Retirement Security: Annuities with Guaranteed Lifetime Withdrawals Have Both Benefits and Risks, but Regulation Varies across States
Published: 2012-12-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: As older Americans retire, they may face rising health care costs, inflation, and the risk of outliving their assets. Those entering retirement today typically face greater responsibility for managing their retirement savings than those who retired in the past. Lifetime income products can help older Americans ensure they have income throughout their retirement. VA/GLWBs and CDAs, two such products, may provide unique benefits to consumers. According to industry participants, while annuities with GLWBs have been sold for a number of years, CDAs are relatively new and are not widely available. GAO was asked to review issues relating to these financial products. This report (1) compares the features of VA/GLWBs and CDAs and examines potential benefits and risks to consumers and potential risks to insurers, and (2) examines the regulation of these products and the extent to which regulations address risks to consumers. GAO analyzed insurance company product information, proposed and final rules and regulations, and studies and data related to retirement and product sales. GAO also interviewed federal and state regulators and selected insurers, consumer advocates, and industry organizations.
GAO provided a draft of this report to NAIC and SEC. Both provided technical comments, which have been addressed in the report, as appropriate.
section_title: What GAO Found
paragraphs: Annuities with guaranteed lifetime withdrawals can help older Americans ensure they do not outlive their assets, but do present some risks to consumers. Two such products, variable annuities with guaranteed lifetime withdrawal benefits (VA/GLWB) and contingent deferred annuities (CDA), share a number of features but have some important structural differences. For example, both provide consumers with access to investment assets and the guarantee of lifetime income, but while VA/GLWB assets are held in a separate account of the insurer for the benefit of the annuity purchaser, the assets covered by a CDA are generally held in an investment account owned by the CDA purchaser. Consumers can benefit from these products by having a steady stream of income regardless of how their investment assets perform or how long they live, while at the same time maintaining access to their assets for unexpected or other expenses. VA/GLWBs and CDAs are complex products that present some risks to consumers and require them to make multiple important decisions. For example, consumers might purchase an unsuitable product or make withdrawal decisions that could negatively affect their potential benefits. Several insurers and regulators GAO spoke to said it was important for consumers to obtain professional financial advice before purchasing these products and making key decisions. These products can also create risks for insurers which, if not addressed, could ultimately affect insurers' ability to provide promised benefits to consumers.
VA/GLWBs are considered to be both securities and insurance products, and are therefore covered by both federal securities regulations and state insurance regulations. For CDAs, the National Association of Insurance Commissioners committee responsible for life insurance and annuities products has determined CDAs to be life insurance products subject to state law and regulation for annuities. According to SEC officials, existing CDAs have been registered as securities with SEC, and therefore are covered by both federal securities laws and regulations, and state insurance regulations. At the state level, NAIC has developed state disclosure and suitability regulations for annuity products. However, states differ on the extent to which they have adopted these annuity regulations, and some do not have protections at all. As a result, consumers in states that have adopted different regulations may benefit from different levels of protection. NAIC and state regulators told GAO that they are currently reviewing the regulations of CDAs. In March 2012, NAIC began reviewing existing annuity regulations to determine whether any changes are needed to address the unique product design features of CDAs, including potential modifications to annuity disclosure and suitability standards. It is also reviewing what kinds of capital and reserving requirements may be needed to help insurers manage product risk. In addition, NAIC and the National Organization of Life and Health Guaranty Associations are each working to determine whether state insurance guaranty funds, which protect consumers in the event insurers become insolvent, cover CDA products. Both agree that each state will have to reach its own conclusion about whether their particular state guaranty fund laws allow for CDA coverage. Until these regulatory issues are resolved, consumers may not be fully protected.

section_title: Letter
paragraphs: Longevity risk, or the potential for outliving one’s financial resources in  retirement, is a critical issue for today’s older Americans. Life expectancy  for many older Americans grew significantly from 1980 to 2010, and  today’s retirees may face a greater number of years than earlier  generations for which they will require income. They also face the risks of  inflation and rising health care costs. Because of a decrease in defined  benefit retirement plans that guarantee retirees a certain level of income  for life, workers entering retirement today also typically have more  responsibility for managing their retirement savings than previous retirees  and must make difficult investment and withdrawal decisions.
Recent market turbulence has also sparked questions about retirement  account values and longevity risk, and many Americans already retire  without sufficient savings to sustain them throughout a lengthy retirement.  For example, a recent study showed that only 42 percent of those  surveyed had calculated how much in savings they would need for  retirement, and the percentage of Americans saving for retirement had  declined by 9 percent from 2009 to 2012. Products with guaranteed  lifetime withdrawals, such as variable annuities with a guaranteed lifetime  withdrawal benefits rider (VA/GLWB) and contingent deferred annuities  (CDA) can potentially help older Americans plan for retirement and  address longevity and market risks by providing guaranteed income even  after retirement assets are depleted. However, some industry participants  suggest that VA/GLWBs and CDAs are complex products which involve  potential risks for both consumers and insurers.
In response to questions you have raised about annuities with guaranteed  lifetime withdrawals, this report:  compares the features of VA/GLWBs and CDAs, and examines the  potential benefits and risks to consumers and potential risks to  insurers of these products; and examines the regulation of these products and the extent to which  regulation addresses any identified risks to consumers.
To compare the features of VA/GLWBs and CDAs, we analyzed specific  insurance company products to obtain information on how the products  function, including how investment gains and losses are treated, how  withdrawal amounts are determined, and what happens when a  consumer’s investment account is depleted. We also interviewed  insurance company officials to verify our understanding of their products  and VA/GLWBs and CDAs in general. To identify potential benefits and  risks to consumers, we analyzed the product information we obtained and  also interviewed insurers, consumer advocates, and state insurance  regulators. To understand the potential risks these products pose to  insurers and how they manage these risks, we also interviewed NAIC  officials and reviewed information from insurers and stakeholder groups.  We also obtained data from industry organizations on the sale of annuity  products with guaranteed lifetime withdrawals. We discussed the sources  and reliability of the data with officials from these organizations and found  the data sufficiently reliable for the purposes of this report.
