Here are two life lessons that relate to the subject of complexity in lifetime income benefit rider pricing.
Lesson one, be where your feet are. We too often live as though there’s a tomorrow, but tomorrow is not guaranteed. Lesson two, things aren’t always what they seem.
The complexity of LIBR pricing, specifically on fixed indexed annuities, creates an environment where the insurer is incentivized to charge in excess of the actuarial cost and repurpose this revenue to purchase higher crediting rates. Thus, it creates the illusion of a better product.
I had an epiphany regarding this issue recently:
Find the net present value of the LIBR cash flows on a product that charges the actual cost of the benefit. Then we can reverse engineer the excess cost (profit) of a LIBR with higher fees. From here, we can determine if it’s possible to bump up the budget for interest credits by charging more for a LIBR.
Spoiler alert: An increase in LIBR cost of just 0.10 percent can result in triple the LIBR revenue to the insurer.
Examining the cost of a LIBR is to examine the cost of an FIA, or the pricing of an FIA (they are one and the same). The first leg in my FIA cap pricing journey started about six months ago when I was listening to a quarterly investors’ earnings call for a publicly traded insurer we use. An investment banker asked how this insurer priced their LIBR. He inquired whether they profit from it.
What do you mean “if they profit from it”? Why would he ask this if it wasn’t possible (which it is) and if it wasn’t something other insurers are doing? As I thought this, the CFO answered that their LIBR fee is set at the actuarial equivalent. Surely others were doing the same. Was this unique?
To answer this, you should instead ask what would motivate an insurer, other than profit, to profit from ancillary product benefits? It’s a counterpunch to the Department of Labor’s fiduciary rule. What better way to say a product is more consumer-friendly than to give it better interest potential? Surely an FIA crediting 5 percent symbolizes the client getting a bigger piece of the pie. Are things always as they appear?
Could a contract with a LIBR fee calculated against the income account value of just more than 10 basis points create an aggregate fee of two to three times that of a contract with a LIBR fee calculated against the account value? As a financial professional, have you ever told your clients, “Little changes, over many years, can result in big results”? Of course, you have! Yet, this fact is ignored in the construction of the financial products.
Simply put, an insurer can charge more for a LIBR than it costs them to create it. They can take these funds and use them to buy higher caps. People like higher caps because higher caps symbolize more money.
How do we determine the cost of a LIBR? What is the cost? Let’s get more basic. What’s the purpose of insurance? To transfer the risk from an individual to an insurer. In the case of a LIBR, the risk being transferred is longevity — outliving one’s money. The principal risk to the insurer is being contractually obligated to continue income payments after the FIA account value is reduced to zero.
Here’s the kicker. All else equal, wouldn’t an FIA with a cap of 5 percent carry an account value north of zero longer than an FIA with a cap of 2.25 percent? If the account value is likely to be positive longer, then isn’t the risk to the insurer lower, and de facto, the cost to provide the LIBR benefits lower as well? Yet, I can find FIAs with higher than average caps with higher than average LIBR fees.
Some carriers assume lower lapse ratios than others. This is a pricing strategy. For example, if a carrier assumes the same lapse ratio on an FIA with a LIBR as it does on an FIA without a LIBR, despite FIAs with LIBRs historically having lower lapse ratios, then this frees up pricing.
Moving forward, for simplicity, here are two examples I will call Thing 1 and Thing 2.
Thing 1 is a real product. It is offered by the insurer I mentioned in the story above. Thing 1 has an annual point-to-point cap using the S&P 500 of 2.25 percent. Its LIBR fee is 0.90 percent of the account value.
Thing 2 is not a real product. It’s more of a conglomeration of other FIAs currently available. We’ll assume a 5 percent cap using the same index as Thing 1. Thing 2, however, will have a LIBR fee of 1 percent based on the income account value.
Both Thing 1 and Thing 2 will use an initial deposit of $100,000 using a 60-year-old man and an approximate annual lifetime income of $7,300 starting in the fifth contract year. Although, unimportant for Thing 1, Thing 2 will have an income account value of a bit more than $147,000 when the income phases begin.
