First Of Three Parts
Ask most financial advisors to define “variable annuity,” and theyre likely to talk about tax-deferred accumulation, fund choices or minimum death benefits. This is consistent with VA product development over the past decade, as insurers and distributors focused more on accumulation period benefits than on the original premise of the annuityincome.
Demographics–millions of steadily aging baby boomers–have driven this emphasis on retirement saving rather than retirement spending in recent years, precipitating the evolution of the VA as an accumulation vehicle. Those same demographics are also leading some industry experts to predict that income annuities will make a comebacksomeday. As we will see, the industry still has a long way to go to convince investors and reps of the merits of annuitization.
Decade of Accumulation
Saving for retirement has become more challenging in recent years. Investors looking ahead to more years in retirement than any generation before also have to worry about stretching their savings to deal with years of increased costs of living, the declining number of defined benefit pension plans and concern over Social Security’s future.
Personal savings, the third leg of the proverbial stool, took on greater importance as investors assessed their needs for generating income throughout their retirement years. Many workers turned to VAs, lured by the products tax advantages and investment choices, particularly as the equity markets soared during the 1990s.
The healthy markets brought about another concern among workerslocking in the gains on their investments. Annuity manufacturers responded by creating products that, ultimately, focused on the accumulation phase of the contracts.
Death benefits (DBs), which were once limited to a return of premium, became increasingly complicated, offering a periodic lock-in of gains (“stepped-up” DBs), a pre-determined annual percentage increase (“rising floor” DBs), or a percentage of earnings to offset estate taxes and other final expenses (earnings enhancement DBs).
A variety of living benefits also emerged, offering premium enhancements and minimum accumulation guarantees as means to maximize the accumulated value of the contract.
The concept of annuitization was addressed with the introduction of two riders in the late 1990s. The guaranteed minimum income benefit and guaranteed minimum payout floor riders provided assurances that future VA payouts would not dip below specified levels. Still, the fact that annuitization is required to receive either benefit will result in less than widespread utilization of these newest features.
The emphasis on accumulation phase benefits led to exponential growth in the VA industry during the 1990s, particularly in the second half of the decade. As of June 30, 2001, assets invested in the variable sub-accounts of VA contracts stood at $760 billion, representing more than a three-fold increase over the $235 billion in assets at year-end 1995. Variable sub-account assets peaked at $795 billion during third quarter 2000 as a result of record net sales and investment returns. (See chart 1.)
Net sales, defined as gross sales less internal exchanges, external exchanges, and all other surrender activity, saw extraordinary growth during the mid-1990s. Fueled by the introduction of bonus VAs and robust equity markets, industry-wide net sales of VAs grew from an estimated $27 billion in 1995 to $48 billion in 1997, according to Financial Research Corporation (FRC) data. Net sales began to slow the following year, partly due to uncertainties in the equity markets, eventually sliding to $29 billion in 2000 and just $7 billion in the first half of 2001.
Also contributing to this decline was an increase in 1035 exchanges as contract owners and reps sought out the latest product features, nearly all of which were limited to the accumulation phase of the annuity.
Annuitization: The Unused Benefit
It comes as no surprise to those in the industry that processing an annuitization remains a rare occurrence in VA back offices. Most VA professionals we spoke with estimated annuitization rates for both their companies and industrywide to be “around 1% or less.” The reality is that “less” is more accurate. In fact, annuitization rates for deferred VAs are best expressed in hundredths of a percent.
In analyzing annuitization rates for FRCs study, “Opportunity of a Lifetime: VA Income & Product Trends,” we segmented participant firms into three tiers based on VA assets under management:
–Tier 1: Firms with VA assets of $20 billion or more.
–Tier 2: Firms with VA assets of $5 billion to $20 billion.
–Tier 3: Firms with VA assets of less than $5 billion.
Furthermore, when calculating annuitization rates, we assumed that not all deferred VA contracts were “reasonably annuitizable.” That is, while all deferred contracts were theoretically available to be annuitized, contract owners who had not yet attained retirement age or were in their first years of retirement were unlikely to do so.
Assuming that 50% of deferred VA contracts were reasonably likely to annuitize, we determined (as shown in chart 2) the annuitization rates per 10,000 contracts for Tier 1, 2 and 3 companies. (A score of 100 equals 1%).
Tier 1 averages jumped after 1999 due to the inclusion starting in 2000 of data from one product with significantly higher annuitization rates. Rates for smaller firms (Tiers 2 and 3) were higher for all periods. We believe this is due primarily to these products being sold through captive sales forces such as insurance agents, and other financial advisors who tend to have more comprehensive, long-term relationships with their clients. However, the average annuitization rates for all tiers and all periods were still well below 1%.
The emphasis on accumulation during the 1990s led to the misnomer that VAs were little more than “mutual funds in an insurance wrapper.” As a consequence, systematic withdrawal plans, a popular method of extracting money from mutual funds, were applied to VAs and now outpace annuitization by a factor of one thousand or more. The overwhelming preference for systematic withdrawal plans will be examined in the next article in this series on VA income and product trends.
Art MacPherson is assistant vice president, senior writer, and Lisa Plotnick, FLMI, CLU, is senior analyst, VA analytical research, with Financial Research Corporation, a Boston-based financial services research and consulting firm specializing in competitive intelligence and analytical services. They can be reached via email at AMacpherson@frcnet.com and Lisa.Plotnick@frcnet.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, January 7, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.