Variable Annuities and the Crash of 2008-2009
Remember, those who cannot remember the past might end up repeating it
Many investors, panicked by the market crash of 2008-2009, started a search for some type of investment vehicle to protect them from the next market downturn. Some decided the answer was a variable annuity with a guaranteed living benefit rider. That was probably a mistake.
With a variable annuity, the issuer invests your money in mutual funds. If the annuity’s investments drop, that’s a problem. The guaranteed living benefit ensures that you receive income, regardless of what happens to the underlying investments.
An Auto-Insurance Analogy
At first blush, this seems to be a good use of insurance. For a nominal cost, insurance helps us spread the risk of a catastrophe. Consider auto insurance. There is a very small chance I will total my car in the next year. It’s hard to predict whether that will happen, but one thing is sure, it is all or nothing. Either I will or I won’t.
However, predicting the number out of a large group of people who will total their cars becomes much easier. While we don’t know who will total their cars, we do know about what percentage of people will. This predictability allows an insurance company to determine the average number of claims and set an annual premium that covers the anticipated claims and generates the company a profit.
But Market Crashes Work Differently
Insuring market crashes works much differently. The problem with trying to insure against a market catastrophe is that the risks don’t average out over time, instead, they clump together. In other words, the insurance company has either no claims or 100% of their policyholders filing claims.
Why? When insuring against a stock market decline, there are absolutely no claims when markets trend upward. However, when markets head down, every policyholder potentially has a claim. And usually companies are very cautious not to back risks that could result in a mass number of claims all at once. This is why most insurance policies have exclusions for terrorist attacks and war.
To help insure against this concentrated risk, companies use several methods to design these policies. One is to collect a fee for the guarantee that funds a reserve to offset potential losses.
Another way the companies mitigate their loss is that, unlike with auto insurance, these policies do not pay immediate benefits. If the market drops by 50%, you don’t get a check for your original investment plus a fair return for the time they had your money. What you get is a promise to pay you a lifetime stream of income, usually at some date in the future.
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