Trojan horse (noun): 1. a person or thing intended secretly to undermine or bring about the downfall of an enemy or opponent.
2. an act where a government allows private insurers to sell annuities to retirees as a means to create a future dependency that could ultimately lead to expropriation.
There is a lot of excitement in the life and annuity industry over the recently passed SECURE Act which changes certain rules related to retirement savings. While some of the new regs are positives, I suspect some will turn out not to be as promising as advertised.
What Does The SECURE Act Do?
The SECURE Act does a number of things. For retirees, it raises the age before they are required to take minimum distributions to 72. For employees, it allows them to contribute up to 15% of income (subject to the $ cap) to a 401k up from 10%. For small businesses who might not have had enough assets to form a viable plan, they can now pool with other similar small businesses to essentially form cooperatives to make plans more affordable.
These are all positive actions on the margin, but the one change that is potentially more significant is the endorsement of “lifetime income” – essentially annuities – in 401k plans.
Why is Guaranteed Income a Big Deal For Insurers?
The biggest reason is it creates a growth opportunity for life and annuity providers. While some of these companies currently administer 401k plans, often they are what is referred to as the “recordkeeper”, meaning they do the administration and a mutual fund firm does the investing.
If participants decide to move their investments out of mutual funds and into annuities (likely with a not-so-subtle push from the plan manager), market share moves from investment firms to insurance firms. This is a big win (at least for the top line)!
With Opportunity Comes Risk
The challenge for life and annuity companies is income guarantees are long term liabilities that can bring short term volatility. Unlike a mortality product, where the macro environment doesn’t change the long term risk, long term investment guarantees can cause significant changes in customer behavior and capital requirements in down markets.
In other words, an income product’s ultimate financial returns are path dependent where a traditional mortality or morbidity product isn’t. Throw on top of this imminent new accounting rules that are pro-cyclical and the pain from a down market now means rising capital requirements and excessively punitive GAAP financials.
Why is the industry excited to sell more of this? Great question! The best answer I have is the perfume of the premium triggers a neurological reaction that releases endorphins which lead to excessive optimism that this time will finally be different!
The Market Has Spoken
Rightly or wrongly, investors hate companies that sell too many annuities. The fastest way to sink your company’s valuation is to grow the contribution to earnings from annuities. While this certainly made sense ten years ago, the market growth since then has reduced the “bad vintages” to almost nothing while many years of healthy business have been added to the mix.
One would think investors would have forgiven annuity companies by now and cheered their strong growth. On the contrary, sum of the parts exercises suggest annuity earnings are valued between 0 and 5X earnings. Given how much of the mix is now recent vintage, this suggests investors believe every new sale, even in a raging bull market, destroys value.
I will explore this dynamic more in a future article, but for now, the important thing to understand is companies that view the SECURE Act as an all-clear sign to sell as many annuities as they can are likely to see their stock prices suffer. But this is only the first gift from the Trojan Horse.
The Legislative Failure
The government made a big mistake in giving their blessing for annuities in 401ks without getting certain assurances in return. Namely, there should be a requirement to implement conservative risk management practices and to limit the amount of annuities any one provider can sell.
Why? Well, there are only so many insurers with the balance sheet size and ratings to assume significant amounts of income guarantees. Maybe it’s ten. It’s likely going to be closer to five. Thus, there will be great concentration of risk with a few providers.
Treasury may not realize it, but they effectively gave a “too big to fail” guarantee to the large annuity writers. If all the big sellers run up in forces of $50+B of liabilities to 401k participants, what happens when the market is down 25% and hedges don’t work as intended? Capital requirements spike, book values nose dive, and the rating agencies are demanding capital raises at 50% (or lower) of book value?
Is the government really going to let 401k holders lose their life savings? I think we all know the answer to that. They will not let the life companies fail.
The Trojan Horse
So, what am I so worried about? Isn’t an implicit government guarantee a good thing? Look how it worked out for the banks. Oh, I mean look how it worked out for the banks!
The SECURE Act is opening the door to potential government control of the life insurance industry. Treasury will realize it can’t let what are essentially “private pensions” be controlled by so few companies. At least not without significant government oversight!
If insurers don’t effectively hedge (and they won’t – either intentionally or unwittingly), then the government will be in the lifetime income guarantee business. That means they will set the rules, they will dictate the capital requirements and the hedging practices, and they will determine how low the return on capital will be for the insurance companies.
The life and annuity companies haven’t heeded the market’s message that these products destroy capital. While I am sympathetic to the companies’ arguments that the current in force is worth more than the market gives them credit for, I am wary of the systemic risk that could come from future growth.
While the SECURE Act may be well intentioned, it ironically will likely reduce security for retirees. Concentrating what are effectively personalized pension plans among a small number of carriers raises the odds of financial distress for individuals. The road to insolvency is paved with good intentions.