To determine how VA/GLWBs and CDAs are regulated and the extent to  which regulation addresses identified concerns, we identified regulations  and processes used by federal and state regulators, as well as any  proposed regulations, and compared them with the risks to consumers  that we identified as part of the work under the previous objective. We  reviewed model laws developed by NAIC, specific state regulations, and  SEC and FINRA rules. We also interviewed NAIC, state, SEC and FINRA  officials to determine how VA/GLWBs and CDAs are regulated. We also  interviewed other stakeholder groups, such as consumer advocates and  industry organizations, to gain their perspective on issues related to  regulation of lifetime income products considered in our review. Appendix  I contains additional information on our scope and methodology.
We conducted this performance audit from February 2012 to November  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Annuities
paragraphs: An annuity is an insurance agreement or contract that comes in a number  of different forms and can help individuals accumulate money for  retirement through tax-deferred savings, provide them with monthly  income that can be guaranteed to last for as long as they live, or both. A  variable annuity is an insurance contract in which a consumer makes  payments that are held in a separate account of the insurer. While the  insurance company is the owner of the separate account assets, the  assets are held for the benefit of consumers. In return, the insurer agrees  to make periodic payments beginning immediately or at some future date.  The purchaser’s payments can be directed into a range of investment  options, typically mutual funds, which the insurer makes available in a  separate account for the benefit of consumers. Purchasers may withdraw  assets from their contracts at any time prior to annuitizing—that is, to  convert the account into some form of lifetime payments.
VA/GLWBs protect consumers against outliving their retirement assets  and the effects that market losses on those assets can have on lifetime  income by allowing them to withdraw a certain percentage each year until  death. If the market performs well, the consumer may receive larger  withdrawals, but if the market performs poorly, the consumer still receives  the set withdrawal amount.
VA/GLWB sales have grown in recent years. Data from LIMRA show that  from 2008 to 2011, the number of VA/GLWB contracts in force rose from  1.5 million to 2.8 million and that average annual sales were around $58  billion. During that same period, total VA/GLWB assets held in insurers’  accounts increased from $133 billion to $323 billion. According to the  Insured Retirement Institute, states with the highest sales of variable  annuities in 2010 were California, New York, Florida, Texas,  Pennsylvania, and New Jersey. In addition, LIMRA data on the  demographics of VA/GLWB consumers show that in 2010 the average  age of the consumer purchasing a VA/GLWB was 61 and the average  age at first withdrawal was 68. Typically, the average annual withdrawal  has been around $5,500. Also according to LIMRA, the average amount  of a VA/GLWB contract sale from 2007 through 2010 was around  $106,000.
Like a GLWB rider, a CDA is an insurance contract that provides  guaranteed lifetime income payments if a consumer’s investment account  is exhausted, whether through withdrawals or poor market performance.  In this case, the investment account contains the “covered assets”—  typically mutual funds or managed accounts. However, the insurance  company does not have ownership of the assets underlying the CDA,  which are typically held in brokerage or investment advisory accounts  owned by the CDA purchaser. Similar to a VA/GWLB, a CDA contract  defines how much a consumer is able to withdraw—for example, 5  percent of the benefit base annually. Even if the value of the covered  assets drops to zero, the insurance company has guaranteed the 5  percent withdrawal benefit (based on the benefit base value when lifetime  withdrawals began) and continues making the annual payments to the  consumer. Whether or not a policyholder receives payment from the  insurance company selling the CDA is contingent upon the covered  assets dropping to zero. On the basis of the products we reviewed, fees  on CDAs are calculated as a set percentage of the investment assets or  benefit base per year. These fees do not include any fees the consumer  might pay related to the underlying investment that is covered by the  CDA. Such investment management fees are paid to the investment  company, not the insurer.
section_title: Regulation
paragraphs: State insurance regulators are responsible for overseeing insurance  products, while SEC and FINRA are responsible for the oversight of  securities. Federal and state regulators consider variable annuities to be  both insurance and securities products, and GLWB riders that are  attached to variable annuities to be an additional insurance benefit. The  National Association of Insurance Commissioners committee responsible  for life insurance and annuities products has determined CDAs to be life  insurance products subject to state law and regulation for annuities.   According to SEC officials, existing CDAs have been registered as  securities with SEC, and therefore are covered by both federal securities  laws and regulations, and state insurance regulations.
Insurance is unique among financial services in the United States in that it  is largely regulated by the states. State insurance regulators are  responsible for enforcing state insurance laws and regulations, including  those covering the licensing of agents, reviewing insurance products  (including variable annuities) and their rates, and examining insurers’  financial solvency and market conduct. State regulators typically perform  financial solvency examinations every 3 to 5 years, and they generally  undertake market conduct examinations in response to specific consumer  complaints or regulatory concerns. State regulators also monitor the  resolution of consumer complaints against insurers. State insurance laws  focus on solvency, market regulation, and consumer protection. In  addition to state insurance regulators, NAIC—a voluntary association of  the heads of insurance departments from the 50 states, the District of  Columbia, and five U.S. territories—plays a role in insurance regulation.  While NAIC is not a regulator, it provides guidance and services designed  to more efficiently coordinate interactions between insurers and state  regulators. These services include providing detailed insurance data to  help regulators understand insurance sales and practices; maintaining a  range of databases useful to regulators; and coordinating regulatory  efforts by providing guidance, model laws and regulations, and  information-sharing tools.
