Variable annuities suffered a blow last month when President Bush’s new tax law, the Jobs and Growth Tax Relief Reconciliation Act of 2003, failed to give dividends paid on stocks held in annuity subaccounts the same favorable treatment afforded to stocks held in mutual funds. The oversight “could prompt investors to shift away from annuities and into after-tax mutual funds or ETFs,” says Dan Foley, a CFP with Principal Financial Group in Steamboat Springs, Colorado.

President Bush was originally seeking to eliminate the double taxation on dividends, but instead ended up reducing the dividends tax rate at 15%. Because of this, “investments both in variable annuities and 401(k) plans that invest in stocks that are paying dividends will still have to pay the taxes at income tax rates, not at the dividend rate,” says Gumer Alvero, executive VP of annuities at American Express Financial Advisors in Minneapolis, Minnesota. So “a large part of consumer assets are still being taxed at income tax rates.” Alvero says the annuity industry also lobbied to include the investments underlying an annuity in the new tax law, but to no avail, since the bill included a sunset provision of 2008. In fact, he says, the sunset provision was the likely reason annuity language was left out of the President’s bill. “If you have a sunset provision in a product that has accumulation in it, you can’t approve it because you can’t sunset a tax benefit on an annuity that [a client is] going to have for a much longer period of time.”

Jack Dolan, a spokesman for the American Council of Life Insurers (ACLI) in Washington, D.C., says the life insurance industry lobbied hard for “Capitol Hill not to harm us” in the new tax law, but the harm has been done nonetheless. “We thought that if individual stocks were going to get a reduced rate on earnings and on dividends received, that it should also be accorded to variable annuities.” Even Maurice “Hank” Greenberg, chairman and CEO of American International Group (AIG), fired off a letter to Treasury Secretary John Snow voicing his disapproval of the new tax law. “…The tax law did not cure the problem for variable annuities, hence the life insurance industry will be at a disadvantage against the mutual fund industry,” he told Snow.

The ACLI and other insurance groups are now lobbying to attach annuity language to any additional tax legislation that comes down the pike this year. “The Administration is talking about a variety of tax-cut bills,” Dolan says. “We know we have support in Congress for annuities.”

But Alvero says that before annuity language can be attached to pending legislation, the insurance industry has to figure out “how to work through the sunset provision.” He says the last batch of tax law changes (EGTRRA, the Economic Growth and Tax Relief Reconciliation Act of 2001) included sunset provisions, which have made it difficult for consumers to plan for retirement. “Right now, we don’t know if we’re going to have an estate tax or not, we don’t know what our income tax rates are going to be, and we don’t know what our capital gains rates are going to be,” he says.

Looking for the Silver Lining

One likely Congressional proponent that may come to insurers’ aid is Rep. Ben Cardin (D-MD), a member of the House Ways and Means Committee. Cardin told attendees at the Securities Industry Association and Investment Company Institute joint retirement savings conference in Washington in early June that while it’s too early to get a handle on all of the new tax law’s negative ramifications for annuities, he believes the bill “could have been worse.” He said his committee will be reviewing the law, and hinted that it may play a part in finding some kind of annuity remedy.

But there are some bright spots for annuity owners in the new tax law, says Michael DeGeorge, general counsel for the National Association for Variable Annuities (NAVA). One benefit is that the bill lowers the marginal income tax rates from 38.6% to 35%. “Annuity income is taxed at ordinary income tax rates,” he says. “So owners of annuities who withdraw money from their annuities or annuitize and start receiving lifetime annuity payments will pay taxes on the gains of those annuities at a lower rate now.”

Edward Spehar, a Merrill Lynch analyst, says a good piece of news for annuities arising from the new law is that “variable annuity sales no longer hinge on tax deferral.” DeGeorge begs to differ: “I wouldn’t say that [the tax law] eliminates tax deferral as a factor; tax deferral is still a benefit that annuities and other qualified plans, which likewise are not covered by the tax bill, still offer.” Case in point, he says, is someone who invests in a deferred annuity when they’re 25 and doesn’t withdraw from the annuity for 50 years. “That’s 50 years of tax deferral; even though the advantage of that tax deferral has been lessened by the lowering of the capital gains rate and the tax rate on dividends, that’s still 50 years of complete deferral of taxes.” DeGeorge adds: “I think tax deferral is still a factor. It may just take a little longer before the benefits of the compounding effect of tax deferral will outweigh any additional costs that the annuity may have.”

Flat Sales for VAs

The new tax law aside, how is the annuity business faring these days? According to NAVA, variable annuity sales in 2002 were up slightly over 2001, with fourth quarter 2002 VA sales increasing 4.3% over third quarter sales. Total sales for 2002 were 0.7% higher than the previous year, increasing from $112.9 billion to $113.7 billion (see “The Top 10″ on page 70). “There had been a decrease [in VA sales] from 2000 to 2001, so any increase is better than a decrease,” DeGeorge says. “Given the market for this past year, I think the industry was encouraged by those sales.”

