Do GICs and annuities work today?
How reliable are guaranteed investment contracts and annuities in today's insurance industry environment? To put the question in perspective, GICs alone represent an asset class of between $150 and $200 billion.
Corporate pension managers see the answer revolving around two major insurance industry issues. The first is the liquidity of the insurance industry and the implications for corporate sponsors. The second is the pressure for increased regulation of the insurance industry at the federal level.
These two subjects were addressed by roundtable talks at the recent fall conference of FEI's Committee on the Investment of Employee Benefit Assets (CIEBA), held in Washington, DC. The following is an edited version of the participants' remarks, including a brief Q&A session.
THE KEY is SOUND REGULATION
James P. Corcoran
Wilson, Elser, Moskowitz, Edelman & Dicker
(Former Superintendent of Insurance, New York State)
Regulators usually try to keep the insurance industry boring and dull. But that wasn't such a good idea back in the 1980s. The pressures on the industry were substantial. Not least was a tremendous increase in policy loans in response to the high interest rates available in other financial markets.
When I became Superintendent of Insurance for New York State in 1983, the cry was to liberalize investment restraints so that consumers could fully participate in this new economic boom. Of course, by the time I left office in 1990, there had been a 180-degree turn.
During the 1980s, proactive insurance regulators weren't very popular. When I joined with a few other commissioners-from Arizona and Maryland-to put a 20-percent cap on the amount of its assets a fund could invest in junk bonds, the insurance industry in New York was supportive. But it was not a national movement. In fact, I still have press clippings-including one from The Wall Street Journal-calling me an economic Neanderthal for daring to slow down the 1980s' geniuses.
I'm convinced that if we had federal regulation of insurance in the 1980s to match the wild west regulation in other industries, we would have today an insurance crisis parallel to what has occurred in banking. But because some state regulators were more proactive than others, while we do have a problem now, we don't have a crisis. The insurance industry and regulators have been criticized, of course, and significant change is certain.
WHAT WILL REGULATORS DO?
Rating agencies-Many of the agencies rating insurance companies are relatively new to the business and, at least before Executive Life and Mutual Benefit, did not really understand the industry. They have been reluctant to make public the methodology they use in rating insurance companies. I don't agree with another regulator that regulators should rate the rating agencies, but I do think regulators need to put pressure on the agencies to reveal their rating methodology. I also support the move by regulators to require the rating agencies to analyze the risk-based capital of insurance companies, where they put their special reserves in light of their portfolios and the businesses they are in. Uniform regulation-When New York pushed for uniform regulation a few years ago, it was regarded as a conspiracy. We suggested that insurance regulatory bodies be certified, that they be audited to make certain they have enough capital and staff, and that essential solvency statutes have been enacted in those states. Consumers and companies doing business with insurance companies in states that are certified would know that they are being adequately regulated. States that don't support their regulatory bodies would lose premium income, because companies would move to certified states.
Guaranteed investment contractsGICs used to be regarded as long-term investments, and in New York we required the matching of assets and liabilities. In fact, because Equitable was forced to do this early in the game, it has been able to work out of its difficulties.
But when companies offer GICS-OR any long-term product, for that matter-that have ease of surrender, as they have been doing recently, they undermine the stability of the product. So regulators have to look at product design. If one product has an easy surrender, the odds are that others will also have it. And that's when a run on a bank becomes a real issue, which is what happened at Mutual Benefit. That's why you need state regulation that defines appropriate surrender provisions and that also requires the matching of assets and liabilities.
Financial guarantees-Financial guarantees running inside a holding company are difficult to understand, especially for someone outside rating the company. Regulators in the Mutual Benefit case did not adequately oversee the intra-company guarantees running the subsidiaries.
The life insurance industry is now much more sober in its expectations. But when you look in the marketplace and see the industry proposing to set up its own emergency funds to provide liquidity, this raises antitrust and other legal implications. The work of the National Organization of Life and Health Guaranty Association, a national organization that coordinates the guarantee funds, could represent a step in the right direction-but only if it sets up criteria whereby any company licensed in a participating state is provided liquidity for long-term ends. That might further the process of self-regulation. Certainly, we need a national approach to guaranteed funds.
The Group Annuity Participant Protection Association (GAPPA), which represents defined contribution plan interests, faces its own issues. Each state has different laws regarding coverage of guarantee funds. There will be a big push to make everyone aware of the need for uniformity and for the laws to make very clear what's covered and what's not.
