Do Variable Annuities Pose a Systemic Risk?

Posted by Frank

August 14, 2008

Insured from ANYTHING! Variable annuities have grown in popularity over the past couple of years and the downturn in our economy has only intensified retiree’s interest in such products. Variable annuities are essentially an insurance product against down markets by guaranteeing minimum payments (income) to the policy holder regardless if a bear market exists. Usually, a variable annuity is purchased in a lump some, let’s say $100,000. The money is invested into the market in securities like mutual funds for the investor. During retirement, checks are sent to the policy holder in guaranteed amounts with the potential of increasing in successful markets but no dipping below the guaranteed amount in down markets. Sounds good right?

Those reaching retirement are starting to take large sums of money out of their current securities/savings and purchasing variable annuities to secure their retirement – the problem, fine print. Variable Annuities are incredibly expensive; fees can total as much as 3.5% a year. Remember, a fee of just 1% can reduce earnings by 17% over a twenty year period. In addition, if a variable annuity holder decides to liquidate their entire policy, they will be faced with high surrender charge around 6-7% of the entire policy. As you can see, the insurance against terrible markets is extremely costly.

There is a major problem with this current setup of variable annuities – how can the insurance companies guarantee returns? As the number of dollars keeps flowing into this relatively new market, the number of dollars needed to make these guaranteed minimum payments also increases. If the current market were to double, triple or quadruple in size, I’m not so sure the insurance companies would be capitalized enough to withstand a bear market. In other words, if the investments the insurance companies make with our initial buy in don’t meet their original expectations, there could be a lot of retirees waiting for their money.

The parallels to our recent auction rate securities markets and subprime problems share scary similarities to the growing variable annuities market. If these insurance companies don’t properly evaluate and handle their risks, we could have a repeat performance of our current market. With the variable annuity market being relatively new, there isn’t a strong track record of success and or failures. Nobody really knows how well the industry will hold up. Is it possible this insurance against bad markets is too good to be true? Only time will tell, only this time I hope our regulators can keep pace. $

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