Variable annuities have been selling like air conditioners in January. The market is down, returns are down, and there’s precious little to attract buyers these days. Statistics from the National Association for Variable Annuities (NAVA) show that total premium flows (the sum of new sales [all first-time buyers of a contract, including inter- and intra-company exchanges] and recurring premiums from existing contract owners) for 2001 were down 17.8% from 2000. According to Harold Drescher from the insurance trade group LIMRA Intl., sales for both fixed and variable annuities as a whole fell 3% in 2001; sales for VAs alone fell 18% over the same period. By contrast, sales of fixed annuities rose 36% during 2001.

With such a dismal outlook, is there any hope on the horizon? Are there good things to be said about VAs? Well, yes, actually, there is some cheer to be had–along with a caveat or two.

According to Eric Sondergeld of LIMRA, after nearly six years of consecutive increases in sales, sales of VAs began to decline in the first quarter of 2001. Sales were down 21% in the first quarter (from first quarter 2000 sales), 20% in the second, 19% in the third, and 9% in the fourth quarter. Sales were down only 2% in the first quarter of this year. But Sondergeld points out that most VAs these days have fixed accounts in addition to the variable accounts, and sales of the fixed accounts declined only 4% in each of the first two quarters last year. Third quarter fixed account sales were up 9%, fourth quarter sales were up 38%, and first quarter of 2002 sales were up 34%.

The fixed portion, of course, is not what makes a VA variable, and with market troubles driving sales down, enhanced creativity is called for on the part of marketing specialists, who endeavor to find ways to make an apparently unattractive product appealing, or enhance the waning popularity of something that has seen demand peak. The VA market is no different, and products with new variations have emerged. Some of those changes are beneficial for the salesperson, some for the client; it pays to be wary when deciding which feature offers the greatest rewards.

Says Stephan Cassaday of Cassaday & Co., an investment advisory and planning firm in McLean, Virginia, “It’s disconcerting to me that a lot of the features we’re seeing marketed now are commission-oriented–higher commissions with larger trails–because that comes right out of the client’s hide. It’s in everybody’s best interests for everyone to make money, but the client’s interests have to come first. Some of these products, because of the new commission structures that I think are too inflated, well, right out of the box the client’s got to make 3% to be even and I think that’s too much.” He points out that in many products, fees and costs are hidden, so that the client is never quite sure what the cost will be.

High M&E (mortality and expense) charges, he says, sound an alarm. “A lot of reps out there don’t care about that,” he says. “They would rather show a client a product that will be really hard for the client to make money on, but if they [the reps] make a whopping amount of money, that’s all they care about. That will come back to haunt them,” he warns. A simple 1% difference in investment returns for a retiring client, he says, can make the difference between the client “dying with a million-dollar estate or running out of money in his 80s.”

There are some changes the industry is implementing that are good for the client, however. American Life of New York is heading in the right direction, with a product available online that carries no other expenses than the fees of the funds within the annuity. There are no commissions for selling the annuity; it’s designed for fee-only planners to offer to their clients and is available on ALNY’s Web site (www.americanlifeny.com). Average fund fees, according to Mary Kaczmarek of ALNY, are around 100 basis points.

TIAA-CREF’s variable annuity, which became available to the general public about three years ago, has seen considerable growth, according to Assistant Product Manager George Spindell. There is a fixed component within the VA, says Spindell, that offers a return of 4.85%–a rate that looks very attractive in today’s market. Coupled with the low cost of TIAA-CREF’s products (the stock index portfolio, says Spindell, carries a charge of 37 bps versus ALNY’s average 100 bps charge), the VA has “no front-end sales charge, no back-end charge, no per-account charge, no commission.” This, says Spindell, “coupled with the flexibility built into the annuity, has enabled us to experience a boom where others have not.”