Federal securities laws and SEC rules govern the securities industry in  the United States.  SEC’s mission is to protect investors; maintain fair,  orderly, and efficient markets; and facilitate capital formation. SEC  oversees key participants in the securities markets, including securities  exchanges, securities brokers and dealers, investment advisers, and  mutual funds.  The Securities Act of 1933 (1933 Act) regulates public  offerings of securities, requiring that issuers register securities with SEC  and provide certain disclosures, including a prospectus, to investors at  the time of sale.  Investors may rely on broker-dealers and investment  advisers for information or advice about securities, including insurance  products such as VA/GLWBs and CDAs. Money managers, investment  counselors, and financial planners who, for compensation, engage in the  business of providing advice to others about securities, including asset  allocation advice, are subject to the antifraud provisions of the Investment  Advisers Act of 1940.  Large investment advisers, those with $100  million or more of assets under management, generally are subject to  SEC registration and regulation under the Investment Advisers Act and  accompanying rules.  Investment advisers with assets under  management of less than $100 million generally are regulated by the  states.  Securities, including annuities that are securities, are subject to  registration and disclosure requirements under the 1933 Act, and large  investment advisers providing advice about securities must be registered  with SEC.  Broker-dealers that are engaged in the business of buying and  selling securities generally are subject to broker-dealer regulation at the  federal and state levels.  FINRA is the largest regulator of securities firms  doing business with the public in the United States.  All registered  securities broker-dealers who do business with the public must be  members of FINRA and their personnel must be licensed with FINRA.   FINRA oversees almost 4,500 brokerage firms and approximately  630,000 registered securities representatives.
section_title: Features of VA/GLWBs and CDAs May Benefit Consumers but also Pose Risks to Consumers and Insurers
paragraphs: VA/GLWBs and CDAs share a number of features, but they also have  some important structural differences. For example, both provide  consumers with access to investment assets and the guarantee of lifetime  income, but while VA/GLWB assets are held in a separate account of the  insurer for the benefit of the annuity purchaser, the assets covered by a  CDA are generally held in an investment account owned by the CDA  purchaser. In part because of their shared features, these products can  provide similar benefits to consumers. Yet as complex instruments that  require consumers to make multiple important decisions, they also  present certain risks to consumers. VA/GLWBs and CDAs may also  involve risks for insurers, who must manage these risks in order to make  promised payments to consumers.
subsections: section_title: VA/GLWBs and CDAs Share Some Features
paragraphs: VA/GLWBs and CDAs share a number of product features. In general,  both allow consumers to take lifetime withdrawals from their assets at a  rate that the insurance company guarantees even if such withdrawals and  investment losses deplete the consumer’s assets. VA/GLWBs and CDAs  generally have three distinct phases of ownership: an accumulation  phase, a withdrawal phase, and an insured phase (see fig. 1).
The accumulation phase begins when a consumer purchases a  VA/GLWB or CDA contract.with a GLWB rider or the value of assets covered by a CDA contract  establishes the initial withdrawal value, or benefit base, on which the   The initial premium paid under a VA contract  amount of lifetime withdrawals are based. This benefit base is not a  cash value that can be withdrawn, but rather is the amount to which  lifetime withdrawal percentages will be applied during the withdrawal  phase. The investment account value, on the other hand, represents the  total value of the consumer’s investments, which is increased by  investment gains and decreased by fees, withdrawals, and any  investment losses. During this phase the consumer decides how to  allocate investment assets among various options, including funds made  available by an insurance company for investment under its VA/GLWB  products and funds that an insurance company has agreed to cover  under its CDA products. Also during this phase, the insurance company  monitors each consumer’s account value and automatically adjusts the  benefit base periodically should investment gains increase the value of  this account. This feature, which exists for the VA/GLWBs and CDAs we  reviewed, is referred to as a step-up or ratchet. Once a consumer’s  benefit base is stepped up, it cannot later decline because of investment  losses that reduce the consumer’s investment account value.
Some VA/GLWBs have an additional feature that guarantees that, no  matter how the investments perform, the benefit base will grow each year  by a set percentage. This guaranteed percentage, alternatively referred to  as a roll-up rate, growth credit, or bonus, is added to the benefit base, as  adjusted for any prior step-ups. For example, some of the VA/GLWBs we  reviewed included annual roll-up rates that ranged from 5 to 7 percent.  The amount of the roll-up rate and the frequency, duration, and manner of  calculation can affect the value of a consumer’s benefit base and thus the  amount that can be taken as lifetime withdrawals. While such features  can increase a consumer’s benefit base on which lifetime withdrawals are  determined, annuities with higher roll-up rates can have higher fees.
The withdrawal phase starts when a consumer begins taking annual  lifetime withdrawals. The maximum amount of lifetime withdrawals that a  consumer can take each year (without incurring a reduction in their  benefit base) is calculated as a percentage of the consumer’s benefit  base at the time of the first lifetime withdrawal. The VA/GLWBs and CDAs  we reviewed had withdrawal percentages for a single life that ranged from  3 percent to over 8 percent of the benefit base, and the percentages were  generally lower for younger consumers and higher for older consumers.  Some products also have a joint life option where, if the consumer dies,  the guarantee of lifetime income passes to their spouse. When such an  option is elected, withdrawal amounts are typically one-half a percent less  than they would be otherwise.
Step-ups, like those during the accumulation phase, can increase the  benefit base after lifetime withdrawals have begun, increasing the amount  of annual lifetime withdrawals. Typically, the insurance company will  increase the benefit base if a consumer’s account value, net of  withdrawals and fees, has increased above this amount. After a step-up  during the withdrawal phase, the base and the lifetime maximum  withdrawals cannot decline because of investment losses that reduce the  consumer’s account value. Step-ups that occur after lifetime withdrawals  begin allow consumers to benefit from investment gains that can offset  the effects of inflation.
