How insurers are losing when it comes to variable annuities

Variable annuity sales have been on a steady decline the last several years, with market volatility, growing popularity of indexed annuities and a looming Labor Department regulation being primary contributors.
But insurance companies have also shot themselves in the foot by severely limiting investment choice on annuity products bought with income guarantees following the financial crisis.
These restrictions — which come via mandated use of managed-volatility funds or conservative asset allocations in VA products — have watered down investment returns, angering consumers and advisers alike as the products have lagged the broader stock market.
“The frustration with investors is that they’re in these 60-40 [stock-to-bond] blend and managed-volatility allocations, and those are underperforming the S&P 500 because they’re less exposed to equity,” said Gregory Olsen, partner at Lenox Advisors Inc.
When factoring in product fees, performance has been kind of “blah,” he said.
Taken together, the restrictions represent a sort of disconnect between insurers, who are trying to mitigate their risk, and the advisers and investors using variable annuities (rather than more conservative annuities) to maximize returns and generate the most guaranteed income, according to insurance experts.
“Reps I’ve talked to want to go as fast as they can inside a variable annuity,” said Kevin Loffredi, senior product manager of annuity solutions at Morningstar Inc.
Because VAs with a lifetime-income feature provide downside protection in the form of a guaranteed income floor, many advisers prefer investing with aggressive equity allocations, Mr. Loffredi said.
“There’s no benefit in having more fixed-income exposure in a VA with living-benefit exposure,” he said.
Although insurers imposed few investment restrictions prior to 2008, contract limitations became more prominent following the financial crisis as companies sought ways to mitigate their risk.
Due to the way VAs with lifetime-income guarantees are structured, while investors’ account balances dropped precipitously during the downturn, there wasn’t a corresponding drop in the promised benefits. That left insurers exposed to a “gigantic liability they never expected to happen,” according to Scott Stolz, senior vice president of Private Client Group investment products at Raymond James & Associates Inc.
However, investment limitations are meant to create more stable account values and lower risk when offering guaranteed lifetime income benefits.
Now, “nearly all of the top variable annuity living benefit writers” require such “account-value risk mitigation strategies,” according to an Insured Retirement Institute report from December.
According to Alison Reed, executive vice president of operations for Jackson National Life Distributors, the biggest change post-crisis was the introduction of managed-volatility funds.
The funds aim to buffer investors from big market swings, protecting on the downside but, consequently, not capturing as much upside.

While the S&P 500 returned 1.4%, 13.5% and 32.2% in 2015, 2014 and 2013, respectively, asset-weighted average net returns in managed-volatility VA sub-accounts lagged, at a respective -3.5%, 3.5% and 15.3%, according to Morningstar.
The number of managed-volatility sub-accounts, which are like mutual funds inside VAs, is up 240% since 2006, to more than 7,100 from approximately 2,100, according to Morningstar.
Assets in VA managed-volatility portfolios increased markedly over that period, ballooning to $133.2 billion through June from $25.1 billion as of year-end 2006, according to Morningstar.

Such funds now capture more than half of net positive cash flow, and use of these strategies is unlikely to abate, IRI says.
Insurers also have required more conservative allocations when coupling a VA with a living-benefit rider. For example, rather than allow investors to put 100% into equities, many firms may put “guard rails” on asset allocation by allowing up to 60% in equities, with the rest in fixed income or cash, Mr. Loffredi said.
According to IRI, whereas large-cap blend funds benchmarked against the S&P 500 once held the lion’s share of assets, money has moved dramatically toward more conservative funds. Over 2005-15, “conservative” allocation funds gained about 7 percentage points in market share and “moderate” funds about 10 points, according to the IRI report. Large-caps lost about 15 points.
Some insurers take an even more regimented approach by dictating that particular percentages of an equity bucket can go to small-cap funds, large-cap funds, etc., Mr. Loffredi said.
Such restrictions “kind of defeat the goal of having a variable annuity,” according to Mr. Stolz of Raymond James, which has about 6,700 advisers.
“It’s like getting double insurance,” Mr. Stolz said. “I’ve been telling our advisers for four years now, if you’re going to buy a VA with a living benefit you have to invest the money as aggressively as the contract allows and the client is comfortable with.”
VA DECLINE
Industrywide variable annuity sales have been on a multi-year decline. New VA sales decreased each year of 2011-15, going from nearly $158 billion in 2011 to $133 billion last year.
Although it’s not the only factor, investment restrictions factor tremendously into these declines, Mr. Stolz said. And he’s not alone in believing that.
Mr. Loffredi points to VA sales of Jackson National, which doesn’t impose any fund restrictions, as evidence of adviser and investor preference for open-architecture VA platforms. Jackson, the No. 1 VA seller, is the only one among the major insurers that doesn’t impose some sort of investment restriction, he said.
Over 2006-15, Jackson saw net annual sales increase a whopping 225%, to $23.1 billion from $7.1 billion, according to Morningstar.
Among the top 10 VA sellers last year, about half posted gains in new annual sales over the same period. In percentage terms, the closest to Jackson was Transamerica, which posted a 114% increase to $7.9 billion in sales, a third of Jackson’s total.
Jackson is one of the main carriers Mr. Olsen of Lenox Advisors uses with clients seeking VAs with guaranteed income riders, due to its lack of restrictions (as well as its strong credit rating), he said.
Of course, advisers and clients may have goals other than boosting investment return, such as maximizing guaranteed income from day one. In that case, other insurance companies and potentially other annuity products may be the answer, advisers said.