Variable annuities on cusp of change

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Hi, I’m Dennis Hopper. Remember me from “Easy Rider” and “Blue Velvet”? I’d like to rap with you a minute about variable annuities. …

No, you’re not having a ’60s flashback. It’s merely the first wave of the really far-out trip formerly known as retirement.

Hopper’s over-the-top TV commercials for Ameriprise, in which cinema’s bad boy rants from a desert floor (note the subtle imagery), are the latest attempt by the financial services establishment to pitch its products to rebels without a pause — the baby boomers.

Variable annuities have gotten bad press, sometimes deservedly so, but don’t write these insurance products off altogether.
Not your grandmother’s annuity
  1. Target market: cash-rich boomers
  2. What’s a vriable annuity?
  3. A mixed reputation
  4. Not supposed to solve all problems
  5. Designed to provide (emotional) security
  6. Tough product to evaluate
  7. “War and Peace” complexity
  8. Living benefits

Target market: cash-rich boomers

Small wonder. The financial research firm Tiburon Strategic Advisors says the cash generated as 76 million baby boomers sell their businesses, downsize their homes and liquidate their 401(k)s is expected to nearly double consumer investable income from $17 trillion to $30 trillion by 2010.

What right-thinking insurance provider wouldn’t want a larger slice of that pie?

As baby boomers make the transition from workaday accumulation to budgeting for the back nine (don’t mention the R-word, man), financial institutions are giving their variable annuity products a makeover in hopes of attracting a greater market share, especially those major bucks expected to roll over from qualified retirement plans into IRAs.

Rest assured, these aren’t your grandmother’s annuities. Instead, they are packed with a growing menu of options known collectively as living benefits that, in theory, will allow aging boomers to have their cake (a lifetime stream of income) and eat it too (greater and prolonged participation in equity markets without risk to principal).

“I think the living benefits have really been driving annuity sales,” says Mark Mackey, president and chief executive officer of NAVA, the Association of Insured Retirement Solutions. “Someone who is 62 or 64, if they’re in good health, they may need to make their money last 25 or 30 years, so they really need to continue exposure to the equity market in order to do that. With the principal protection of the living benefit, it allows people to have their equity exposure but it protects them from a downturn for which they might not have enough time otherwise to recover.”

What’s a variable annuity?

Quick refresher: A variable annuity is a financial product with an insurance wrapper that offers three things mutual funds typically do not — tax-deferred treatment of earnings, a death benefit and an annuity stream that can provide guaranteed income for life. Like their cousin the fixed annuity, they can be purchased to begin paying out immediately (an immediate annuity) or at a future date (deferred annuity). Unlike a fixed annuity, variable annuities offer exposure to potentially greater earnings through their underlying portfolio of stock, bond and money market investments.

Granted, variable annuities are still a bit wobbly on their feet from the numerous beatings their reputation has taken in recent years. During the explosion of mutual funds in the go-go ’90s, it became fashionable to knock variable annuities for their relatively high fees (roughly double that of mutual funds), high commissions (anywhere from 8 percent to 18 percent) and inflexibility (i.e., steep withdrawal fees). A guaranteed income stream? Bah, critics said. Simply annuitize your own portfolio and save the fees. Variable annuities truly were the Rodney Dangerfield of financial products — they couldn’t get no respect.

A mixed reputation

If that wasn’t enough, the lure of those high commissions prompted some unscrupulous sales reps to sell variable annuities inappropriately to the elderly, prompting a firestorm of lawsuits, consumer complaints and increased scrutiny from their two regulatory entities, the Securities and Exchange Commission and the National Association of Securities Dealers.

When the technology bubble burst with the new millennium, followed shortly by the Enron scandal, variable annuities were no longer the only punching bag in the schoolyard. In fact, in light of new concerns about market volatility, the stability of pension funds and the predicted demise of Social Security, annuities began to be seen more for what they can do — remove the risk that you will outlive your money — than for what they can’t, which is provide a return on investment directly competitive with mutual funds.

Add in recent studies that indicate today’s retirees could live far longer than their parents, even into the triple digits, and annuities start to look downright attractive again.

Not supposed to solve all problems

Scott Sanderson, vice president of marketing and strategic relationships for The Hartford, says now that boomers are focused less on return on investment and more on going the distance, variable annuities are being viewed in their proper context.

“First of all, we’re talking about a portion of somebody’s assets, certainly never all. Where it matches up really well is with those income needs that are really nonnegotiable: your housing, your food, your health care. Those things you have no room to play around with,” he says. “You can decide to play less golf, travel less or give away less money, but you can’t decide not to spend any more money on essentials.”

Variable annuities were never designed to be the whole enchilada. Instead, used correctly, they can augment Social Security and pension benefits to provide for living essentials should the rest of your nest egg suddenly spoil. In fact, the SEC recommends that you max-out contributions to tax-favored 401(k)s and IRAs before buying an annuity product.

