You have to hand it to insurance companies. Given investor skittishness that lingers from the equity market turmoil of five years ago, they have mastered the art of developing products with guarantees that mitigate downside risk. Nowhere are these newfangled guarantees more prevalent than in the variable annuity marketplace, where insurance companies are feverishly churning out new contract features that protect principal, preserve income and even guarantee growth.

The goal in offering these kinds of features as add-ons to the basic variable annuity chassis is to make the much maligned VA appealing to as broad a customer base as possible, from aggressive growth seekers to risk-averse seniors. The insurance industry’s approach appears to be working. The National Association for Variable Annuities reported late last year that combined net assets held in U.S. variable annuities increased 3.7 percent from the second quarter to the third quarter of 2005, to $1.2 trillion. That’s an increase of 12.2 percent from the third quarter of 2004, the trade group indicated. Total VA premium flow for the third quarter was $33.8 billion, a 12.4 percent increase from the same period in 2004. Overall premium flow for the first nine months of 2005, according to NAVA, was $99 billion, up slightly from $98.5 billion for the first three quarters of 2004.

A premium on protection
Besides their own creative product development staffs, insurance companies have advisors like Kelly F. Bills to thank for the recent surge in VA sales. Bills, who primarily serves clients 60 and older as an advisor for Cambridge Financial Center in Salt Lake City, says he continues to steer many of those clients into variable annuities, some via roll-out from 401(k) plans and IRAs, and others with new money. And when he recommends a variable annuity to a senior client, it’s never without a guarantee feature – a principal-protection guarantee in particular.

Generically known as a guaranteed minimum accumulation benefit, it’s a feature that, for the price of about 0.5 percent of contract value, assures the variable annuity contract value will be at least equal to a certain minimum amount – typically the premium amount – after a specified number of years (10 years is standard), regardless of actual performance. Bills says it’s rare for him to write an annuity contract without a GMAB. If clients are to hold a stake in the equities markets, his preference is to have that stake within a variable annuity rather than in “unprotected” accounts with individual mutual funds, stocks and the like.

While it costs money for the protection afforded by a GMAB, the half-point a client spends for that protection “isn’t going to change their life,” Bills says. “But losing principal from an unprotected [equity] account, that can change a person’s life. Which is why, psychologically, many seniors need the principal protection a variable annuity can offer. It’s not just to give them a sense of comfort, it’s to get them to leave the investment allocations [within the contract] alone so the annuity can work as it is intended.”

For many older people, protecting the final bankroll is paramount, Bills explains. “The only way I know to get that protection is in a variable annuity.”

NAVA echoes that assertion. “If an individual were to construct a ‘homemade’ GMAB using alternative financial instruments, it would cost significantly more than a GMAB feature provided through a variable annuity.”

Give people what they want
The argument for guarantee-laden VAs appears to be resonating in the market. According to NAVA, more than 85 percent of all variable annuity contracts sold today offer one or more living benefit guarantees. Besides the GMAB, among the protective measures to gain prominence in recent years are the guaranteed minimum withdrawal benefit, the lifetime GMWB and the guaranteed minimum income benefit.

These all fall into the category of living benefits.

The GMWB allows the contract holder to withdraw a fixed percentage of annuity premium (typically 5 percent to7 percent) annually for a specified period until the entire amount of premium paid into the annuity is withdrawn. That amount can be withdrawn regardless of subaccount performance and value. The lifetime GMWB takes that a step further, guaranteeing the contract-holder the right to access an income payment for life via a somewhat lower fixed annual withdrawal percentage in the range of 4 percent to 5 percent. Payments may continue even after the initial investment amount has been paid out – and regardless of actual account value. Essentially it’s a hedge against the client outliving his retirement income.

Then there is the GMIB, which ensures that upon annuitization, payments will be based on the greater of the actual contract value or a minimum payout base, which typically is equal to the amount invested plus interest. If contract value grows, payments may be higher, but never lower, than the guaranteed base amount.

With people generally living longer and thus requiring a portfolio with a more aggressive growth component, Bills touts VAs with principal protection as the best way for older clients to participate in the potential upside of equities with less risk than pure stock investments.

Growth opportunity is one key motivation for steering clients toward variable annuities. Wealth preservation is another, says Bills, pointing out that funds associated with the VA contract aren’t subject to probate. When wealth preservation is the goal, Bills recommends a VA with an automatic ratcheting mechanism that periodically locks in a higher death benefit when the value of the contract increases. He also favors a guaranteed death benefit rider ensuring that at least a portion of a contract holder’s estate will be passed on to his heirs, even if subaccount values plummet. “Death benefit protection to us is a big deal,” Bills says.

Fear and loathing
Even with all the new bells and whistles that insurers are offering with their VA products, the advisor community remains sharply divided on the question of whether variable annuities are suitable for senior clients. Most advisors fall into one of two camps: those who recommend VAs wholeheartedly to 60-plus investors and those who suggest their clients shun them like the bird flu.

“I would fight to the death,” vows a steadfast Benjamin A. Tobias, CFP, CPA, of Tobias Financial in Fort Lauderdale, Fla., “before I would allow a client to go into a variable annuity.”

“I haven’t recommended a variable annuity to a client in 15 years,” says Joel Javer, principal at Sharkey, Howes & Javer in Denver.

Advisors like Javer and Tobias might as well post a No Variable Annuity sign right beside the No Soliciting sign on their office doors. But even members of the seniors-and-VAs-don’t-mix club concede there are situations in which it may be appropriate to suggest a senior client invest in a variable contract. Not that those situations come up very often.

Tobias says he doesn’t recommend VAs to any of his senior clients, but acknowledges there are scenarios, however rare, in which he can envision doing so. One is if a client is so concerned about losing principal that the person has put his entire retirement nest egg in fixed investments.

“There I’d suggest using a variable annuity if it’s the only way you can get the client involved in the equity market. It’s a better alternative than having a portfolio that produces a 100 percent fixed income. Today more than ever, seniors need to have balanced portfolios. They should have a stake in equity markets.”

Javer says the tax-deferred growth offered within variable contracts can be very appealing to certain senior clients. But other more negative tax consequences associated with variable annuity investments – namely the treatment of gains as ordinary income – overshadow that benefit, he says.

“The first thing I don’t like about variable annuities is that you’re taking capital gains and converting it to ordinary income.”

Under tax laws enacted in 2003, capital gains enjoy a much lower tax rate than ordinary income. Which is why, “from a tax standpoint,” Tobias says, “variable annuities just don’t make sense.”

Nor are Javer and Tobias especially enthralled with all the new guarantees to come down the pike in recent years. While living benefit guarantees are designed to make variable annuities more appealing to risk-averse clients, what Javer doesn’t find so appealing is the annuitization requirement that comes with many guarantee riders. Such a requirement is ill-suited to senior investors who want lump-sum access to their money, he notes.

Compounding Javer’s argument against using VAs with senior clients is what he views as a lack of equity investment choices within many contract subaccounts. “The selection of investments is limited. You lose flexibility.”

For those and other reasons, when approached by clients about a variable annuity, Tobias says he will almost always try to convince them to look at other equity-based alternatives.

Advisors in the anti-variable camp can point to the shortcomings of VAs all they want, but Bills says he won’t stop recommending them to his 60-plus clients.

“If a person understands investing, if they have been in mutual funds and had a brokerage account, they usually understand what a variable annuity can do for them. I think they’re crazy if they don’t put money in a variable annuity. If they are risk-averse, here’s a way to invest for growth.”