Guaranteed lifetime income from a DC plan requires a contract with a life insurance company. Period. Even if the program is provided by a mutual fund company, a bank, or any other non-governmental entity, insurance companies are the only businesses which can issue to DC plans a contract guaranteeing lifetime income.
Choosing the right insurer is an important task. It is a fiduciary act, and it is incumbent upon the fiduciary to be able to make a prudent choice of insurance companies.
Advisors and attorneys often struggle with this, though we don’t believe it is difficult as it seems. We have suggested that there are some sound ways to do this, particularly since trustees have been buying annuity contacts for centuries (yes, centuries. The material we have found in “Open Library” and “Mendely” are fascinating).
What is NOT sound, however, is a mere reliance on an insurer’s ratings in deciding what insurer to choose-or even the improper use of a rating in the decision making process. It does seem like such a simple task doesn’t it? When choosing between a AAA rated insurer, and an A rated insurer, you are better serving the fiduciary function to always choose the “AAA” rating, right?
No so. There are, in fact, circumstances under which relying solely on the current level of an insurer’s ratings may actually cause the fiduciary to engage in a breach.
This became apparent in Moshe Milevsky’s (an economist, and one of the world’s leading authorities in lifetime income) presentation on Tontines (more on that in another blog, but tontines were, effectively the first annuities) at the Stanford Center on Longevity’s roundtable on Best Practices in Retirement Income in May (which was well put together by Steve Vernon). Moshe discussed in some detail as to when an annuity is worth the price you pay for it. His answer was that it depends on the “load” an insurer builds into its annuity contracts.
How does “load” relate to an insurer’s rating, and to a potential fiduciary breach in relying upon that rating? Simply put, an insurance company can effectively “buy” a high rating by making sure its RBC Ratio-which is fundamentally determined by its level of reserves-is high. However, in order to have the funds to increase its reserves necessary to obtain or maintain a higher rating, an insurer typically needs to charge more for its annuities, placing a heavier “load” on them. The insurer, in effect, passes on its cost for a higher rating to its annuity policyholders.
The problem for a fiduciary is that a higher RBC ratio (and higher ratings) above a certain level does not necessarily provide greater assurance of insurer solvency. It may just mean that the fiduciary is paying too much for an annuity, without getting a commensurate return in the form of lessened risk of insolvency.
I do invite you to read, as an example, Consumer Reports’ discussion of insurer ratings. It makes the point that, above a certain level of financial strength, ratings may have limited usefulness.
The question a fiduciary needs to ask if making a decision based upon ratings is whether, given the relative rating of two insurers, is it worth paying potentially higher premiums for the higher rated company. This is particularly true for ratings in the same class (for example, S&P has seven different levels within its “A” class of ratings). Paying too much for an annuity contract can be a fiduciary breach, which means the fiduciary needs to exercise caution under these circumstances.
Ratings do have their usefulness in a fiduciary review. Any changes in an insurer’s ratings, for example (either higher over lower), within recent years should provide fertile grounds for the fiduciary to ask a number of important questions. But merely using upon an insurer’s static rating in making a fiduciary decision may actually be the basis of a breach.