James W. Watkins, III, J.D., CFP Emeritus^TM, AWMA®

In Part 1 of “Knew or Should Have Known”: Annuities, Plan Sponsors, and Fiduciary Law,” I examined the basic structure of fiduciary law and some of the potential fiduciary liability issues posed by the inclusion of annuities within 401(k) and 403(b) plans. In this post, I want to address some of the key issues that plans sponsors and other investment fiduciaries should consider during the course of their required fiduciary investigations and evaluations.

Annuities are complex investments. During both my compliance and legal careers, I have been fortunate enough to have had three annuity experts that I knew that I could trust implicitly – Peter Katt, John Olsen, and  most recently, Chris Tobe. Chris is one of the co-founders of the CommonSense 401(k) Fiduciary Project (commonsense401kproject.com). I highly recommend that anyone interested in potential fiduciary liability issues posed by annuities visit the Project’s web site and read Chris’ posts.

Sadly, Katt passed away in 2015. Fortunately, his informative articles are still available online.

John and I actually exchanged emails this past weekend as I was preparing to write this post. John is an incredible resource on annuities and is available for consulting work via LinkedIn (JohnOlsen CLU, ChFC, AEP) or through his company, Olsen Annuity Education.

I contacted John to let him know that I intended to reference his excellent article on indexed annuities, “Index Annuities: Looking Under the Hood.”¹ John has always had an incredible ability to simplify the complexity of annuities. I highly recommend that any investment fiduciary considering including annuities in ERISA plans, or continuing to offer annuities within their plan, contact John.

Annuities, Fundamental Fairness, and Fiduciary Liability
I want to discuss a couple of John’s more significant points in terms of understanding annuities, especially with regard to potential fiduciary liability issues for plan sponsors and other investment fiduciaries.

As a compliance director, one of my concerns was with regard to the marketing strategies used by the index annuity issuers, specifically the potentially misleading reference to market returns. Typically, the return on such market indexed annuities is based on the performance of an underlying market index, such as the S&P 500 Index.

However, as John points out, indexed annuities typically contain various “moving parts” which limit the actual return received by indexed annuity owners.

It is not simply a matter of if the index increases by 10 percent, the annuity owner gets 10 percent interest. Rather, that interest is based on the index growth, modified by one or more contract features that are often called moving parts.²

If an index has declined, zero current interest is credited with respect to that index for the crediting period. If an index value has risen, the amount of that gain is noted, and one or more moving parts are applied to determine the portion of that gain that will be declared as current interest to be credited in accordance with the contract language.³

The spread is the percentage of index gain that will not be credited as interest, the first few percent off the top, so to speak. For example, if the spread (i.e., margin or fee) is 3 percent, then only gain in the index in excess of that percentage will be credited. Given the spread of 3 percent, a 10 percent index gain would produce 7 percent interest credited to the annuity (assuming a 100 percent participation rate).⁴

Cap rates and participation rates are two commonly used means by which annuity issuers can further resrict the actual gain realized by an annuity owner. As John points out, there are actually two types of cap rates – one that limits the amount of the index gain that will be recognized in calculating the interest to be credited to the annuity owner; the other cap being a limitation on the amount of the indexed-linked interest that will be crediteed to the annuity owner

Using the example above, if the annuity imposed an annual cap rate of 6 percent, the annuity owner would only be credited with 6 percent of the original 10 percent gain. If the annuity issuer also imposed a participation rate of 70 percent, the annuity owner’s realized return would be further reduced to just 4.2 percent.

Only 4.8 percent on the original 10 percent gain. Remember, fiduciary law focuses primarily on fundamental fairness.

John also addresses a common mantra used by annuity advocates, that investors cannot lose money in an indexed annuity. Lack of liquidity is one of the often cited drawbacks of annuities. If an annuity owner needs to withdraw money from an annuity, such withdrawal will typically result in a surrender charge. John notes that such surrender charges may actually result in a loss of an annuity investor’s premium:

While some contracts have a genuine guarantee of principal (surrender charges may wipe out interest earned but not the money contributed in premiums) that preserves premium even in the early contract years, most do not.⁵

This possible lost of premiums paid is clearly inconsistent with the annuity industry’s mantra that you can never lose money in an annuity. However, to be fair, negative performance of the base index in one year does not reduce the accumulated credit in the annuity.

One final point addressed by John has to do with the fact that annuity issuers often reserve the right to change the value of the annuity’s cap rate and/or participation rate. During my compliance director days, this was the subject of some intense discussions in the compliance department, as some annuity issuers will offer “teaser” rates to entice investors to purchase an annuity, with the annuity issuer knowing that they intend to significantly reduce the actual interest rate almost immediately. “Annuities are sold, not bought,” is a well-known saying in the financial services industry…and for good reason.

