Every time interest rates go up there is a flurry of demand for a product that has been around at least since the Roman Empire — annuities. The insurance industry has already seen rapid growth in annuity sales since 2021 and if rates remain at or move above current levels, demand seems poised to explode.
There’s been some hand wringing of late about whether annuities could be bad for investors, for insurance companies or even for the financial system. The concerns spring from changes to the structure of the industry and the products themselves. Private equity firms have gotten into the business, buying public insurance players or starting new private ones, and now represent 10% of the sector. Both new and old insurance companies are using more leverage and expanding their holdings of exotic assets such as collateralized loan obligations and reinsurance contracts to fund annuities. In addition, insurers are offering greater liquidity to investors, raising the risk of bank-run-type disasters for the companies.
All these changes could lead to a race to the bottom where the most aggressive companies offer the highest annuity rates, win a bigger share of new business, chase the riskiest strategies to fund them and, eventually, collapse first. A big enough collapse could cause systemic problems in the financial system. It’s not clear that state insurance regulators can keep up with the changes.
I’m not going to discuss annuities used by wealthy investors with professional advice for tax savings, estate planning or creditor protection. Those are specialty needs that do not apply to most investors and do not represent a significant share of the annuity market.
The basic annuity of most interest to individual investors is one that is purchased for a lump sum, and makes monthly income payments that rise with inflation, for the lifetime of the beneficiary, with zero value upon death. The amount of income insurance companies offer depends on three main factors: the long-term real interest rate, the life expectancy of the beneficiary, and the amount of investment risk the company is willing to take.
The long-term real interest rate, as measured by the yield on 30-year inflation-protected treasuries, has been rising steadily over the last 18 months from negative values to about 2.5%. This puts many inflation-adjusted life annuities above 4%, the traditional threshold for demand to surge.
That’s because diversified portfolios of stocks and bonds can deliver about 4% while growing with inflation over the long-term, at least they always have in the past. These portfolios are available with zero or near-zero fees, and with high liquidity and flexibility. They generally are worth more, even after inflation, at death than at inception, allowing beneficiaries to help their heirs.
Inflation-adjusted life annuities have to offer higher rates than 4% for most investors to consider paying the often-high fees, while accepting the loss of liquidity and flexibility (as well as the complexities) of many contracts, and the loss of assets that can be passed along to their heirs.
One factor that can go either way is that a portfolio might fail to deliver the 4% above inflation, while the annuity is guaranteed though tied to the insurer’s financial strength. In the kind of market meltdown that might deliver unprecedented long-term losses in stocks and bonds, it’s anyone’s guess whether individual portfolios or insurance companies would fare better.
Insurers offer a few variations beyond real life annuities, but all of these — for example, fixed payments without inflation increases or variable payments tied to market indices — will benefit in the current rates environment; and are facing similar competitive pressures to bring in new customers .
It’s not just the asset side causing concerns either. Competition has led some annuity companies to offer investors more liquidity and flexibility. While that’s good for customers in the short run, it could introduce the risk of something akin to runs on banks. If interest rates keep rising, even annuities securely funded with cash-flow matched, high-quality, fixed-income assets could fail. Annuity holders might redeem to get higher rates elsewhere, forcing the annuity provider to sell assets at a loss, imperiling its financial stability, causing more annuity holders to redeem, until the slowest customers are left with nothing.
It’s impossible to predict whether recent innovations among insurers will eventually help annuity customers get higher rates or result in a financial disaster if a major provider becomes insolvent. The sector already looks very different from what it was during the last big demand surge between 2004 and 2008. Investors typically look to the credit ratings of insurance companies to judge risk, but rating firms aren’t always up to the task of evaluating aggressive and sophisticated strategies. Some people remember the financial crisis.
These are only worries for now not substantiated problems. Investors and regulators can count them as one of many pressing issues to consider as we transition to a financial system built around persistently higher interest rates than we have seen since 2006.
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