A MVA, or market value adjustment, is a tool used by insurance companies to protect themselves from interest rate risk. For example, let’s assume John buys a $100,000 fixed or fixed index annuity (FIA) from company A. At the time of issue, the 10-year treasury—a good barometer for what the company can earn on their bond portfolio—is at 4.00%. The policy is issued with a 10-year surrender schedule and whatever current rate the company can offer, based on their investment earnings and overhead.
If John holds the annuity for the entire 10 years, the MVA never comes into play. But what if he doesn’t and surrenders the policy early or takes a withdrawal in excess of the annual free amount? In that event, the carrier will make a MVA to the contract. To understand why, we need to review how bond valuations work.
A bond is a debt instrument—a loan to a company or the government—for a fixed interest rate and period. At the end of the term, the loan is returned in full (hopefully). But what happens if you sell your bond before the maturity date?
Let’s look at a couple of examples. Let’s say you buy a $10,000 bond with a 4% interest rate (coupon) and a 10-year maturity. Three years later, rates have risen to 6%. If you want to sell your bond at that point, you won’t get full price. It would sell at a discount. Who would pay $10,000 for a 4% bond when they could buy a new 6% bond for the same price? A buyer would look at the years to maturity (where they know the bond will be worth $10,000) and calculate what discounted value would give them the same 6% yield to maturity available in the market today. In this case, $8,863.
If we go back to our original annuity transaction, the insurance company assumed at issue that the contract would remain in effect for 10 years and priced it accordingly. However, if it is surrendered early, the surrender charge would cover their issue expenses (and commissions), but what about their investment loss due to having to liquidate a portion of their bond portfolio early? The insurance company adjusts the surrender value to compensate for their investment loss due to an early surrender, and the interest rate environment would mean they’d have to sell bonds at a loss—a market value adjustment.
In the chart below, you can see the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices drop and vice versa. The amount of rise or drop is a function of the difference in interest rates and time. In other words, the longer the time to maturity and the greater the difference in rates, the greater the swing.
The interesting thing about MVAs is that they work in both directions. For almost 40 years, interest rates have steadily fallen. So, there’s a possibility that an annuity issued over the last 10 years has a positive MVA, thereby mitigating some or all of the remaining surrender charge in the contract. Should the client consider surrendering or exchanging the contract for another annuity? As with most situations, it depends.
If a positive MVA mitigates a surrender charge in an existing contract, and the client’s goals have changed since the contract was issued, it may make sense to take advantage of the window of opportunity. For example, if the annuity is an IRA and the client would like to allocate to a different type of investment, like an advisory platform, the positive MVA would allow this transition earlier than waiting until the end of the surrender charge term. Keep in mind that if the annuity is non-qualified, this type of transaction would trigger a taxable event.
A positive MVA may also allow a §1035 exchange at minimal or no cost to a client. Tread very carefully here. On the surface it may appear as a great way to offer a client a new product design that was not available in the past without waiting several more years. On the other hand, purchasing an annuity in today’s historically low interest rate environment virtually guarantees a negative MVA in the event of an early (or excess) surrender going forward.
With that in mind, you should seriously consider the rewards and risks associated with the transaction. A surrender or excess withdrawal going forward will be much more costly than it would be for the existing policy. Does your client have enough liquidity to satisfy his or her expected and unexpected needs for the entire term of the new contract? Is this a trend? If a regulator would ask for a list of §1035 exchanges, would they see similar exchanges for you with similar rationales? With the increased Reg BI scrutiny, would you be willing to defend this transaction in front of a regulator or arbitration panel?
As you can see, there are two sides to every transaction. Be sure you look at the pros and cons of each to ensure you are working in the client’s best interest.
If you have questions about the above or any other retirement strategy, please contact our Advanced Planning department at firstname.lastname@example.org.