The fact that annuity issuers typically reserve the right to change cap and/or participation rates has potentially serious fiduciary liability implications for plan sponsors and other investment fiduciaries. As I have successfully argued, this is clearly a material fact that a plan sponsor knows or should know as a result of the plan sponsor’s required investigation and evaluation. The law defines “material fact” as

[A] fact that a reasonable person would recognize as relevant to a decision to be made, as distinguished from an insignificant, trivial, or unimportant detail. In other words, it is a fact, the suppression of which would reasonably result in a different decision.⁶

The annuity owner’s right to unilaterally change the rules for their benefit and significantly reduce the annuity owner’s realized return is clearly inconsistent with the “fundamental fairness” principles of fiduciary law. While the annuity industry tries to justify this right as necessary for the annuity industry, the practice and its impact on plan participants should automatically preclude any consideration of such an annuity in any ERISA plan.

John’s article addresses an additional concern that fiduciaries should consider in deciding on whether to include annuities which reserve the right to unilaterally change the terms of the annuity to protect its interests over those of an annuity owner – the potential ability of the annuity owner to manipulate an annuity’s cap rates and/or participation rates to increase the annuity issuer’s return at the expense of the plan participants who purchase such annuities.

It is possible, of course, that an insurer will set participation and cap rates on its contracts lower than necessary, in order to retain more of the index gain itself, but an insurance company that does that will quickly find its products uncompetitive.⁷

Annuity advocates become annoyed when I respond to their arguments by simply pointing out that ERISA does not require a plan to offer annuities within a plan. Therefore, given the risk of exposur to unnecessary fiducairy liability, why go there? As I tell my fiduciary clients, a prudent investment fiduciary does not voluntarily expose themselves to the risk of unnecessary fiduciary liability. Plan participants desiring to purchase an annuity are obviously free to do so outside of their plan, without exposing the plan sponsor to concerns about fiduciary liability exposure.

Annuities and Fundamental Fairness/Commensurate Return
Insurance companies typically condition settlement of a civil case with significant damages on the plaintiff’s willingness to agree to the use an annuity in paying damages. The young and/or inexperienced plaintiff’s attorney may then communicate to their client that the insurance company has offered to settle the case for a million dollars.

The client agrees to accept the offer of a million dollars, only to learn later that the present value of the annuity offered is much less than a million dollars, perhaps 70-80 percent less. The difference in present value of the annuity is due to the time value of money factor. In short, a dollar due in 10-20 years is worth much less that a dollar received today.

The Restatement of Trusts (Restatement) is a valuable resource for investment fiduciaries. Even the Supreme Court has acknowledged the value of the Restatement in resolving issues involving fiduciary law.⁸

As a plaintiff’s attorney, I had to learn how to apply actuarial methods to evaluate offers involving annuities, as defense attorneys and insurance companies are typically defiant when questioned about the present value of a proposed annuity in a settlement. Most courts no longer tolerate such tactics and value the settlement offer based upon the actual cost that the insurance company will incur in purchasing the subject annuity. Judges have little patience with attorneys who prevent the court from controlling the court’s case load.

In a recent post, I posted the results of a hypothetical forensic breakeven analysis of an annuity using common actuarial tables and calculations. The results exposed a common issue that plan sponsors and other investment fiduciaries must consider – the fact that in many, if not most, cases, annuity contracts are drafted in such a way to ensure that the odds favor the annuity issuer’s interests over the interests of the annuity owner, resulting in a windfall in favor of the annuity issuer.

“Equity abhors a windfall” is a basic tenet of both equity and fiduclary law. With regard to 401(k) and 403(b) plans, fiduciary law demands that the best interests of the plan participants and their beneficiaries are always paramount. One of my favor fiduciary mantras is that “there are no mulligans in fiduciary law.” For non-golfers, that equates to “there are no do-ovewrs in fiduciary law.”

After I posted my actuarial hypothetical, people accused me of “cherry-picking” my facts to support my position. The again, a retired actuary told me that my analysis was sound.

However, I decided to run some additional scenarios with different assumed interest rates for future presentations. I ran the forensic actuarial analysis using interest rates of 5 percent and 6 percent, again based on both present value alone and present value plus mortality factors. The chart below shows the results of my forensic actuarial analyses based on a 65 year-old client purchasing a $250,000 annuity at the indicated interest rate.

If we assume that fiduciary prudence requires that an annuity provide an annuity owner with a realistic opportunity to receive a commensurate return, an opportunity to at least breakeven, the chart shows that using the annuity’s present value alone only provides a commensurate at a 6 percent interest rate. The approximate breakeven point in such case would be $250,520 at age 94

If we analyze the same annuity using both present value and discount for a mortality factor, each annuity fails to provide a commensurate return at all three interest rates. Courts typically require that annuities be analyzed in terms of both present value and a mortality factor.

