Money under lock and key, income protection

Recent yields on fixed rate annuities, also called multi-year guaranteed annuities (MYGAs), have become increasingly attractive for investors as interest rates have declined. While other similar 5-year “guaranteed” investments like Treasuries and CDs are yielding up to about 1%, a number of insurance companies are offering 5-year fixed rate annuities today that have yields just over 3%.

You read that right: You can get a MYGA yielding about eight times more than a more traditional guaranteed investment. While MYGAs are generally less liquid than Treasuries and CDs since they typically have high surrender charges on early withdrawals, MYGA rates seem almost too good to be true.

Some people that see rate differentials are probably thinking that while the MYGA rate is guaranteed, there’s still some risk there. While that perspective is technically true, since even governments have defaulted on their loans (and along those lines insurers could theoretically too), before dismissing MYGAs (or any annuity) as unsafe, it’s important to understand how the guarantee works with an insurance product such as an annuity.

The first line of defense should an insurance company go into liquidation is the insurer’s assets. It is relatively rare for an insurer to go into liquidation, and even if the insurer does, that doesn’t mean the annuitant loses money.

For some perspective, according to A.M. Best’s Impairment Rate and Rating Study, between 1977 and 2018, no A++ rated insurer went into liquidation up to 15 years after receiving the A++ rating.  Even for B rated insurers, the historical cumulative probability has only been 4.78% at 5 years, 7.68%% at 10 years and 9.59% at 15 years.

A comparison of assets to expected liabilities is a primary driver of the financial strength rating of an insurance company. A company with a lower rating will have a lower asset surplus and lower quality underlying assets, and thus will be more vulnerable to eventual liquidation.

Not surprisingly, financial ratings also correlate to MYGA payouts. A++ rated companies like New York Life and MassMutual only offer 5-year MYGAs with yields around 1.5%, but insurers rated B++ have yields that can exceed 3%.

What if an insurance company does go into liquidation and the assets are insufficient to cover the liabilities? That’s where the state guaranty associations kick in.

With state guaranty associations, each insurance company doing business in that state is assessed an amount based on the premiums each insurance company collects in that state. While coverage varies by state, annuities are typically only covered up to $250,000 in present value of annuity benefits, including net cash surrender/withdrawal values.

The coverage applies separately to each insurer (i.e., should multiple insurance companies become insolvent at the same time). A great resource if you want to learn more about state guaranty associations is the National Organization of Life & Health Insurance Guaranty Associations website.

It would take quite an event for the insurer’s assets and the state guaranty association to not be enough to make annuitants whole, but even beyond that there is the possibility other insurers could step in (like AIG during the global financial crisis). If consumers start questioning whether annuities are “guaranteed,” this could endanger the entire industry and other insurers would have at least an incentive to make annuitants whole.

What does all this mean? First, guaranteed return annuities, or fixed rate annuities, are definitely safer than similar high-yield investments without a guarantee. Is it possible that all these various backstops fail? Sure, but if that happens, I would contend that you’d still likely be better off with an annuity than other products that don’t have similar guarantees.

With respect to MYGAs, it probably makes sense to purchase a product from a lower rated insurer to get the higher yield. If you’re going to purchase MYGAs beyond the respective state guaranty association coverage limit (again, generally $250,000, but it varies by state) it might make sense to purchase products from multiple insurers to ensure you’re covered no matter what happens.

— More by David Blanchett on ThinkAdvisor:

David Blanchett is head of retirement research for Morningstar Investment Management LLC. Views expressed are his own and do not necessarily reflect the views of Morningstar Investment Management LLC. This blog is provided for informational purposes only and should not be construed by any person as a solicitation to effect, or attempt to effect transactions in securities or the rendering of investment advice.