Section 939A of Dodd Frank has a very interesting mandate to federal agencies. It requires federal agencies to review their regulations to determine those which require the use of a credit-agency rating in assessing the credit-worthiness of a security and:
“Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations.….”
This mandate, to my mind, is justified. A number of practices of financial service companies (and, apparently, governments) are often geared to obtaining the favor of the (sometimes conflicted) rating agency, sometimes even acting as a substitute for their officers' better business judgment. There is pressure to defer to the ratings agency’s thoughts about the financial company’s business, even though the agency may well not fully understand the business of the companies they assess. Those rating agencies, and their opinions, are far short of infallible- and may often be seriously flawed.
This plays out in any interesting way in the development of a fiduciary standard for the purchase of lifetime income products for defined contribution plans. In developing any annuity fiduciary regulation, the DOL will likely be unable to reference rating agency standards (even when issuing prohibited transaction exemptions, it noted that it is “cognizant…. of the Congressional intent to reduce reliance on credit ratings and is considering alternative standards for use instead of, or in addition to, existing requirements for credit ratings in granted individual prohibited transaction exemptions").
I had blogged a few months back on the development of such an annuity standard, and had suggested extensive reference to the credit ratings. Thinking it through, however, I now realize I was just using a “lazy man’s” way out to make the standard sound more legitimate. In reality, actual ratings may or may not be relevant as, somtimes, the higher rating is not necessarily the best for the plan or the participants. A classic circumstance is where the “cost” of getting the higher rating (by means, for example, of establishing higher reserves) on the annuity product results in a higher priced annuity-without necessarily any commensurate, and real, increase in “safety.”
So, let me recast my suggestions for a safe harbor.
The DOL could require, as part of a safe harbor, that the insurance company which provides the annuity product being purchased by the plan should be prepared to describe to the fiduciary the following, in terms the fiduciary can understand:
-Provide an explanation of any assessment of its financial condition that independent third parties have provided to it, or have been disclosed to a regulatory authority (such as the state insurance department) without reference to any rating which as been assigned to it.
-Describe any material changes in its financial condition in the past five years and describe why. Have those changes affected the interest rate upon which annuity pricing is based?
-Explain how the state guaranty association rule would apply to the company’s product being sold.
- Describe material outcomes of the most recent state insurance exams.
-Explain the level of reserves, and why they were chosen.
-Describe the risk profile of the investment portfolio that supports the annuity contracts.
In a vacuum, the answers to these questions may mean little to the fiduciary. However, when compared to the answers of a competing insurance company, they could take on a quite a bit of relevance.
The fiduciary would use the answers using these sort of standardized questions (and a few others), focusing on the close details that are indicative of financial strength (or trouble), to arrive at a prudent decision-especially when used to compare the answers of other insurers. It could possibly have the effect of putting insurance more into the vernacular and make it an extremely useful safe harbor. It could act to help guide fiduciaries through some of the dense and often arcane material that is related to insurance, and to help sort out what is impotent’s to what really is important.
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