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Caveats to Weigh When Evaluating the CDA

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My feature on contingent deferred annuities portrays a generally positive future for these newfangled insurance products, one that could yield a significant revenue stream for fee-based investment advisors. Financial professionals would be wise, however, to consider some caveats before investing much time and resources in this nascent market.

Let’s start with a big one. The CDA—a guaranteed minimum withdrawal benefit that offers principal protection and the assurance of  a lifetime income stream—is, depending on the contract, potentially no match in bear markets for another popular rider that can only be offered with variable annuities: the guaranteed minimum income benefit.

Why might be a GMIB be superior to the GMWB? To use an example cited by Herb Daroff, a partner at Baystate Financial Partners in Boston, consider a hypothetical 54-year-old client with an initial investment of $100,000 in May 2001, when the Dow Jones Industrial Average reached the 14,000 mark, a high that it has not since attained. With a GMWB rider, the now retired client would be assured in 2013 of an income stream totaling $100,000, despite market troughs in the intervening years.

But if the same client were to pay an additional fee in 2001 for a GMIB rider offering a guaranteed 6% payout, compounded annually, then the accumulated value will be significantly greater. Given the rule of 72—the number of years required to double one’s money at a given interest rate—the investment would by 2013 have doubled to $200,000 (72/6 = 12 years).

The client may thus decide that a GMIB rider on a VA is a better deal than a CDA, even if the VA comes at a higher expense. Only in bull markets, when both a CDA and the VA enjoy gains equally, would the lower-cost CDA be superior, notes Daroff.

Performance relative to the VA aside, there’s another reason to counsel caution in projecting CDAs’ growth potential: market-strangling regulation. As I note in my feature, the National Association of Insurance Commissioners ruled in March that CDAs qualify as hybrid insurance products, but has charged a subcommittee with determining the appropriate capital reserve requirements for the products.

Moshe Milevsky, a professor of finance for the Schulich School of Business at York University in Toronto, warns that if the NAIC imposes excessive reserve requirements, it could kill off CDAs.

“The reserving issue is critical,” says Milevsky. “You can safeguard the consumer by ensuring that carriers set aside enough reserves, but the result could be making the product uncompetitive and unprofitable to offer. State insurance regulators have to properly balance the public interest in keeping assets safe against the public interest in keeping products on the shelf.”

In addition to the regulators, financial professionals will be closely scrutinizing CDAs to decide whether the products fit their business practice. Several insurers I referenced in my feature—Great-West Life & Annuity, Nationwide and Transamerica—use the assets under management model to appeal to the fee-based advisor.

Yet another issue for advisors is the potential competition. Milevsky says that many investors may choose to buy CDAs directly from the brokerage firms that manage their assets—Fidelity Brokerage Services, The Vanguard Group, Morgan Stanley Smith Barney, and others—cutting out the advisor as intermediary.

Assuming, however, that advisors and carriers successfully navigate these obstacles, then CDAs could go mainstream, adopted widely by individual investors and by participants in employer-sponsored retirement plans. The products, however, may experience a further evolution on the way to market maturity.

Milevsky, who has questioned insurers about the product development plans, envisions the companies will ultimately tie the GMWB guarantees to the performance of an industry index, such as S&P’s. If the S&P were to fall below a certain benchmark, then the CDA guarantee would kick in; otherwise, the investor would simply live off the capital gains and dividends generated by a rising equities market.

A market index-linked CDA, Milevsky adds, would be win-win for advisors, consumers and insurers. It would offer to the first two an investment concept that’s easy to explain and understand; and it would afford insurers a better way to hedge against reserve risks associated with the guarantee.

This would be a positive outcome, indeed. Only time will tell, however, whether CDAs live up to their promise.