Designed to provide (emotional) security

Frank O’Connor, product manager with Morningstar, says variable annuities are best viewed alongside other insurance products and not strictly as financial investments. If you fear you may outlive your assets, that risk is real to you, and may be worth paying a price to avoid.

“I would argue that fees only matter in the absence of value. If you are deriving value, even if it’s perceived value like homeowner’s insurance where the value may never be extracted, it can be a good thing,” he says.

Who is most likely to benefit from a variable annuity? Forget the rich; they have little reason to believe they will wind up as wards of the state. Mackey says a good place to start would be the 80 percent of workers not covered by a defined benefit pension plan.

“If you don’t have a pension, Social Security by itself is not going to be enough. Most people are going to have to have something to supplement it,” he says.

That said, the industry focus these days is clearly on middle-income baby boomers looking to hedge their longevity risk. Though a case can be made that starting on a deferred annuity in your 30s and 40s will help recoup the higher fees over time, the combination of long waiting periods (typically seven to 10 years) and steep withdrawal fees (7 percent to 20 percent) makes it a tough sell.

Instead, insurers now tout their variable products as a platform from which to safely stay invested longer in equity markets.

“If you had $500,000 as a nest egg, we’re talking about taking $50,000 at the most and buying off that ‘tail risk’ (longevity risk),” says Sanderson. “That dramatically changes the risk you can take with the other $450,000 in your portfolio. You can now take a little more risk because you know that, at a predetermined age, you’re going to have your basic income needs taken care of.”

Tough product to evaluate

Glenn Daily, a fee-only insurance consultant in New York City, begs to differ.

“My response is, I think it’s pathetic if that’s the best we can do,” he says.

Daily says he and many other financial advisers are frustrated by today’s variable annuities, which are time-consuming and difficult to evaluate, much less compare.

“It’s necessary, but not sufficient, to know what the ratio is between the present value of the benefits and the present value of costs. You really don’t have a chance to be able to evaluate their products and compare them if you don’t know that, because they’re all different; they’re not standardized at all.”

Daily agrees there may be a place in a baby boomer’s portfolio for a variable annuity. But as things stand, there’s no easy way for advisers to evaluate variable annuities apples to apples, and clients would be unwilling to pay them hourly to do so.

“I’ve been dreading this, simply because I know that it’s going to be very hard for me to give good advice on these products. These products are sold on an emotional level. Advisers want to advise based on hard facts. That’s a major disconnect.”

‘War and Peace’ complexity

Naturally, with flexibility comes complexity. For every option offered to a prospective buyer, there’s a corresponding risk to the insurer that must be managed, resulting in riders that read as long as “War and Peace.”

The insurers are trying to address these issues through education. NAVA is working on instituting electronic processing of new business that would include a pre-sale screening tool to help advisers narrow the scope of suitable products for their clients. The Hartford has deployed 25 “retirement solutions consultants” not tied to any product to work directly with brokers and consumers.

“You’ve hit our biggest challenge in terms of distribution,” says Sanderson.

Daily’s best advice to his clients today? Wait.

“I’m not saying wait a decade; I’m saying wait six months. Put it on your calendar. There will be more information available in the next six months, and that information will be worth having waited. The problem of doing something now is, once you do it, it can be hard to undo it. It’s not easy to reverse these decisions.”

Living benefits

Look for these living benefits when considering a variable annuity:

Guaranteed minimum income benefit (GMIB): This hedge against market decline guarantees that when your contract is annuitized, your income payments will be based on the greater of either the actual realized value or your principal plus a previously agreed upon interest rate, often 5 percent. That means if you purchased a $100,000 variable annuity that guarantees 5 percent annual growth and leave it untouched for 12 years, you would have at least $179,585 to annuitize, even if stock market losses erode the value.

Guaranteed minimum withdrawal benefit (GMWB): Another hedge against market decline, the GMWB guarantees that you can withdraw annually a fixed percent of the annuity premiums, usually 5 percent to 7 percent, for a period of time until the invested amount has been exhausted, regardless of market performance. A $100,000 variable annuity with this benefit at 7 percent would guarantee an annual withdrawal of $7,000 (7 percent of $100,000) until the $100,000 has been withdrawn, even if market losses erode the value of the annuity.

Guaranteed minimum withdrawal benefit for life: Like the GMWB, this guarantees that you can withdraw a fixed percentage of the annuity premiums, usually 4 percent to 5 percent, for life, even after the investment amount has been exhausted. The GMWB above then continues for life, regardless of the account value.

Guaranteed minimum accumulation benefit: Guarantees that the value of your variable annuity will be at least equal to the face value of the policy’s premium after a certain period, regardless of the market performance of the underlying sub-accounts. If you hold a $100,000 variable annuity for the contracted waiting period and make no withdrawals, this benefit guarantees it will be valued at $100,000, even if market losses have eroded the underlying portfolio.

Source: NAVA, the Association of Insured Retirement Solutions