of annuity contract holders. Annuity companies may become exposed to lifetime payments to a generation of investors with bad timing and whose potential return on investment depends on how long they can live.

Encouraging investors to ignore risk has never been a sound long-term strategy. Insurance companies have the ability to hedge some of this volatility; but will they do enough of it successfully? Will these guarantees work until the next extended bear market, and then collapse as annuity companies fail and the guarantees disappear with the guarantors? Will that require another massive government-sponsored bailout? Will this be another logical conclusion of an illogical design?

I am not qualified to calculate the risks/probability of default on living-benefit guarantees; but my stomach reminds me that guarantees are only as good as the guarantor.

Keith Diffenderffer is president of Endowment Income, LLC.