This type of actuarial analysis is essential in analyzing potential liability issues and is applicable to any type of annnuity involving a series of future payments. My concern is that most plan sponsors are unaware of the importance of such analyses with regard to fiduciary prudence and loyalty, much less being able to perform and/or interpret such analyses. As a result, a plan sponsor could be unnecessarily exposing themselves to unwanted and indefensible fiduciary liability.

Annuities are essentially bets, the annuity issuer betting that the annuity owner will not live long enough to break even, which would result in the annuity owner receiving a windfall equal to the remaining balance in the annuity at the annuity owner’s death. As discussed earlier, the annuity issuer could then place such funds in a so-called “mortality pool,” an account that an annuity owner can use to help cover their legal obligations to other annuity owners.

Remember – “Equity abhors a windfall.”

Going Forward
In these two posts, I have focused on what I have taught my fiduciary risk management clients and attorneys on what I believe the major opportunities will in litigating fiduciary breach actions involving annuities. Each of the identified issues can be simplified in terms of (1) breaches of fundamental fairness, and (2) plan sponsors involving themselves in actions/choices which they are not required to be involved in under either ERISA or basic fiduciary law, my “why go there” mantra.

The various fiduciary prudence and loyalty issues discussed herein are all issues that a plan sponsor should consider in deciding whether to offer annuities with their plan. Should a plan sponsor decide to offer annuities within their plan, the plan sponsor should be prepared to defend their decision in court by showing that factoring all the issues discussed herein, a prudent would have made the same decision.

Most plan sponsors desire to receive the extra liability protections provided by ERISA Section 404(c). Plan sponsors seeking such extra protection will have to address and resolve is how to coimply with Section 404(c)’s requirement that a plan sponsor has to provide “sufficient information to allow a plan participant to make an informed decision.”

While we discussed several fiduciary issues that would arguably constitute material facts which would need ro be provided to plan participants, we did not discuss arguably the most complicated and confusing aspect of indexed annuities, that being the various methods used by annuity issuers in calculating the interest to be credited to an annuity issuer.

John does a good job in discussing the various calculation methods used. I will leave it at that and wish the readers good luck in trying to understand the various calculation methods used.

Tomorrow, October 31, 2023, the DOL is scheduled to release its new Retirement Security regulation. The 10th Circuit Court of Appeals recently handed down a decision in the Matney case⁹, a decision that I believe will be vacated if reviewed by SCOTUS due to the Court’s erroneous interpretation of the application of revenue sharing. A decision in the Home Depot 401(k) action¹⁰ is currently pending in the 11th Circuit Court of Appeals, the key issue being the same as was presented in the Matney case, namely which party has the burden of proof on the issue of causation in 401(k)/403(b) fiduciary breach actions.

I am often asked whether I could envision any situation where an annuity might be a prudent investment option under fiduciary law. My response is always the same:

Unless and until the annuity industry recognizes the legitimacy of the fiduciary liability issues involved with annuities and guarantees a plan participant a commensurate return for the extra risks and costs associated with annuities, annuities will continue to be a fiduciary liability trap. When it comes to providing a commensurate return, it is not a question of the annuity issuer’s ability to do so, but rather the profitability of doing so.

I suggest that plan sponsors and other investment fiduciaries seriously consider the message in that last sentence as it pertains to potential fiduciary liability situations. Going forward, plan sponsors can anticipate increasing litigation involving the issue of breaches of the fiduciary duties of prudence and loyalty.

The issue is not, and never has been, about the value of retirement income. The issue is about the fundamental fairness of the investment vehickle offering the additional retirment income. For fiduciaries, the question is, and always has to be about commensurate return for any extra costs and risks associated with viable investment alternatives, about cost-consciousness and the relative cost-efficiency of each investment alternative under consideration.¹²

Plan sponsors ultimately deciding to offer annuities within their plan should be prepared to justify their decision in terms of each of the issues discussed herein and other “fundamental fairness” issues, especially when compared to other viable and more transparent alternatives such as certificates of deposit, and various types of bonds, e.g., investment-grade corporate bonds, U.S. government bonds, municipal bonds. “Humble Arithmetic,” common sense, and current fiduciary law suggests that that will be a significant hurdle to clear, especially with new regulations and legal decisions on the horizon.

Remember this truism – Prudent plan sponsors do not voluntarily expose themselves to the risk of unnecessary fiduciary liability.

Notes
1. John Olsen, “Index Annuities: Looking Under the Hood,” Journal of Financial Service Professionals, 65-73 (November 2017). (Olsen)
2. Olsen, 66.
3. Olsen, 66.
4. Olsen, 66.
5. Olsen, 72.
6. https://en.wikipedia.org/wiki/Material_fact
7. Olsen, 72-73.
8. Tibble v. Edison International, 135 S. Ct. 1823 (2015).
9. Matney v, Barrick Gold of North America, No. 22-4045, September 6, 2023 (10th Cir. 2023.
11. Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022).
12. See Restatement (Third) Trusts, Section 90 (The Prudent Investor Rule), comments b, f, and h(2).

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This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.