Finally, there is the issue of separate accounts. Some insurers are now asking regulators if they can do separate accounts with a minimum guarantee. Regulators are sensitive to this issue, and there is some support for federal regulation of separate accounts. Frankly, I don't think the federal government has the will to do the job. Of course, federal solvency criteria should be discussed, but such criteria should be administered by the National Association of Insurance Commissioners, which is basically what the certification program is. In fact, if the federal government keeps the pressure on state regulators, certification will become very real, as opposed to a cosmetic response to a political environment.
HOW TO BUY ANNUITIESAND FROM WHOM
Thomas P. O'Connor
Executive Vice President New York Life Insurance Co.
Only two or three years ago, the prevailing view was that, if you had seen one insurance company or one policy or one contract, you'd seen them all.
So the insurance companies entered a bidding contest to get clients. We'd get a phone call from a potential client who said that one of our competitors, an established company, was two basis points higher in its quote, and if we'd just beat that, we'd get the business.
Today, everything is radically different. It's recognized that there are differences among the insurance companies. So the question has become: how to choose the right one.
Most people don't know much about buying annuities. It is an infrequent transaction. It really amounts to spinning off part of your pension plan-the liabilities and the corresponding part of the assets to go with them-to an outside insurer who offers a conservative, tightly structured fixed-income product. In fact, annuities were considered so conservative a few years ago that insurance by the Pension Benefit Guaranty Corporation was deemed unnecessary.
A few spectacular cases changed that way of thinking. When the annuity became a tool in LBO takeovers, particularly leveraged by junk bonds, it seemed a good way to generate capital for a takeover, to get the excess out of the pension plan. Annuities suddenly seemed much less secure. I submit, however, that, if done correctly, buying annuities is still a safe, conservative move. There are many retired people today comfortably receiving checks, even if their former employer, and probably their pension plan, have become history.
But how does a plan sponsor approach buying annuities today, given the attention the market has drawn from both federal and state governments? More than 15 Congressional committees and subcommittees are addressing annuities and the insurance industry. We hear talk of a presidential commission on rating agencies, and of legislation being proposed in Congress. There are no firm guidelines for annuities. The only regulation affecting the pension plan sponsor is ERISA, which is not very comforting.
But an annuity purchase need not be complicated, and is a viable risk-control technique. In considering annuities, the first point is to find out what type of annuity to use. There are two types. One is the traditional, non-participating annuity for a one-time, lump-sum payment, with the insurer assuming responsibility for a block of liabilities. The second is the participating annuity. The sponsor pays a larger up-front premium, but participates in the investment results and gets back any excess. The assets are isolated in a separate account, and the investment strategy is agreed to jointly by the plan sponsor and the insurer.
To help decide the size and type of annuity contract, you should use an actuarial consultant. Among your first considerations: What will be the contract's final effect on the plan? What is the future funding status? How will that affect future contributions into the plan? Very important is how the specifications are drawn up, including the supporting documents the insurer will use for his quote. The groundwork here can contribute a great deal to a smooth transaction.
The next step is to select the carrier. This is easier than it sounds. The best way is to screen out a group of carriers and seek bids. From that point on, it's very much like hiring any investment manager.
You are looking for a firm with a good reputation for service, a clear investment strategy, and a good track record, plus one that is consistently profitable and well capitalized. The service capability is paramount. Even though an annuity contract is a onetime transaction, it covers a large number of your employees. Service is particularly important if you give cost-of-living increases. Can the carrier work with you to accomplish this smoothly?
Investment philosophy is the number one question when evaluating either an investment manager or an insurance company. How do they invest the capital they control? How liquid are they? What quality criteria do they use? No one screening Executive Life as an investment manager would have accepted its heavy concentration on high-yield bonds for an employee savings plan.
Equally important is a track record. A profitable company is going to stay in business. But is it profitable in its pension line? You don't want a company deciding that since it's not making money in the pension business, it's going to leave it. Then you've got a big service problem.
I'd also want the insurance carrier to be well capitalized. This is, after all, the basis of the guarantee. What are its capital ratios? A little bit of due diligence by an experienced analyst can find the financial guarantees that may be flowing off, such as through a subsidiary operation.
Finally, I'd go to the rating agencies to confirm my homework. And I would pay the insurance company a visit. Once inside the four Walls, did what we find look and sound and act like what they told us before we got there? Most of the time it does. Some of the time it doesn't.
In regard to the future, I suspect we will see new and tougher regulation of insurance companies. I know many in the industry quake in their boots at the mention of federal involvement. My only real fear is that we end up with dual regulation, with half our business covered by the states and another half by the federal government. That's a no-win situation.