Based on these assumptions, we can determine the total revenues (future cash flows) generated by each LIBR pricing method for Thing 1 and Thing 2. The difference in raw cash flow is somewhat misleading though, since Thing 1 charges much less in later years than does Thing 2. A dollar in 10 years is worth less than a dollar today. To account for this, we’ll need to calculate the net present value of these future cash flows for both Thing 1 and Thing 2. In this calculation, we’ll use a discount rate of 4 percent.
The second leg in this journey happened about a month ago when I was attending a home office meeting. I asked the carrier’s head actuary, in general, how much does each 1 percent of cap (using an annual S&P 500 index) cost in terms of budget? Although actuaries don’t particularly like the term, he said in general each 25 bps of cap costs the insurer about 10 bps. Looking at other products, this doesn’t seem to be outlandish.
In other words, Thing 2, with a 5 percent cap, needs to have about 1.1 percent more budget than Thing 1. We can find the budget in an FIA by looking at the fixed rate option. The fixed rate option is the amount the insurer spends on options. FIAs are efficiently priced, meaning the insurer isn’t meaningfully more profitable when a consumer chooses one interest crediting option over another. The fixed interest rate levels the playing field when comparing one product with another.
The cap rates between different insurers can vary widely, but then so should the fixed interest rate option. If not, then they’re messing with other assumptions, levers, or IE pricing mechanisms. This is possible, but as mentioned earlier in this article, just a 10 bps greater LIBR charge can result in two to three times the revenue.
I found one product with a 1 percent fixed rate that had nearly the same annual point-to-point cap using the S&P 500 as one with a 2.60 percent fixed rate. Yes, the first insurer could be offering artificially higher cap rates with the intent of decreasing them later, but compellingly, the LIBR was a percentage of the income account value and it was mandatory.
My article serves as an explanation that this mathematically is possible. It does not conclude or assert that any carrier is doing this. It illustrates, given the legislative environment created by the Department of Labor fiduciary rule compounded with the complexity of pricing levers, that this could be done and it would be decades before it was actually noticed.
Aggregate Cash Flows
Next, we need to determine the aggregate cash flows derived from Thing 1’s and Thing 2’s LIBRs. I used the same Excel spreadsheet I’ve previously used to discuss the effect of different cap rates on FIAs. It uses the S&P 500 annual returns (without dividends) from Jan. 1 to Dec. 31 each year from 1975 to 2016.
Thing 1’s account value, on average, was depleted in the 21st contract year. So I took the average account balance for each maximum rolling period available and multiplied this amount by the LIBR fee. In total, over the 21 years, the aggregate LIBR fee was $12,881.
Thing 2’s account value, on average, was depleted in the 23rd contract year. Using the same method as before, the aggregate LIBR fee for Thing 2 was $33,148.
Using a discount rate of 4 percent, the net present value of the LIBR cash flows for Thing 1 is $4,757. Thing 1’s LIBR charge was 0.90 percent. In today’s dollars, Thing 1 receives $528 per 10 bps of LIBR cost (4,757 divided by 9). Again, we’re assuming Thing 1’s LIBR costs to be the actuarial equivalent. This should represent the cost for this benefit.
Using the same discount rate, the NPV of the LIBR cash flow for Thing 2 is $11,361. Using $528 of revenue per 10 bps of LIBR true costs, the cost for Thing 2’s LIBR is 2.15 percent. That’s 125 additional bps. If 10 bps buys 25 bps of caps, then the excess LIBR cost could account for up to 3 percent greater cap.
This mathematically explains the difference. Yes, higher LIBR fees can be used to buy higher caps.
I am not claiming one pricing strategy is superior to another. In fact, the pricing strategy of a LIBR has nothing to do with LIBR payments because the LIBR fees do not impact LIBR payments.
I would not have thought 10 more bps on the income value was that much greater than on the account value. I haven’t named any insurers because I’m proving it’s mathematically possible to divert greater LIBR fees to buy higher caps. I cannot prove, undeniably, this is what is being done. And I haven’t found an insurer to discuss this “on the record.” You’ve seen the math. You be the judge.
Michael Jay Markey Jr. is a co-founder and owner of Legacy Financial Network, Kentwood, Mich., and is the author of Fireproof Your Retirement. He may be contacted at [email protected]