Variable Annuity Benefits & Drawbacks

The variable annuity market experienced tremendous growth over the past decade. The introduction of a product which guarantees lifetime income payments while providing the opportunity for market growth was precisely what many investors were looking for. Companies such as Prudential, MetLife, AXA, Nationwide, Jackson, and Transamerica rolled out product after product which generated billions of dollars in sales through financial advisor channels. The purpose of this article is to determine if these products are still working well for investors and to point out the challenges which the current market environment presents to the insurance companies which issue these variable annuity products. In essence, are the product offerings at the current costs worth purchasing? Or should investors be looking at other products and strategies to augment their retirement income?

First, it should be noted that insurance companies are facing a very challenging atmosphere right now in terms of issuing new and competitive variable annuity products. The persistently low interest rate environment is directly at odds with the traditional insurance company model of generating profit through interest rate spreads. The most common fixes for this challenge include raising contract fees and expenses along with reducing contract features and benefits. That's not to say new variable annuity offerings don't have a strong value proposition but you're more than likely getting less now than you did in years past and potentially at a higher price.

Beyond the interest rate environment, some companies have further challenges in the way of managing their back businesses (annuity contracts written in years past) which may not have been properly priced. I like to refer to this as "mispriced liability" and it presents a slate of problems for insurers. Without going into the specific companies that are probably most guilty of this, let's just say that it does affect how those companies are designing new products today. One of the central issues with variable annuity back business is that it is generally not portable. If you are contractually obligated to make large lifetime payments to a contract holder who may live a very long time, you can believe other annuity providers aren’t lining up to buy that liability from you.

Insurance companies have been dealing with the above issues in various ways. Below is a list of trends I'm noticing right now within the industry. As an advisor who has sold and consulted about variable annuities at length, I have a pretty good pulse on this market.

1. Buying Back Living Benefit Riders - This is a very perplexing strategy which several insurance companies are offering to their variable annuity contracts holders - specifically those contract holders who have living benefit bases which are well above their current contract values. The reason I call this a 'perplexing strategy' is that there are many moving parts and no exact science for how much above their current contract value they should offer. Essentially this strategy will be practiced by insurance companies who wish to remove potential liability from their books and not look back. Most of the financial press about buyback offers encourages contract holders to reject them because insurers would supposedly never offer a buyback which makes financial sense for anyone other than themselves. My opinion is that it never hurts to look at what you're being offered. In some cases where you may want to make an illiquid asset liquid again, it could make financial sense. What I would say is that the larger the gap between your contract value and your living benefit base, the more sense it makes to hold onto your annuity.

2. Issuing Heavily Diluted, Maximum Priced Products - What's the most obvious way to improve your finances if you're an insurer selling variable annuities? Price them high and reduce the benefits. This will generate current revenue for the insurer and potentially offset some of the outstanding business which they are dealing with. Remember that insurance companies are trying to maximize profits while putting out products that are still marketable enough that financial advisors will continue to sell them. Somewhere there is a fine line where the product starts to become unattractive to an advisor and ultimately the client. Insurance companies need to carefully consider how they structure variable annuity products going forward so that the offerings remain attractive and sellable.

3. Diversifying Product Offerings - Most financial advisors have been seeing new product offerings lately which are considerably less capital intensive than variable annuities. This basically means the insurance companies don't need to put out their own cash to hedge the way they do with variable annuities and less cash to hedge generally equates to more profitable product offerings. Examples of this would be the structured capital products offered by MetLife, Prudential, and AXA. Also Jackson has new product offerings.

4. Completely Exiting the Business - With the challenging atmosphere facing variable annuity products, some companies have just decided to exit completely (from new sales, not from servicing existing contracts). Recently exiting companies would include Sun Life, Hartford, ING, and others. Many of these companies have also stopped accepting additional premium into existing contracts which may cause them financial challenges in the future.

I suppose the takeaway here is that now, more than ever, clients and advisors need to be increasingly efficient with the VA when viewing it as an asset class. I recommend speaking with a knowledgeable advisor when it comes to assessing what you already have and certainly if you're about to buy a new variable annuity product. I still consider there to be valuable products out - products which can work well as part of a retirement planning strategy. You need to understand how to use them because otherwise you may end up losing some liquidity and paying onerous fees and expenses.

Living Benefit Riders

In my experience, most people purchase variable annuities for longevity protection. As such, which living benefit riders one chooses will be a major component in the choice of a VA. Ideally I would map out each company and rider for you, but that would take dozens of pages. Instead I'll speak generally about living benefit riders and you can feel free to call or e-mail me to elaborate on what you have or what you are considering.

Living benefit riders often have guarantees on both the accumulation and distribution side. Typically a company will credit your living benefit base in each of the years in which you don't take a distribution - even if the market value of the contract falls. If you are fortunate and your contract value grows by more than the guaranteed credit amount, the living benefit base will usually assume that market value instead. And this process can often go on for years until you eventually want or need to take distributions from your annuity.

At that point, the guaranteed annual withdrawal amount is usually a function of your age. Those percentages have come down over the years but are generally in the 5% range for withdrawals started after age 65 and the 6% range for people who wait until they are a bit older, perhaps 75. Again, this will depend on the specific annuity company and rider which you choose. Those payments will continue for life, even if your contract value falls to 0, assuming the insurer maintains a claims paying ability and makes good on their promise. It's rare that an insurer defaults on an annuity payment and frankly I've never seen it in my 10 years. A default by any one provider would likely send shockwaves throughout the industry.

The living benefit business is competitive and companies are continuously innovating to gain an edge. For example, many companies will offer to look back and lock your living benefit base in at high watermarks including monthly, or even daily. Naturally there are trade-offs for companies offering this sort of volatility protection including limiting the ways in which you can invest your funds to protect them for letting you lock in too high a value.

I haven't talked much about death benefits in this article. Death benefits and Income benefits sort of function opposite (maximum income withdrawals typically reduce the death benefit) but you would want to look on a case-by-case basis at each company offering a variable annuity and see what their death benefit options are. Some are definitely better than others.

For more information on this topic, I can always be reached at rbailyn@pfawealth.com. 

Best,

Russell Bailyn