Regarding guaranteed funds, I raise a big red caution flag. There is a place for a guaranteed fund, but doing it wrong will sow the seeds of what happened to the S&L industry. If a guaranteed fund masks bad management, and customers don't care because of the guarantee, you're in trouble. Investors didn't care that the S&Ls were sick-they had FDIC protection.
In the spirit of reform, we mustn't push the insurance industry backwards. More coordination among both the guaranteed funds and the states would be helpful, but an industry-sponsored emergency fund-with strong capital requirements-is probably the healthiest answer.
Finally, I believe the ratings of the insurance industry by the rating agencies have been too high relative to industrial America and to the banks. The total of AAA listings at one point a few years back was unbelievable. Maybe part of the problem was overreaching by regulators, and part was the enthusiasm of agencies to sign up companies to get rated.
Now it's back to reality. The rating agencies are more knowledgeable than before. A few years ago, the mystery of insurance liabilities had them buffaloed. Now, they're asking the right questions. Liquidity, for example, is not looking just at your assets; it's looking also at your liabilities. All this is healthy. There's nothing wrong with an AA rating. In industrial America, that's a dam good company. Hopefully, when the dust settles, it will be a dam good insurance industry, too.
CONSIDERATIONS IN MANAGING YOUR GIC PORTFOLIOS
What are some of the key issues you have to consider when you're planning, organizing, and controlling a portfolio of guaranteed investment contracts?
An important item is communication, which all too often is misinformation. The media is confusing plan participants. When I was administering the benefit plans at Shell Oil, reporters would call me to check out their facts for a story, but in my view they weren't really interested in the real facts unless they were "newsy." Nor were they interested in doing extensive research; they all had deadlines to meet.
Company officers, legislators, and regulators are also confused by the media. In the midst of all this confusion, the pension manager has to explain what's happening to his investment committee and CEO.
Given the recent failures of some insurance companies and the rash of downgradings of others, why have GICs at all? Because employees and participants love them. GICs still offer low risk and relatively high returns versus bank CDs or money market instruments. GIC rates change very slowly. And they don't mark to market-although if the FASB changes Statement 35 to require sponsors to mark GICs to market, I predict they will disappear very quickly as a 401k option.
Another issue is the question of the guarantee: Who's guaranteeing what? The pension sponsors aren't offering the guarantees, and many are even removing the word "guarantee" from the name of the funds that hold GICS. There is also an issue between insurance company GICs and annuities, and which instrument comes first in the event of insolvency. So far, the courts have not been consistent in their rulings. There are a lot of problems here that insurance regulators still need to resolve.
Another whole set of issues is raised by BICS, or bank investment contracts. You have to be very, very careful about the guarantees in these contracts. Our due-diligence team visited two large New York banks a few years ago to qualify them for our monthly bidding process. Because a BIC is in effect a loan to a bank, we wanted to understand how these banks administered their BICs before we did business with them. Both banks said we were the first group ever to come in to look at their books. And, frankly, after finding a few surprises, we decided not to do BICs with them or, for that matter, with any other bank.
I agree with Tom O'Connor (page 52) that due diligence is very important. Rating agencies can be valuable as a double check after the fact. Until five years ago, however, they didn't know much about insurance companies. Doing the work yourself is the best way to go.
Similarly, in my view, it's not enough for a pension sponsor to pay a consultant five or 10 basis points to manage a GIC portfolio. If your company has $100 or $200 million or more in this option, you really should be doing the due diligence yourself. I also believe you need a dedicated staff for all of your defined contribution plans, but especially for the GIC option.
At Shell, defined contribution plans have more money in GICs than in any other options. And we are one of the top two or three of all defined contribution plans in terms of the amounts we have in GIC options. I predict, however, that the funds we have in OICs will decline to 20 percent to 30 percent of total defined contribution plans.
IS THE EMPLOYER RESPONSIBLE IN A GIC FAILURE?
During the program on GICs and annuities, a question regarding the responsibility of the company sponsor in an insurance company failure was directed toward Robert Evans, assistant treasurer of Xerox and chairman of the steering committee of the Group Annuity Participant Protection Association (GAPPA). Evans' response:
"Some members of GAPPA have stepped up and said that, even though they are not legally obligated to do so, they would make their participants whole. It remains to be seen whether it will actually cost those companies any money. Under a defined contribution plan, participants or the company puts money in, and participants walk away with whatever value accrues, whether it goes up or down.