Jacob Herschler, vice president of variable annuity marketing for American Skandia, which has decided to focus its efforts on VA sales and mutual funds, extols the virtues of its new products. He is particularly voluble about the GROW, or guaranteed return, option that can be had for 125 bps per year and enables the annuity holder to lock in market gains or to ensure that principal will not be lost. If an annuity is purchased with the GROW option, it locks in the basic value of the account (say $100,000) for seven years. The account is reviewed nightly by a computer model that may transfer funds from the account’s equity holdings into fixed holdings to ensure that the account’s long-term value will not drop below the original figure of $100,000 by the end of the seven-year term. Since one clear industry trend is visible in the flight to guarantees, the GROW option will no doubt be popular.

There has been much criticism of VAs in the past, in our pages and in numerous other places. But there is a time and a place for everything, and VAs have a definite champion in advisor Femi Shote of Asset Harvest Group in South Waltham, Massachusetts. Says Shote, “If I say I love VAs, it’s like someone saying, ‘I love minivans.’ Of course I’m going to love minivans if I have kids.” He goes on to point out that VAs “do one thing: they provide an income stream.”

Shote says that people use VAs for the wrong reasons. “They use them to help people accumulate money,” he says. “I use them to distribute money. That was the real reason they were designed. A mutual fund cannot do a job that an annuity can do. I don’t use annuities as a wealth transfer vehicle, either. Again, that’s like buying a minivan when what you need is a four-door sedan.” Shote is firm on the subject. “I’m very particular about how I use them.”

Shote says that VAs are overrecommended, and inappropriately recommended. As he explains it, “The vehicle itself says, ‘I’m going to give you X amount of money for the next 20 years, or 30 years, or the rest of your life.’ As a variable annuity, it will vary, but there is always a stream of money that comes. I’m focusing on the vehicle itself, not the investments. There is a floor. The annuity says, for instance, ‘Give me a million dollars and I’ll give you a minimum of $35,000 a year for the rest of your life. That number will always come. It could be more if the subaccounts you pick perform better. If the market continues to perform on an aggregate basis and goes up, instead of $35,000, I may give you $40,000 or even $50,000 but you will always get that minimum of $35,000.’” He uses VAs, he stresses, for core client income needs.

VAs have a bad name, he feels, because they have been overpromoted. He cites the movie Get Shorty as an example, in which Danny DeVito, playing a movie star, saw John Travolta, a “cool Mafia dude,” driving a minivan. He didn’t know that Travolta had been given the minivan because the car rental company at the airport didn’t have the Cadillac Travolta had requested. They gave him the minivan, telling him that “it was the Cadillac of minivans.” So DeVito, seeing Travolta driving the minivan, goes out and buys one himself. And then other people, seeing DeVito driving a minivan, go out and buy minivans. Says Shote pointedly, “Maybe they should have been driving sports cars.”

Fees are important, he reminds us, and he likes the new products. “The insurance companies and investment companies have been more responsive,” he says. “They’re designing annuities that are skeletal. You build what you want into it. In the old days, they were all loaded; M&E and all built in. Now there are products where there is an engine, and you pick and choose the options that you want. I pick the kinds of things I want in it.”

Cassaday disagrees with Shote about wealth accumulation; that’s one of the ways Cassaday uses VAs. He finds them useful “if you’ve got someone who wants to invest systematically,” he says. “The problem is that if you put money over a long period of time into a mutual fund or a drip plan, tax basis accounting for that is very difficult.” Cassaday says he sees this often in his practice: “A relatively wealthy client with five little accumulation accounts, where he puts fifty bucks a month in each of them.” With VAs, Cassaday points out, “you can put a hundred dollars each into five funds and get one statement with everything on it. No 1099s; the cost basis is taken care of by the annuity company. It’s very straightforward; what you put in is your basis, and the rest is your gain.”

Cassaday also believes that putting VAs into retirement plans is not necessarily a bad thing. “There’s no cost for tax deferral,” he says, and points out that an annuity in a non-tax-deferred account has “no step-up in basis. Everything in the annuity is taxable. With an annuity in a non-qualified account, you don’t get the step-up in basis and every dollar will be taxed as ordinary income to someone; there’s no capital gains rate, no long-term rate.” Advisors, he says, should keep an open mind.