New sales (excluding internal VA to VA exchanges) of variable annuities totaled $154.9 billion in 2006, an amount that was in line with earlier projections and that represented just under an 18% increase over 2005 new sales of $131.4 billion.

Contrast this with 2005, when the year over year increase was only 2.3%, from $128.5 billion in 2004 new sales.

Assets under management in VA products increased significantly as well, from $1.187 trillion to $1.357 trillion, or an increase of approximately 14%.

Examining only these 2 data categories would lead one to conclude that the VA industry is healthy and growing rapidly, but the cloud behind this silver lining is the net cash flow data, which indicates that 1035 exchanges are a large component of sales growth. Asset growth, of course, has been primarily driven by equity market returns.

Net flow in 2006 was $29.7 billion, or just 19.2% of new sales. Granted, this is a significant increase over 2005, when net flow was only $20.4 billion, or 15.5% of new sales. But these numbers also fall far short of 2003 and 2004 levels, when net flow was 37% and 31.3% of new sales, respectively.

The following paragraphs will examine some of the underlying factors driving this disconnect between product sales and net new dollars.

Demographic trends, retirement risks and the evolution of living benefits from simple models, such as guaranteed return of principal, to complex designs addressing a multiplicity of risks are starting to change the perception of the variable annuity. This has reached a point where there is more balanced treatment in the popular financial press, where at least some discussion of the value of living benefit guarantees accompanies the standard reproach regarding high fees.

For many boomer retirees who have not saved adequately, or, perhaps more to the point, who have income expectations that cannot be met by their savings, assuming current fixed income returns, variable annuity living benefits can be an effective part of the overall income strategy–a concept that is increasingly embraced by advisors and financial journalists.

Why, then, does net cash flow continue to lag behind the levels of a few years ago? A few things are at work here. First, the increase in sales in 2006 was in large part fueled by the exchange of contracts sold in 2000, a huge year for total VA sales at approximately $138 billion (note that internal exchanges are included in this number, as the source of funds is irrelevant to this particular discussion). Many of these contracts came fully out of their 7-year surrender charges in 2006, and of course could be exchanged without the investor incurring a charge at the point of sale.

Given the continuous evolution of living benefits since 2000, particularly living benefits, it is reasonable to conclude that many of these contracts were exchanged in 2006 as a means of accessing the new benefit structures, often not available to existing contract owners.

L-shares, which began to be widely sold just a few years ago but also emerged from surrender in 2006 due to the shorter duration of their charge schedules, compounded this effect.

At the industry level, sales increase and net flows are unaffected when contracts emerging from surrender are exchanged for contracts offering the latest living benefit designs, or for contracts with lower expenses.

Second, the risk of running out of money in retirement and the application of variable annuity products with guaranteed living benefits as vehicles for managing this risk are well-known concepts in the retirement products industry. But the message is only now starting to get out through mass marketing efforts (think AXA’s gorilla and RiverSource ads featuring Dennis Hopper), stepped-up education for advisors and investors (for example, a higher level of wholesaler effort, in-house developed and 3rd party materials, and concept exhibits), and increasingly through the use of dynamic illustration tools.

Finally, while the demographics are moving along, we’re not quite there yet. The leading edge of the boomer generation turned 62 last year, so what is observed today in sales vis-?-vis net flow data should be interpreted as the very beginning of the substantial increase in future sales that can be driven by increased understanding and adoption of variable annuities by advisors and investors.

If the variable annuity industry can continue to build awareness, improve the purchase experience through technology initiatives such as straight through processing (STP), and, most importantly, train and support advisors through wholesalers that can help them build retirement income-focused practices and the use of dynamic, interactive illustration tools that make the concept “real” for the investor, there is no reason the industry should not see annual sales of $300 billion or more by 2009 (the year the first boomers turn 65), coupled with a substantial increase in net cash flow as IRA and 401(k) rollovers contribute substantial amounts of net new money to the industry.

Time will tell.