We spoke to several advisors in researching our latest white paper and inadvertently gained insight into the thick cloud of uncertainty enveloping the annuity industry. In the last two months, we have written extensively on this blog about the effect of the economic downturn on annuity firms. One such topic is the modification of living benefit rider guaranties and what that product change says about the ability of firms to meet their financial commitments to annuity contract holders.

When the topic of living benefit riders came up in one of our conversations, an advisor passed along some interesting investment advice he is giving current and prospective clients.  Given the amount of living benefit riders that are being discontinued or modified, the advisor said this was a good time to put a minimal investment (5-10k) into a GMIB in order to lock into the current guaranteed rate. In the event the guaranteed rate is changed or the product is discontinued, the investor would later be able to add a significant investment that would, in turn, be grandfathered into the locked-in rate.

While this is certainly a very viable (not to mention perfectly legal) option for annuity contract holders seeking optimal downside protection during the ongoing recession, it could be potentially disastrous for firms with poor balance sheets. It is safe to assume that if firms have already moved to reduce guaranties by an average of 2% and quietly decrease living benefit rider product lines, there are serious doubts internally around whether payout guarantees can be met going forward.

Interestingly, the guaranties given out by annuity firms are insured by the state of issue. If a firm becomes insolvent, the states are currently liable under law to cover a substantial portion of the present annuity contract value. The guaranty laws vary by state offering coverage on individual annuity contracts ranging from $100k to $500k in the most generous states New York and Washington.

With many states facing severe budget deficits that are only likely to worsen in this tough economic climate, the insolvency of prominent annuity firms would leave a hefty tab for the issue states to pick up. There is a good chance that government intervention would be required either to nationalize as in the case of Fannie, Freddie and AIG, or to dish out bailout funds to cover the states’ liabilities. Hundreds of billions of dollars worth of annuity contracts and a record number of living benefit riders have been sold over the past few years, let’s hope that the firms are able to keep up their end of the bargain.