The motto for the real estate world might be “location, location, location,” but for fixed annuities, it’s “rate, rate, rate.”
Sales compensation, liquidity, and features can be important, but the fixed annuity focus usually comes down to rate. So, what is a company to do when it can only earn gross returns of 3.75% to 4.5% on its own A-rated securities and 4.25% to 5% on its BBB-rated bonds?
This is the dilemma that declared rate fixed annuity insurers are facing. The above gross yields must be further reduced by investment expense, default risk charges, and required product spreads in order to arrive at the policyholder’s yield.
In today’s environment, fixed annuity carriers have begun to search for rate “nuggets” in their product design and pricing, like the 49′ers of the 1800′s. These chunks of rate boosters may be small on their own, but together, they can turn a disappointing fixed annuity return into one with marketplace appeal. Here are 11 rate boosters to consider:
1. Effective yields. First, although obvious to most, make sure the investment professionals in the company are passing along annual effective yields, and not nominal yields, to the credited rate setters. It is amazing how often these few basis points of rate have been left on the table.
2. Minimum size. Increase it if the policy does not vary credited rate by premium band. A $25,000 minimum (and even $50,000) can help credited rates by a tick.
3. Surrender charges. Most distributors believe that the length of the surrender charge is more important than its level. A one percentage point change in one year for a surrender charge will change the required interest spreads (and credited rates) by one basis point, according to an approximate rule of thumb. So changing a 5-year surrender charge schedule from 6, 5, 4, 3, and 2 points to 6, 6, 6, 6, and 6 points, respectively, frees up 10 basis points of rate under that rule of thumb.
4. Add a market value adjustment. Depending on the type of MVA and its protective value, rates can be increased by 10 to 25 basis points. Make sure the MVA behaves consistently with real changes in asset value, however.
5. Drop the principal guarantee. It rarely comes into play, but everyone pays for it, to the tune of 6 to 10 basis points. Adding a bailout instead in this environment can be more capital efficient.
6. Adopt the Change-in-Fund Method of reserving. This statutory reserve approach can help when future interest rates are expected to increase. Even if rates stay level, this approach can generate some rate pickup.
7. Eliminate the free partial withdrawal in the first year or lower it in all years. Initial surplus strain strongly impacts profits and rate setting. Do policyholders really need this liquidity, especially in the first year? It serves to boost reserves, and drags down returns.
8. Levelized sales compensation. Even just “more levelized,” rather than strictly level, compensation can substantially alleviate surplus strain, adding to rates/profitability.
9. Reflect covariance in risk-based capital. This means that insurers active in a variety of product lines with offsetting risks can reduce the amount of capital they carry, boosting rates. Many companies do not currently reflect covariance in pricing.
10. Add measured amounts of BBB and higher grade BB investments. Although required capital will increase, extra returns may more than offset, so it is important to look for value.
11. Reduce the guaranteed minimum credited rate. This change gives an indirect benefit to current credited rates for carriers that price using a range of interest scenarios.
Some of the above nuggets are more technical in nature, and others are more customer-facing. In either case, applying these and other adjustments may help re-energize a tired credited rate. Other possibilities, such as including a surrender charge at death, may help the credited rate, but be too harsh from a policyholder and regulator perspective to be acceptable.
One other way to potentially boost credited rates is by managing all of a company’s new and in-force fixed annuity business as a consolidated whole. This usually leads to a “robbing of Peter” (the older business) “to pay Paul” (the new business), a distasteful situation. However, if the management of older assets and liabilities can be combined with newer assets and liabilities in such a way to avoid policyholder equity issues, this can represent a meaningful way to support credited rates.
The environment is challenging. Product designs that de-emphasize today’s interest rate–such as Treasury-linked or CD-linked annuities–ultimately may be the answer. In the meantime, however, it may be necessary for many insurers to take out the gold pans and start the prospecting.
Timothy Pfeifer, FSA, MAAA, is president of Pfeiffer Advisory, LLC, Libertyville, Ill. His email address is [email protected]