A consumer enters the insured phase only if their investment account  value has been reduced to zero as a result of lifetime withdrawals;  investment losses; or any expenses, fees, or other charges. In such  cases, the consumer’s benefit base on which lifetime withdrawals are  determined (the amount to which the withdrawal percentage is applied)  remains unchanged but the consumer’s investment account value, which  was the source for the funds previously withdrawn, is zero. Consequently,  the funds needed to continue paying the same level of benefits to the  consumer (and spouse, if a joint life option is elected) would then come  from the insurance company’s own assets, and consumers receive  payments from the insurance company that are equal to their prior lifetime  withdrawal amount. Once the insurance company begins paying the  agreed-upon withdrawal payment, the fees that the consumer had been  paying for that protection would cease, as would any investment  management and other fees paid for other benefits. Once the insured  phase begins, all rights and benefits under a VA/GLWB or CDA contract,   In addition, all  except those related to continuing benefits, terminate. lifetime withdrawal benefits will continue to be paid to the consumer on  the established schedule and generally cannot be changed.
section_title: Structural Differences Exist between VA/GLWBs and CDAs
paragraphs: For example, the right to make additional contributions and receive the benefit of future  step-ups in the withdrawal amount would no longer be available to an owner once the  account is depleted. a separate account of the insurance company. The mutual funds may be  managed by outside advisers, but the insurance company holds these  assets for the benefit of consumers. By comparison, the investment  assets covered by a CDA are held by the consumer in his or her own  brokerage or investment advisory account and invested in investment  funds, such as mutual funds, that the insurance company has agreed to  cover under a CDA. The investment assets are not owned—nominally or  otherwise—by the insurance company issuing the guarantee. Like the  investment options available under a VA/GLWB, the investment assets  covered by a CDA may or may not be managed by the insurance  company or an affiliate. In this way, consumers can accumulate  retirement assets in a personal account, such as an individual retirement  account (IRA), and obtain lifetime withdrawal guarantees without having  to transfer those assets to an insurance company.
Further, the base variable annuity contracts to which GLWB riders are  attached provide additional benefits not available under CDAs. For  example, a VA/GLWB contract permits the consumer to annuitize an  account balance in the future and receive benefit payments from the  insurance company for life at rates set forth in the annuity contract.  Also, with a VA/GLWB, if a consumer dies before annuitizing the account  balance or taking lifetime withdrawals, the death benefit payable to  beneficiaries is typically the greater of the sum of premiums paid or the  investment account value. The additional VA/GLWB benefits come with  additional costs, however. For example, in addition to the guarantee fee,  variable annuity contracts with death benefits entail additional fees to  cover the cost to the insurer. For the CDAs we reviewed, the assets  covered by the CDA could not be annuitized in the future. The assets  would first have to be sold and the proceeds used to purchase a separate  annuity. In addition, unlike a variable annuity contract, a CDA does not  have a death benefit.
section_title: VA/GLWBs and CDAs Can Provide Consumers with Similar Benefits
paragraphs: Similar to other annuity products, VA/GLWBs and CDAs can provide  consumers with the benefit of a guaranteed stream of income for life. That  is, for a fee, they can ensure that consumers receive a minimum annual  payment until they die, regardless of how long they live or how their  investment assets might perform. These products may also lock  investment gains into the benefit base on which future lifetime  withdrawals are determined and, in the case of variable annuities, also  offer other potentially beneficial features such as death benefits, which  pass on certain guaranteed amounts to a spouse or other beneficiaries.  Further, VA/GLWBs and CDAs typically offer consumers the ability to  invest their assets in a variety of investment funds.
A unique benefit of these products is that they allow consumers to receive  income guarantees while still maintaining ownership of and access to their  funds during the accumulation and withdrawal phases. With traditional  annuity products, in order to receive lifetime income consumers must  transfer assets to the insurer, who holds them in their own general account  and uses them to fund an annuity (they are annuitized). Consequently,  once these assets are annuitized the consumer does not have access to  these assets. With VA/GLWBs and CDAs, however, the consumers’ assets  are not annuitized. As a result, consumers can withdraw any or all of their  funds at any time. This can benefit consumers should they need funds for  unexpected uses, such as medical or other expenses.
One benefit specific to CDAs is that the guarantee of lifetime withdrawals  can, in certain cases, be applied to existing investment assets. That is,  consumers who have existing investment assets may be able to purchase  a CDA to cover those assets, if an insurer agrees to cover those assets  under a CDA. If the same consumers wanted to use those assets to  obtain a guaranteed stream of income through a traditional annuity, they  would have to first sell the investment assets and then use the proceeds  to purchase the annuity.
section_title: Consumers Face Risks When Purchasing and Withdrawing Funds from VA/GLWBs and CDAs
paragraphs: Several insurers and regulators we spoke with said that VA/GLWBs and  CDAs are complex products, and emphasized the importance of obtaining  professional financial advice before purchasing these products and  making key decisions. Consumers that purchase VA/GLWBs and CDAs  can face risks similar to those they may face with the purchase of other  financial products. These risks include purchasing an unsuitable product,  paying too much, making withdrawal decisions that decrease benefits,  and having an insurer become insolvent before benefits are received.
First, consumers face the risk of purchasing an unsuitable product if they  do not understand how a particular product functions and meets their own  needs, including how much might be appropriate to invest in a particular  product. Insurers with whom we spoke said that VA/GLWBs and CDAs  are generally attractive to middle-income consumers who want more  control and flexibility over the investments they are relying on to provide  retirement income. In addition, one insurer with whom we spoke said that  consumers investing in such products have generally had around  $500,000 in retirement savings and invested around 20 percent of that  amount.
Second, consumers may face the risk of being unable to determine if they  are obtaining the best price for similar benefits provided by different  insurers. Several insurers and regulators told us that because of the  uniqueness of VA/GLWB and CDA products, it would be difficult to  compare one insurer’s product to that of another insurer. For example,  products can function in slightly different ways, have different  combinations of features, and charge different amounts for the  guarantees. As a result, consumers would find it difficult to take a price  quoted to them from one insurer for a specific product with specific  features, then compare that to a product from another insurer to  determine if they could receive similar benefits at a lower price.
