Annuities have long been favored by investors looking to lock in a steady income stream during retirement, once their paychecks come to a halt.
Designed to ensure you don’t outlive your money, annuities are a contract between you and your life insurance company that guarantees lifelong income in exchange for a lump sum or regular contributions over a fixed time period.
Yet as a growing number of insurers falter, the peace of mind annuities provide has rapidly been replaced by anxiety-inducing questions: What happens if the life insurance company that sold me my annuity goes under? How do I check the financial strength of my insurer? Is my guaranteed income really guaranteed?
First, a quick lesson. There are two main categories of annuities: fixed and variable.
Under a fixed annuity, insurance companies guarantee the principal and, in some cases, a minimum rate of interest during the savings phase.
In a variable annuity, your contributions are invested in mutual fund-like investments called “subaccounts,” and the payout stream is determined by the investments’ performance.
To mitigate downside risk, however, and in exchange for higher fees, many retirement savers in recent years bought a variable annuity with a guaranteed minimum withdrawal benefit, which promises a minimum payout during retirement, plus any extra earnings if the value of the subaccounts rise.
That’s where the insurance industry got itself into trouble, since it has not been immune to the market malaise.
“When their investments don’t produce enough to cover those returns, they have to use their reserves to make good on their guarantee,” explains Terence Martin, vice president of insurance research for Conning Research & Consulting in Hartford, Conn.
To offset their risk, in recent weeks variable annuity providers have been raising fees and decreasing benefits. Some firms have even suspended offering the guaranteed income and withdrawal features of these policies altogether.
Nonprofits big investors
It’s not just retirees who own annuities.
Most 403(b) retirement plans offered by nonprofit organizations, such as public schools, religious institutions and hospitals, include tax-sheltered variable annuities as the biggest component of their investment offerings, says Rita Cheng, a Certified Financial Planner for Ameriprise Financial Services in Bethesda, Md.
Employees of those organizations invest in variable annuities, sold by insurance companies, through payroll deductions.
“Schoolteachers, for example, have 403(b)s, and those are the kinds of clients who are more focused on the value of their annuities right now,” says Cheng.
Some of the largest providers, such as TIAA-CREF, don’t offer performance guarantees on their variable annuities. But consumers and plan sponsors can review the financial strength of their life insurers by visiting the Web sites of Moody’sand A.M. Best and typing in the name of their provider. (Moody’s is free but requires you to register.)
Despite the challenging environment for life insurance companies, Andrew Edelsberg, an insurance analyst with A.M. Best, says those that sell variable annuities have been largely successful so far at mitigating market risk through sophisticated investment strategies.
“The companies issuing these guarantees (to variable annuity owners) have been fairly effective at offsetting some of their losses through the use of hedging,” he says, noting no such underwriters have been sent into state receivership during the current downturn. “A number of companies have been downgraded, but in many cases they’re being lowered from one high rating to another high rating.”
Many of the variable annuity writers, he adds, are part of “large, diversified organizations with substantial financial resources.”
Nevertheless, several life insurance companies have assembled in a queue to apply for bailout money from the Troubled Asset Relief Program, or TARP, a sign that all is not well in the industry. Should consumers be alarmed?
Like life insurance policies, annuities enjoy multiple layers of consumer protection.
For starters, companies that sell annuities are regulated under state insurance laws and required to maintain significant cash reserves.
All states, the District of Columbia and Puerto Rico also have guaranty funds to protect contract owners against insurance company insolvency.
Though actual coverage provided for annuity contracts varies by state, cash value and annuity benefits generally are protected for between $100,000 and $500,000.
As with life insurance policies, if the value of your annuity benefit exceeds that amount, you would be eligible to make claims against the estate of the failed life insurance company, which would use its reserves to make policyholders whole ahead of other creditors.
Because they are considered a security, variable annuities are regulated more closely still. The Securities and Exchange Commission along with the Financial Industry Regulatory Authority, or FINRA, oversee firms that sell such contracts.
If you own a variable annuity with a living benefit — or guaranteed protection of the principal investment — and your insurance company goes under, which is rare, your protection may come from two different sources, according to the National Association of Variable Annuities.
First, those who purchase variable annuities allocate payments toward a subaccount of stocks and mutual funds, which is held in the insurer’s separate account.
The assets in that account are insulated against the creditors of the insurance company in the event of the company’s collapse. It belongs to you. In some states, annuity assets are shielded from a contract owner’s creditors as well.
Keep in mind that the investments you select within that subaccount, which rise and fall according to market performance, are not insulated against loss.
Secondly, funds and guarantees for variable annuity living benefits are paid by the insurance company itself. Should it go under, your contractual obligations and annuity benefits would be covered by the state guaranty fund up to the maximum limit.
While numerous safeguards exist to protect policyholders in the event their life insurance companies suffer financial hardship, Martin says it’s important for individuals to evaluate their policy and annuities to be sure they still meet their needs.
“In the vast majority of cases, the answer is going to be yes,” he says, noting it may help to consult a financial adviser. “Consider one policy at a time in light of your individual circumstances. There are certain companies that are going through hard times right now, but overall we believe the system will weather the storm.”