Frank O’Connor, assistant VP and senior analyst with VARDS, a sales tracking and product information source for variable annuities data, says VAs with guarantees and more liquidity are driving annuity sales. “We have noticed very strong sales in contracts that offer good living benefit guarantees in addition to good death benefits,” he says. “Living benefits have been particularly popular; the bulk of them provide guaranteed minimum income benefits [offering] either a capture of a higher anniversary value over a period of time, say 10 years at a minimum, or a 6% annual compounding of the initial purchase payments that are built into the contract as a floor of performance for the contract over a period of time, and it will ultimately be used to determine an annuity payment.” These VAs are popular, he says, because they act as a cushion to loss of principal.

Alvero concurs that VAs with guarantees have gained ground since the bear market settled in, and says the most popular ones have a guaranteed minimum withdrawal benefit. These products allow the annuity holder “to take out a certain percentage of their cash invested into an annuity each year,” he says. “It allows you to be appropriately invested in equities but, as we call it, also have some kind of air bag protection: In case we do have a sustained bear market, you can get back your principal.”

Other strong sellers are contracts offering more liquidity “than the traditional VA from several years ago where your typical structure of a contract would be a seven-year or longer surrender charge period,” O’Connor says. Over the past couple of years, he says, fee-share VAs offering no surrender charge–or 100% liquidity–have been selling like hotcakes. Another top seller that started to proliferate in late 1999, he says, are L shares, which are hybrids between the traditional fee-share or seven-year long surrender period, and C shares, which have no surrender charge. “The typical L share will be three or four years, so that’s an effective marriage of liquidity for the investor with protection for the insurance company issuing the product in recouping some of their acquisition costs.”

A popular strategy that American Express is using to make variable annuities less expensive for clients is “to strip down the features and have the client buy a base contract that is very competitive relative to the fees in the industry,” Alvero says. So “each of the options are optional; the features are not embedded into the contract.” It’s basically an ? la carte approach, he says, allowing clients to pick and choose among features that suit their needs. “Instead of featuring each of the features separately, we’ll talk about packaging them,” recommending, for instance, different features for clients in the accumulation stage versus those who are more risk-averse.

Equity-indexed annuities are also getting more attention these days–and not just because they offer a guarantee. Foley of Principal Financial Group is worried that these products are being sold incorrectly. “I’m really concerned that the wholesalers can’t explain how the equity-indexed annuities are hedging all the risks–which means how they’re covering the upside potential of the market that they’re promising, while making sure they have the downside protection also,” he says.

Equity indexed annuities are often called a hybrid between a fixed annuity and a variable annuity because they offer a guarantee while also allowing investors to catch the upside of the market. Insurance companies “buy options to make sure that if the market goes up, their general account for that particular equity indexed annuity will go up with it,” Foley explains. Alvero of American Express Advisors says the most confusing part of the product is the equity participation. “What are you participating in, and how is it exactly measured?” Foley says equity-indexed annuities should also be required to have a prospectus “outlining how they’re covering their risks” the way mutual fund prospectuses do.

Another issue that concerns Foley is that in the new tax law, dividends are only going to be taxed at 5% to 15%. “Most of these equity indexed products don’t take dividends into account,” he says, “and 40% to 50% of the stock market’s return on the S&P 500–depending on the timeframe–was made up by dividends. So they’re eliminating half of the previous upside potential of the stock market by not including the dividends inside the design of the equity-indexed annuities.” Wholesalers, he says, “don’t talk to the public about not having dividends involved in the product.”

Jack Marrion, president of The Advantage Group, a consulting firm in St. Louis, devotes the majority of his time studying equity-indexed annuities, though he prefers to call them fixed-indexed annuities. “The ‘equity index’ implies that these things are investments, but they’re fixed annuities,” he says. “It’s a fixed annuity with equity linkage; it’s not a variable annuity.” The proper way to refer to these products, he argues, is that they are a “fixed annuity with a potential for 1% or 2% higher return because of the equity linkage; that’s it.” Because these products offer a guarantee, sales are booming: year-end 2002 sales hit $11.7 billion, a significant jump from the $6.5 billion in sales at year-end 2001.

Fixed-indexed annuities, he says, have two basic structures: An advisor can measure index movement over a year or a couple of years, and lock it in. Or he can measure index movement over five, seven, ten, or twelve years–which tends to resemble investments because nothing’s locked in until the end of the period–but they’re still fixed annuities. Marrion says like any other financial product, fixed-indexed annuities can be sold improperly. “There are many advisors who are nervous about [these products] because they don’t understand them.” That’s why Marrion recently wrote a book called Indexed Annuities, Power and Protection (The Advantage Group). The book came out in March, and was written to show financial representatives “how to sell them right,” he says. “You have to think about these things as fixed annuities with potential, rather than variable annuities with guarantees, because they’re not. They’re designed to replace a CD or a bond mutual fund.”