Third, VA/GLWBs and CDAs pose a risk that certain decisions by  consumers in withdrawing their assets, such as the timing and size of the  withdrawals, could affect them negatively. For example, these decisions  can reduce or even eliminate guaranteed benefits and result in additional  fees that further reduce their assets. The investment assets underlying  VA/GLWB and CDA guarantees are typically available for withdrawal  before guaranteed lifetime withdrawals begin, but taking withdrawals too  early or above certain thresholds can result in financial penalties and  deplete assets, as the following examples illustrate,
Variable annuities are frequently sold without any up front sales  charges but impose contingent deferred sales charges, or “surrender”  charges, on withdrawals taken during the early years of the contract  (for example, the first 7 years) that are above a “free” withdrawal  limit. Surrender charges on variable annuities are expressed as a  series of percentages that decline over time and are applied to annual  withdrawals that are typically greater than either accumulated  earnings or 10 percent of premiums paid. Because CDAs split  insurance and investment elements of the guarantee, there are no  surrender charges on the CDA contract. However, a surrender charge  may apply when a consumer sells shares of mutual funds covered by  the CDA contract. In addition to sales charges, income taxes and an  additional 10 percent penalty tax on withdrawals taken before age  59½ may apply.
With some VA/GLWB products, taking withdrawals of any amount  after reaching a minimum age can trigger the beginning of lifetime  withdrawals (at a specified percentage) and stop all future roll-ups of  the benefit base. In addition, a consumer who takes withdrawals  sooner than initially planned can experience a permanent reduction of  the lifetime withdrawal amount. For example, for one of the products  we reviewed a withdrawal at age 64 triggers the establishment of a 4  percent lifetime withdrawal percentage, but waiting for a year would  raise the percentage to 5 percent. Further, starting lifetime  withdrawals during a downturn in the market can have a negative  effect on lifetime income because the investment account balance will  be that much lower than the benefit base, making the possibility of a  step-up, and a possible increase in the withdrawal percentage and  amount, less likely.
The age at which lifetime withdrawals begin can have an impact on  the value of other benefits and guarantees. For example, withdrawals  and the related charges can reduce the cash value and death benefits  under a variable annuity contract, leaving fewer assets available for  surviving spouses and other beneficiaries. On the other hand, waiting  too long to withdraw benefits can result in not living long enough to  benefit from the product’s guarantees or receiving enough income to  offset the amount of fees paid. For example, a person who first  purchases a VA/GLWB or CDA at age 60 and waits until age 85 to  begin taking lifetime withdrawals will be able to take a higher amount,  but likely for a shorter period of time. Further, the purchaser will have  paid fees for 25 years to protect against outliving his assets, a  possibility that becomes less likely over time.
In addition to deciding when to begin taking lifetime withdrawals,  consumers need to decide how much to withdraw and need to be aware  of certain product features when doing so. For example, lifetime  withdrawals above the maximum annual amount specified in the  withdrawal guarantee are permitted and are referred to as “excess  withdrawals.” However, such withdrawals typically reduce the benefit  base to which withdrawal percentages are applied, thus reducing future  annual withdrawal amounts. Further, guarantee fees and other charges  are typically not counted as withdrawals for purposes of calculating the  maximum for a given year, but some VA/GLWB and CDA products we  reviewed counted certain fees and charges or those above a certain  threshold toward the annual lifetime withdrawal maximum.
Finally, as with the purchase of any long-term insurance product,  consumers can face some level of risk that by the time the consumer  needs the benefit promised by the insurer, the insurer may not be able to  provide it. However, insurers and insurance regulators take a number of  steps to ensure that insurers remain financially solvent. In addition, in the  event of an insurer’s insolvency, state insurance guaranty funds can help  pay consumers what was promised by insurers, up to any coverage limits  of those guaranty funds. According to officials from the National  Organization for Life and Health Guaranty Associations (NOLHGA), while  promises made under GLWBs, which are distinct from the investment  portion of a variable annuity, are generally covered by state guaranty  funds, such certainty does not exist with respect to CDAs. As a result, a  risk exists that if an insurer who sold a CDA became insolvent,  consumers owning those CDAs might not collect any promised benefits.
section_title: Insurers Must Also Manage Risks Associated with VA/GLWBs and CDAs
paragraphs: As with the sale of life insurance products in general, insurers must  manage the financial risks associated with VA/GLWBs and CDAs in order  to ensure their ability to make promised payments and, depending on the  amount of such products they sell, their financial solvency. Risks to  insurers can arise when investment returns, interest rates, consumer  longevity, and consumer behavior are different from what they expected.  While a number of insurers and NAIC officials said that VA/GLWBs and  CDAs do not pose undue risk to insurers, as we noted, at least one major  insurer has decided not to sell CDAs because of the potential risk  involved, and another insurer told us that they do not sell VA/GLWBs  because they do not fit with the company’s risk profile.
Insurance company officials with whom we spoke told us that in designing  their products they consider not only the features that will help to meet  consumer needs, but also the company’s own appetite for certain risks,  the methods for managing those risks, and the price charged for the  products’ guarantees. According to insurers with whom we spoke, ways in  which insurers can use product design to help manage their risk can  include the following.
Establishing the minimum age at which consumers can begin taking  withdrawals and the extent to which consumers can benefit from  growth in the investments protected by the guarantee.
Specifying which investments consumers may have covered by the  products’ guarantees. For example, one CDA product we reviewed  limited a consumer’s investments in equity funds to no more than 80  percent of the consumer’s total investment account value. Another  insurer that sells CDAs told us that they were only willing to cover  index funds for major, highly traded indices, such as the Standard and  Poor’s 500.
