STUMP » Articles » A Week of Bad Pension Ideas: First Up, Guaranteeing Returns » 8 November 2015, 17:20

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A Week of Bad Pension Ideas: First Up, Guaranteeing Returns  


8 November 2015, 17:20

This last week, I came across multiple bad ideas proposed for “solving” pension and retirement savings problems.

Because I’m not a clickbaiter, I’m going to list these bad ideas below:

You are free to read these core stories and come up with your own conclusions. But if you stick around this week, I will make comments as to why each of these are bad ideas.

Not evil ideas, mind you: that’s the realm of pension obligation bonds.


I love these free money scams.

Anyway, here’s the concept:

OLIVIA S. MITCHELL: Some 25 states and several U.S. cities are working to establish new retirement accounts to help American workers lacking a pension plan save for retirement. Three states have already passed legislation setting up state-driven individual retirement accounts via payroll deduction, and many more states have indicated they plan to follow suit soon. In some cases, the money will be managed by the state, as in Illinois, Massachusetts and New Jersey. In others, private-sector money managers would do the investing.

One major concern deserving of far more debate is that at least five of the state bills stipulate that the funds’ investment returns would be guaranteed, to protect workers’ money. For instance, Connecticut is moving toward a so-called Guaranteed Retirement Account, providing for a “fixed 3% rate of return adjusted for inflation” backed by the state.

Oh, we’ll be seeing more stupid ideas from CT later this week.


Mind you, guaranteed return funds exist — they’re called fixed deferred annuities. I worked for two different companies that sold these, and I know the details about these products. Most annuities do not have an open-ended guarantee, by the way; the guaranteed accumulation rate will be for a determined period of time, though sometimes it’s as long as ten years.

It used to be the case that everybody used a floor of 3% as the guarantee rate. Because that’s what was written into law.


This happened:

That’s just the 10-year rate, but all the long-term Treasury rates have had the same pattern: spiking in the early 80s, then a secular decreasing trend since then, with rates even lower than those seen in the 1950s. We reached a historical low in 2012, but who knows if that “historical low” will remain historically low.

The decreasing trend of interest rates used to not be a huge problem for insurers guaranteeing returns. The minimum guarantee used to be 3%, and they didn’t have an issue then:

The minimum nonforfeiture rate, which is the minimum interest rate guarantee that an insurance company can use in an individual fixed annuity contract to determine its cash value, is regulated by the Insurance Code. In 1980, when the minimum nonforfeiture rate was placed in statute, it was based on a rate recommended in 1977 by the National Association of Insurance Commissioners (NAIC). At that time, interest rates were quite high (some in the double digits) and so the minimum rate was set at three percent.

However, the recent economic downtown has sent interest rates plummeting. Many interest bearing investments (for example, certificates of deposit, money market accounts, and savings accounts) offer interest rates of only 2 percent or lower, with many financial institutions offering rates as low as .6 percent. The result is that companies offering annuities are finding it more difficult to offer products that consumers want and to offer those at an attractive interest rate. Reportedly, many companies are no longer offering short-term annuities (one to three years). The concern is that if interest rates continue to be flat for a protracted period of time, that companies who sell annuities could, as a result of paying interest rates in excess of the actual market rates, place their financial stability at risk.

According to industry members and the Office of Financial and Insurance Services (OFIS), the NAIC is studying the issue and working to devise a method by which the minimum nonforfeiture rate could be based on an index. This would allow the minimum rate, or “floor”, to move and keep pace with current market conditions. Until such time as this permanent fix is available, industry members have requested that the statute be amended to provide a temporary fix. Therefore, legislation that would lower the minimum nonforfeiture rate for individual fixed annuities from 3 percent to 1.5 percent – for a period of three years – has been proposed.

That was from 2002, by the way.

What have rates done since 2002?

Yeah. This is starting to impinge on my day job, but you can see this isn’t pretty without all the extra stuff I’ve written in proprietary work.


I am something of a specialist in disaster — mainly looking at how spreadsheets fail, but I look for all sorts of disasters and their causes.

And within the insurance world, the worst insurance disaster was Equitable Life UK. Actuaries pay attention to this one, because this was (for once) the actuaries’ fault.

They treated a very valuable guarantee as costless.

“Many of Equitable’s with-profits policies were designed to provide a pension for the policyholder on retirement”11 and the lump sum available for annuity purchase depended on the sum assured, the reversionary bonuses and the larger terminal bonus. Both types of bonus were allocated at the discretion of the directors in accordance with Article 65 of the Articles of Association, the total being intended to reflect the investment return over the lifetime of the policy, subject to smoothing.11 Between 1956 and the advent of Personal Pension Schemes in July 1988, Equitable sold policies with an option to select either a Guaranteed Annuity Rate (GAR) or the Current Annuity Rate (CAR). The latter reflected the anticipated investment return on the lump sum over the annuity holder’s lifetime and could change with interest rates or longevity.11 No additional premium was charged in respect of the guarantee.6 In 1979 legislation allowed the lump sum to be transferred to another annuity provider. As a result, communications with policyholders increasingly focused on the lump sum rather than annuity benefits.

