With markets recovering and interest rate spreads narrowing, the balance in individual annuity sales shifted in the second quarter from fixed annuities to variable.

Fixed annuity sales had outstripped VAs for the previous two quarters, but then declined sharply.

Combined with only a weak gain in VA sales, total individual annuity sales for the quarter fell 9% to $60.5 billion, compared to first quarter of 2009.

It was the first decline in overall annuity sales since the market collapse of 2008, and pulled total performance for the first half down to negative 3%.

For the second half of 2009, VA sales will likely remain fairly level, although a few companies may pursue the VA business aggressively to gain market share. Book value and market value adjusted fixed annuity sales will continue to struggle while indexed annuity sales will thrive under the present market situation.

Growing needs for retirement income will help fixed immediate sales, regardless of the low interest rate environment.

One issue that will hamper sales of both fixed annuities and VAs is the slowdown in external or 1035 exchanges, a significant source for annuity sales. There are several reasons for this.

Fixed annuity policyholders may not get a better deal in a declining interest rate environment and existing VA owners may hold on to their contracts since their guaranteed benefits are “in the money.” In addition, suitability concerns will dampen the number of exchanges.

As a result, if the industry is not able to attract new money from sources like rollovers, it will be difficult to generate real annuity sales growth.

In first half 2009, total individual annuity sales fell 3% to $126.8 billion as strong fixed annuity sales more than compensated for weak VA sales. Compared to first half 2008, year-to-date fixed annuity sales were up 39% to $64.2 billion while VA sales slipped to $62.6 billion, down 26%.

In second quarter 2009, rising equity markets helped push VA sales to $31.9 billion, up 4% compared to the prior quarter. VA sales continued to be fueled by living benefit guarantees–despite many companies raising fees, reducing benefits, or both on new riders. The rate at which any guaranteed living benefit was elected, when available at purchase, remained very strong at 89% during the quarter. Companies that made improvements to their GLB riders or did not scale them back gained significant market share in the quarter.

The double-digit growth that fixed annuities saw over the past four quarters slowed to just 9% in second quarter 2009 as compared to the prior year. Second quarter fixed annuity sales totaled $28.6 billion, down 20% from the all-time high of $35.6 billion in first quarter 2009.

This was the first quarter-over-quarter decline for fixed annuities since first quarter 2007.

The appeal of fixed annuity products seemed to wane because of a decline in annuity interest rates and their corresponding spreads. In addition, some annuity companies pulled back on issuing new business due to capital constraints.

Indexed annuity sales provided a bright spot as sales hit a record high of $8.1 billion in second quarter 2009, improving 14% over first quarter 2009. Historically, indexed annuities perform well during times of improving, yet volatile, market conditions because they are not exposed to losses in the market.

Career agents emerged as the leading distribution channel with year-to-date total annuity sales of $26.3 billion. This distribution channel improved market share by 9% over 2008 and almost doubled its fixed annuity sales.

The top distribution channel for VAs remains the financial planner/independent broker-dealers, despite an 18% decline from 2008. Banks were the top fixed annuity distribution channel.

Deferred annuity assets increased across all product types in first half 2009, rising 6.4% to total $1.8 trillion. Both variable and indexed annuity sales experienced positive net flows while book value and MVA outflows matched the inflows.

The positive net flows were aided by a sharp decline in surrender rates in first half 2009. The year-to-date total annualized surrender rates (cash value) declined to 6.1%, compared to 7% in first half 2008. Annualized surrender rates fell for both VA and fixed annuities, as well as across most distribution channels when comparing first half 2009 to first half of 2008.

The drop in surrender activity reflected the low interest rate environment as well as the ever-growing proportion of VAs with guaranteed benefits (death or living) that were “in the money.”

Joseph Montminy is associate research director-retirement research at LIMRA, Windsor, Conn. His e-mail address is jmontminy@limra.com.