"There is no company I know of that has a defined contribution plan that requires the company to make the participants whole following any loss. What is interesting is that participants don't expect to be made whole if the fund has stocks or bonds; but if there are guaranteed contracts, they think the company should stand behind it. In my opinion, however, that is not logical. Under a defined contribution plan, the employer is not responsible for investment losses, except for exceptions like willful misconduct.
"I would like to add that the GIC has been over the last 20 years one of the most successful products to come down the pike. Part of the problem is that it's done what it was represented to do, and we all began to rely on it. Everybody is talking about getting out Of GICs, but it's not clear that any money has yet been lost. Before companies bail out, they might want to think about what they're going to do with their employees' money as an alternative. I also think employees are going to become more sophisticated. Just as they have diversified their money market investments into equity mutual funds, they will want to do the same with today's GIC funds."
FROM THE FLOOR
Q: If a plan sponsor has 60 percent of its savings and investment fund in GICs, what should it do? Should it diversify? Should it take huge market losses by cashing in some of these contracts? Or should it just sit there with white knuckles, hoping the insurance industry will stay together?
CHAIKIND: The first thing to do is to educate employees and participants. They don't really understand all of the issues, including the risks, and may well be making the wrong decisions in how they place their funds. They should know that, long term, a GIC option will probably underperform a bond fund option by I to 2 percent a year and a stock or equity option by 3 to 4 percent. If you can't use your own staff to educate employees, I recommend you hire consultants. If employees were properly educated about GICs, you wouldn't see 70 to 80 percent of their money go into this option.
Second, if you think you have problems with a GIC carrier, I recommend you negotiate your way out of the contract. If the insurance company can't make good on your contract, and you don't cover the claim, your employees might well sue you, and that could be disastrous. Besides, you may not have to sustain a loss by cashing out, because most GICs were bid out at higher rates than are currently prevailing. So you might even be able to unwind GICs at premiums to the value they reflect in your books. An important element here is what your plan document will allow you to do.
Q: What is the difference between state certification of insurance companies and federal regulation that would do the same thing?
CORCORAN: The problem with the federal government doing the regulating is that every four or eight years its philosophy changes. This brings a change in the will to regulate, which is what happened in the Reagan years.
The insurance industry in the 1980s did have problems in California, but there was no regulatory collapse in New York or illinois, the other major insurance centers. Those state regulators were not out to lunch. I prefer a state system, because it gets you out of the political realm. Financial regulation does not belong in the political realm. It does not belong in the cowboy mentality that real men don't need regulation.
With political oversight, the whole system will go down. We screamed to Congress in the 1980s about junk bonds and the Pension Benefit Guaranty Corporation certifying terminated plans and letting them buy annuities and shift the burden to life guarantee funds. Nothing happened. Had the insurance industry been federally regulated then like the banking industry, both sources of capital would have gone down the tubes. Q: I'm going through what I would call the Executive Life experience. Why do we need to go to an insurance company at all? And do GICs really make sense? We went to insurance companies to avoid risk, but things haven't worked out that way. Why should we go to you rather than to other capital markets?
'O'CONNOR: Guaranteed investment contracts originated 20 years ago when people didn't want to be in an open-ended annuity but wanted to avoid the volatility of the bond market. Insurance companies provided a bond substitute product and provided a guarantee of a stated annual return. Over the years, the term guaranteed has taken on connotations of FDIC insurance.
Why use GICS? Because your employees like them. They work very well in company savings plans, 401k plans, and other defined contribution plans. To employees, they look and act like a savings account, and we did not have to explain to employees why the value of their savings accounts went down when interest rates went down. And for years GICs worked like savings accounts. Things broke down when we turned the GIC into a commodity and, often ignoring credit quality of issues, bought GICs from any company that could sell them.
Selected wisely, I believe GICs are still a very attractive investment. Well-capitalized insurance companies, with diversified asset bases and good credit ratings, still offer a solid product.
CORCORAN: I think the theory of using insurance companies is that by statute they must diversify investments, and that regulators exist to make sure of that diversification. With Executive Life, there was a breakdown in that diversification. Otherwise, a GIC is an ideal investment for a fiduciary plan, because with diversification comes prudence.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||Pension Fund Management; includes related articles|
|Date:||Jan 1, 1992|
|Previous Article:||Health care: where do we go now?|
|Next Article:||Back to basics.|
|C&W to manage 17 State Street.|
|Failure Follows Liquidity Woes.|
|Proceed With Caution.|
|Look to Annuities to Salve Pension Fears.|