The GAR assumed 4% interest until 1975 when it was increased to 7%. By May 2001, of Equitable’s 1.1m policyholders about 16% held a GAR option.11 During the 1980s and 1990s Equitable experienced a further period of rapid growth. It developed market leading personal pension and additional voluntary contribution plans while maintaining its record of operating with one of the lowest expense ratios in the industry.2 Its success was “partly based on its reputation, its strategy of paying no commissions to insurance agents or independent advisers and its tactic of always keeping reserves low and returning to its members more money than other companies.”.12

In 1993 the CAR fell below the guarantee prompting GAR policyholders to exercise their rights. According to actuary Christopher Headdon, policies issued from 1975 to 1988 were worth approximately 25% more than CARs, a cost if paid of £1B -£1.5B.6

Based on an affidavit sworn by Christopher Headdon, on 28 June 1999 “from the 1980s onwards, Equitable was aware of the GAR risk. … At no time did Equitable ever hedge or reinsure adequately against the GAR risk to counteract it. The reason for this was Equitable’s belief that it could …neutralise the potential effect of the GAR risk through the exercise of its discretion to allocate final bonuses under Article 65.11 In 1994 Equitable exercised its discretion under Article 65 to reduce the terminal bonus of policies with Guaranteed Annuity Rates,7 negating any benefit from the guarantee but preserving the assets of non GAR policyholders. By July 1998 there were a number of complaints to the Personal Investment Authority Ombudsman and it was decided to seek a declaratory judgement. Alan Hyman was selected as the representative GAR. Hearings started in July 1999 and in September, the High Court ruled in its favour but this was reversed by the Appeal Court in January 2000. Equitable now sought a ruling by the House of Lords.

Okay, I understand if you read that stuff as bafflegab.

But the upshot was that the guaranteed rates were such that a large number of the accounts had a guaranteed value higher than what the insurer could support. It went insolvent, and the policyholders didn’t get what they were promised. And the actuarial profession in the UK lost its independence.


If you think about it, when a government pension plan assumes a discount rate of 8%, it’s guaranteeing an 8% investment return.

If an insurer tried to do that in today’s interest rate environment, the regulators would be all over it for all sorts of deceptions against the public.

But we pretend there’s something magical about a government plan that they can guarantee whatever the hell they want.

And then reality intervenes.

Insurers and other financial institutions know that financial guarantees can be extremely expensive, and the regulators have learned that lesson as well. Regulators have gotten very persnickety about valuing the financial promises being made in annuity products, and you’ll notice many insurers are making much more modest guarantees than they did ten years ago.

What’s special about government, though, is that politicians can say whatever they hell they want and their “intentions” replace likely outcomes.

I wouldn’t “invest” in any guaranteed savings account where the guarantee was backed by the government.

I’d have a better chance with a private company if it went insolvent than with the government.


The piece I originally linked explained why this is a bad idea:

The issue that many people don’t understand is that it can be prohibitively expensive to guarantee investment returns. On the one hand, if employees are required to cover the cost, this could kill the whole idea. On the other hand, if governments agree to back such promises, taxpayers beware!
By contrast, if a worker’s savings were to be invested in the stock market for 40 years, there is a material chance that her account could suffer a big market drop (such as during the 2008-09 financial crisis). For this reason, about 1% of her lifetime contributions would have to be set aside for the principal protection, according to our estimates.

More costly is a “real principal guarantee” that promised to give the retiree back her inflation-adjusted contributions at retirement. And if she were allowed to invest all of her savings in stocks, the guarantee protection gets pricier–6% of her lifetime contributions every year would be required to cover the promise. It would be even more expensive if the saver wanted the equivalent of a 10-year Treasury return over her 40-year work life. In fact, she’d need to set aside almost one-third of her lifetime pension contributions to cover that promise when investing her remaining retirement savings in stocks. Other analysts report that promising a 3% return guarantee could cost almost half of a worker’s lifetime contributions.

Given recent stock-market volatility, it seems clear to most people that guaranteeing a return on a total stock portfolio can be expensive. Yet even if the worker were restricted to a half-stock/half-bond mix, her guarantee cost would still amount to 16% of her lifetime contributions.

Readers should be aware the underlying risk behind such guarantees is not diversifiable at a point in time, since stock returns are highly correlated. And over time there is also little room for risk pooling since there are no financial products that protect against volatility in workers’ lifetime earnings and retirement age uncertainty. Moreover, pension guarantee costs are driven by stock and bond volatility rather than their expected returns, and the cost of protection against such uncertainty grows over time. For these reasons, pension guarantees cannot be managed with traditional insurance “pooling” techniques.

And yes, insurers could tell you that.

A lot of the bad ideas we’ll see this week are because people are eliding how expensive the guarantees embedded in pensions promises are.

They’re extremely expensive (now).

There are scenarios where they’d be as cheap as these various people pretend they are.

But that’s not the scenario we’re living in.

Saying you promise that people will get a certain return is very different from actually fulfilling that guarantee.

Even when you’re government.

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