Determining the formulas used to rebalance consumers’ investments  into and out of fixed-income funds to mitigate some of the financial  risks associated with providing lifetime withdrawal guarantees.  Prospectuses for these VA/GLWB products disclose that the  automatic rebalancing feature may limit the consumer’s participation  in future market gains and, therefore, the potential for future increases  in their annual lifetime income.
Insurers will also price their products to ensure they have sufficient  revenue and capital to pay for the expenses they expect to incur related  to the products they sell. That is, they will charge more for products that  they deem to be more risky or on which they expect to incur greater  costs. With respect to VA/GLWBs and CDAs, for example, insurers may  charge higher fees for products with features that can result in a higher  guaranteed benefit base. Insurers also use hedging programs to help  further manage the investment risks of the assets underlying the  VA/GLWB and CDA. Hedging involves buying financial instruments, such  as options, to offset the potential loss on an investment.
To the extent that product design and hedging is not sufficient, insurers  can also manage financial risks by modifying their products after they  have been purchased by consumers to the extent permitted by their  contracts, their prior disclosure, and applicable law. For the VA/GLWB  and CDA products we reviewed, insurers sometimes reserve certain  rights, such as the right to determine which investment funds will be  covered by a GLWB rider or CDA guarantee and the conditions  surrounding the allocation of a consumer’s investment assets, change the  frequency and amount of a guarantee fee, or reject additional  contributions or transfers. Some insurers have recently raised fees on  VA/GLWB guarantees or stopped accepting additional contributions to  existing contracts in response to changing market conditions. Insurers  generally cannot change the roll-up, step-up, or withdrawal rates for  existing contract holders, but can make these changes prospectively for  new customers.
section_title: Federal and State Oversight Varies by Type of Product and Is Currently under Industry Review
paragraphs: Federal disclosure and suitability regulations apply to the offer,  recommendation, and sale of securities products such as variable  annuities, including variable annuities with GLWB riders. While it has long  been accepted that variable annuities constitute securities under the  federal laws, because CDAs are a relatively new product, analysis under  the federal securities law is less developed. However, SEC officials have  said that CDAs currently being offered in the retail market are being  registered as securities and are therefore covered by federal securities  law and state insurance regulations. In addition, NAIC has developed  annuity disclosure and suitability regulations for use at the state level, but  state adoption and protection levels vary, so CDA consumers may not be  uniformly protected. Further, questions about the adequacy of existing  annuity regulation and the applicability of state insurance guaranty funds  for CDA consumers if insurers become insolvent have prompted industry  oversight reviews, which were ongoing as of October 2012.
subsections: section_title: Federal Disclosure and Suitability Regulations Apply to Registered Annuity Products
paragraphs: Federal disclosure and suitability regulations apply to the offer,  recommendation, and sale of securities products such as variable  annuities, including variable annuities with GLWB riders. These  requirements aim to inform consumers about products and ensure that  the products themselves are reasonably appropriate for consumers  before they are purchased. As previously noted, while it has long been  accepted that variable annuities constitute securities under federal law,  CDAs are a relatively new product and analysis under the federal  securities law is less developed. To our knowledge, no court has  addressed the securities law treatment of CDAs, and SEC has not  provided written guidance with respect to the status of CDAs under the  federal securities laws. However, according to SEC officials, existing  CDAs have been registered under the Securities Act of 1933, absent  specific exemptions from registration such as the exemption for contracts  sold to certain types of tax-qualified retirement plans, and are therefore  covered by federal securities law and state insurance regulations.
The 1933 Act generally requires issuers of securities that are offered to  the public to register them with SEC and make certain disclosures  through a prospectus that has been filed with SEC. The 1940 Act  generally requires investment companies, including separate accounts  that fund variable annuities, to be registered under the Act. Pursuant to  these requirements, SEC has issued rules and standards for  prospectuses offering registered variable annuities. The purpose of these  requirements is to ensure that investors receive descriptive information on  basic product features, fees, benefits, and risks that can help inform their  investment decisions. Disclosures made through prospectuses filed with  SEC under the federal securities laws are subject to the anti-fraud  provisions of the 1933 Act, which prohibit material misrepresentations or  omissions and provide a general anti-fraud remedy for purchasers and  sellers of securities.
SEC staff has recommended consideration of rulemakings that would apply a fiduciary  standard to both broker-dealers and investment advisers no less stringent than that  applied currently to investment advisers.  The SEC staff also identified certain areas  where laws and regulations that apply to broker-dealers and investment advisers differ,  and recommended the Commission consider whether these areas should be harmonized  for the benefit of retail investors.  SEC Staff Study on Investment Advisers and Broker- Dealers As Required By Section 913 of the Dodd-Frank Wall Street Reform and  Consumer Protection Act (2011), (Washington, D.C. January, 2011).
FINRA Rule 2090, which requires broker-dealers to ask about and  retain essential information on each customer  (“Know Your  Customer”) and concerning the authority of each person acting on  behalf of the customer.
FINRA Rule 2111, which requires broker-dealers to have a  reasonable basis to believe that a recommended securities  transaction or investment strategy is suitable for the customer based  on information obtained through reasonable diligence of the broker- dealer or its associated person to ascertain the customer’s investment  profile. This profile includes, but is not limited to the customer’s other  investments, financial situation and needs, tax status, investment  objectives, investment experience, investment time horizon, liquidity  needs, risk tolerance, and any other information the customer may  disclose to the broker-dealer or associated person in connection with  the recommendation.
National Association of Securities Dealers (NASD) Rule 2210, which  regulates broker-dealers’ communications with the public and applies  to, among other things, variable annuity advertisements. Broker- dealers must file retail communications concerning variable annuities  with FINRA and respond to comments provided by FINRA staff on  such communications.
FINRA Rule 2330, specific to deferred variable annuities, which  governs member broker-dealers’ compliance and supervisory  responsibilities with respect to the recommendation of the initial  purchase or exchange of deferred variable annuities, and initial  subaccount allocations.
These requirements apply to the recommendation and sale of variable  annuity products, including those with guaranteed lifetime withdrawal  benefits. According to SEC officials, issuers of CDAs have been  registering offerings of their CDA products with SEC, and SEC is  reviewing the disclosures associated with these products. While we did  not observe and were not told of any such instances, if CDAs were sold  without being registered as securities, SEC could take action if it  determined that securities laws were being violated. If it were determined  that federal securities laws did not apply to CDA offerings, relevant state  regulations would still apply. In addition, FINRA officials said that they  regulate member broker-dealers that offer variable annuity products,  including variable annuities with GLWB riders. If a broker-dealer offers a  CDA that is registered under the federal securities laws, FINRA also  regulates the sale of such a CDA. If state insurance law issues arise in  connection with a firm’s sale of a CDA, FINRA staff may refer these  issues to relevant state insurance regulators.
section_title: NAIC Has Developed Annuity Disclosure and Suitability Regulations, but State Adoption and Protection Levels Vary
paragraphs: The NAIC committee responsible for life insurance and annuities issues  considers CDAs to be insurance products and has developed annuity  disclosure and suitability model regulations for use by state insurance  regulators. NAIC has developed these model disclosure and suitability  regulations for annuity products in collaboration with consumer advocates  and industry experts. However, unlike federal standards that are  consistently applied to variable annuities regardless of where consumers  live, state adoption of these model regulations varies, so protections may  be stronger in some states than in others. In 2011, NAIC developed a  model disclosure regulation for annuity products that serves several  functions for consumers and insurers, including: helping ensure that consumers understand annuity products by  explaining basic features, benefits, and fees;  suggesting that annuity products with guaranteed income or benefit  provisions are intended to be longer-term investment products; providing guidance for insurers when they choose to develop product  illustrations intended to help consumers better understand how a  particular annuity product works. In particular, the guidance provides  illustration formats and specifies what kinds of illustration disclosures  must be made when an insurer chooses to develop them; and  requiring that annuity customers be provided or referred to NAIC’s  Annuity Buyer’s Guide that also contains general product information  and provides answers to basic questions about risks and investing  that consumers can use to decide whether these products are right for  them.
In addition to its model disclosure regulation, NAIC developed a model  suitability regulation in 2003 to help ensure that insurers consider the  financial needs and objectives of consumers and that these needs are  appropriately addressed at the time annuity sales or exchanges occur.  More specifically, the model suitability regulation requires insurers and  insurance agents to inquire about consumers’ suitability information and  ensure that they have reasonable grounds to believe that annuity  products would benefit consumers before recommending purchases or  exchanges. In 2006, NAIC revised the model regulation to expand its  scope to consumers of all ages, and in 2010 the model regulation was  again revised to further strengthen a number of annuity suitability  protections. Among other changes, the 2010 revision requires insurers to be responsible for compliance with the model regulation whether or  not they contract suitability functions out to a third party; maintain procedures for reviewing each investment recommendation  made to consumers and helping ensure that the product is suitable for  the particular purchaser and that the purchaser understands the  annuity product recommended; ensure that insurance agents, or producers, complete general annuity  training before selling annuity products; and provide product-specific annuity training and training materials to the  agent or producer before an agent or producer can solicit the sale of a  product.
In addition to these changes, NAIC adopted the revised the model  regulation to set standards and procedures for suitable annuity  recommendations and to require insurers to establish a system to  supervise recommendations so that the insurance needs and financial  objectives of consumers are appropriately addressed. The revised NAIC  model regulation includes a “safe harbor” provision that is intended to  prevent duplicative suitability standards from being applied to sales of  annuities through FINRA member broker-dealers. Annuity sales made in  compliance with FINRA requirements are deemed to comply with the  suitability requirements outlined in NAIC’s model regulation. Violations of  state law developed from the model regulation can result in remedies for  consumers and penalties for insurers and agents. Under the model  regulation, state insurance commissioners can require reasonably  appropriate corrective action for violations that have harmed consumers.
NAIC information shows that, as of October 2012, state adoption of  NAIC’s disclosure and suitability regulations varied significantly, meaning  that consumers in some states may not be protected as well as those in  other states. According to NAIC, many states have adopted some form  of annuity disclosure regulation, although some states and the District of  Columbia do not have disclosure protections in place. As of October  2012, officials are working to determine which states had adopted the  revised model disclosure regulation. In terms of the suitability model  regulation, 19 states plus the District of Columbia have adopted NAIC’s  most recent model regulation that incorporates the added protections  noted above, and another 29 states have adopted other suitability  protections for annuity consumers. The remaining 2 states do not have  suitability regulations in place. According to NAIC officials, model  disclosure and suitability standards are not required as part of NAIC’s  accreditation program. Figure 2 summarizes the state adoption of  suitability regulations.
Whether or not states have adopted NAIC disclosure and suitability  regulation is important for CDA consumers. Unlike federal regulations that  apply to the sale of VA/GLWBs nationwide, disclosure and suitability  regulations for CDAs may depend on the actions of individual states and  the extent to which they have implemented these protections. According  to NAIC, regulatory action by states can time to occur and depends on  legislative cycles and the political environment of states. As the  information in figure 2 shows, consumers across states are subject to  different suitability protection and in some cases to no protection at all.
The different regulatory approaches among the sample of seven states  we reviewed also show the variation in regulation of CDAs across states.  Although most states in our sample have not specifically approved CDA  sales, most have adopted some form of disclosure and suitability  regulation for annuity products. Among these seven states, three have  adopted NAIC’s model disclosure regulation and three have adopted  NAIC’s most recent suitability regulation. For the states that allow CDA  sales, the consumer protections found in the model regulations are  critical. Of the two states that allow CDA sales—Iowa and Ohio—both  have adopted NAIC’s model disclosure regulation, but only Iowa has  adopted its most recent model suitability regulation. Ohio, according to  NAIC information, has passed a previous version of NAIC’s model  suitability regulation, and therefore has not adopted added protections  found in the revised model regulation as outlined above. Consumers in  states that have not adopted NAIC’s model regulations may not be  benefitting from available disclosure and suitability protections. More  specifically, states that have not adopted the most recent model suitability  regulations may not be extending to consumers protections developed  through NAIC’s 2010 suitability revision. Table 1 shows the variation in  the disclosure and suitability protections across our seven sample states.
Some industry participants suggest state insurance regulation and  existing actuarial guidance may adequately address risks to insurers  offering CDAs and to consumers. Others said that CDAs may pose  solvency risks for both because insurers offer consumers an income  guarantee but do not maintain the assets on which the guarantees are  made. One major insurer has said that CDAs pose significant enough  pricing and reserving challenges that it does not offer CDAs. In addition,  two consumer advocates with whom we spoke highlighted the solvency  risks CDAs pose for insurers. One advocate suggested that reasonable  and appropriate insurer reserving and capital requirements do not  currently exist for CDAs and that considerable NAIC and state regulatory  work would be needed to develop them. The same advocate said selling  CDA products before key issues concerning the regulatory framework are  finalized might expose consumers to risks that might result from an  insurer’s potential insolvency. The advocate concluded that the potential  for insurers to increase the marketing and sale of CDAs, given the  growing needs of retirees, makes having consumer and insurer  protections in place important.
Potential risks to CDA consumers and insurers have prompted industry  oversight reviews of these products and their regulation. Although NAIC  has determined that CDAs are a life insurance product, it is working with  state regulators, insurers, and consumer advocates through its CDA  Working Group, formed in March 2012, to build greater consensus around  the classification of CDAs and to determine whether any adjustments to  state regulation might be appropriate. In particular, NAIC is evaluating the  adequacy of existing state annuity laws and regulations for CDA sales,  including those on insurer solvency such as capital adequacy and reserve  requirements. According to NAIC officials, both NAIC and state insurance  regulators recognize the complexity of CDA products for consumers and  are also working to revise disclosure and suitability practices where  appropriate.
Another industry review by the NOHLGA, NAIC, and state insurance  regulators aims to address whether CDA consumers are protected by  state insurance guaranty funds in the event of an insurer’s insolvency.  According to NOLHGA officials, variable annuities are not covered by  guaranty funds because they are indistinguishable from equity  products. That is, they are not supported by assets in an insurer’s general  account, but by specific assets in separate accounts dedicated to the  particular fund or funds chosen for the variable annuity. However, the  officials said that guaranteed lifetime withdrawal benefits, which are now  part of most variable annuity contracts, are distinct from the equity portion  of a variable annuity and are generally covered by state guaranty  funds. The officials said that while CDAs would also appear to have an  equity portion and a guarantee portion, they have a committee studying  the extent to which CDAs might be covered by state guaranty  funds. Officials noted that even when the committee has reached a  determination on guaranty fund protections, each state will have to reach  its own conclusion about whether their particular guaranty fund laws allow  for CDA coverage.
section_title: Agency Comments
paragraphs: We provided a draft of the report to SEC and NAIC and relevant excerpts  to FINRA. Each provided technical comments that were incorporated as  appropriate.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the Chairman of the  Securities and Exchange Commission, the Chief Executive Officer of the  National Association of Insurance Commissioners, and other interested  parties. In addition, the report will be available at no charge on the GAO  website at http://www.gao.gov.If you or your staff have any questions  about this report, please contact Alicia Puente Cackley (202) 512-8678 or  cackleya@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  GAO staff who made major contributions to this report are listed in  appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: To compare the features of variable annuities with guaranteed lifetime  withdrawal benefits (VA/GLWB) and contingent deferred annuities (CDA),  we analyzed specific insurance company products to obtain information  on how the products function, including how investment gains and losses  are treated, how withdrawal amounts are determined, and what happens  when a consumer’s investment account is depleted. We also interviewed  insurance company officials to verify our understanding of their products,  and VA/GLWBs and CDAs in general. We judgmentally selected the  companies based on criteria that included their market share of variable  annuity sales and their decisions to sell or not to sell CDAs. To identify  potential benefits and risks to consumers, we analyzed the product  information we obtained and also interviewed insurers, consumer  advocates, and state insurance regulators. To understand the potential  risks these products pose to insurers and how they manage these risks,  we also interviewed NAIC officials and reviewed information from insurers  and stakeholder groups. We also obtained data from industry  organizations on the sale of annuity products with guaranteed lifetime  withdrawals. We discussed the sources and reliability of the data with  officials from these organizations and found the data sufficiently reliable  for the purposes of this report.
To determine how VA/GLWBs and CDAs are regulated and the extent to  which regulation addresses identified concerns, we identified regulations  and processes used by federal and state regulators, as well as any  proposed regulations, and compared them with the risks to consumers  that we identified as part of the work under the previous objective. Our  review of state regulation included model laws developed by the National  Association of Insurance Commissioners (NAIC), specific state  regulations, and Securities and Exchange Commission (SEC) and  Financial Industry Regulatory Authority (FINRA) rules. We selected the  sample of states for our analysis based on the volume of sales of  VA/GLWBs and CDAs in the state, whether the state allowed the sale of  CDAs, and the state’s population. We interviewed NAIC, state, SEC, and  FINRA officials to determine how VA/GLWBs and CDAs are regulated.  We also interviewed other stakeholder groups, such as consumer  advocates and industry organizations, to gain their perspective on issues  related to regulation of lifetime income products considered in our review.
We conducted this performance audit from February 2012 to November  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Patrick A. Ward (Assistant  Director), Emily R. Chalmers, Nima Patel Edwards, Scott E. McNulty, and  Steve Ruszczyk made key contributions to this report. Also contributing to  this report were Pamela Davidson, Marc Molino, Patricia Moye, and   Frank Todisco.