Sophisticated investors don’t often think of variable annuities as vehicles for cutting-edge asset allocation strategies because of the limited fund choices and risk-mitigation techniques long associated with the products. That’s old thinking.

Indeed, many new VAs, a sampling of which was reviewed by National Underwriter, offer an extraordinarily diverse range of investments and risk-mitigation strategies inside the products’ subaccounts.

Among these, says Cindy Galiano, a portfolio manager of Morningstar Investment Management, Chicago, are absolute return and overlay derivative strategies that hedge against market volatility; and inflation-hedging or fixed income vehicles, such as unconstrained bond funds or floating rate bond funds, that hedge against rising interest rates.

VA makers, adds Galiano, are also employing tactical and dynamic asset allocation strategies that manage risk within the VA subaccounts rather than switch between equities and fixed income assets at the contract level. And they’re offering exchange-traded funds that (typically) track indexes like the S&P 500 and that appeal to investors because of their low fees, tax efficiency and stock-like features.

To hedge against market risks, carriers are also availing clients of “alternative investments” that have been much in demand since the downturn. Chief among these are commodity funds that invest in precious metals and futures. A $420 billion market, commodities increasingly appeal to investors because, as “uncorrelated assets,” they tend to do well when equities are tanking and during inflationary times.

Gold, Oil and Buffers

That allure is a key reason why AXA Equitable, New York, offers commodities as an option in a VA unveiled in October: Structured Capital Strategies. The product features a gold index and oil index, as well as S&P 500, Russell 2000 and MSCI EAFE price return indices. The five index funds can be used to design a portfolio distributed among 15 segment types categorized by duration (1-, 3-, and 5-year) and buffer (-10%, -20% and -30%).

Depending on the selected segment buffer, duration and buffer, AXA Equitable will absorb the first 10%, 20% or 30% of any loss in the event of a negative index performance. Conversely, the company also imposes a performance cap rate on the portfolio that may limit the investor’s gain in during an up market.

At the end of each of one-, three- and five-year segment period, investors can also allocate the maturity value of the segment to a new segment. Or they can transfer their gains to other investment options available within the product.

Targeted to clients who are looking for long-term cash accumulation and protection of principle, the VA has generated $125 million in sales since the October launch. And, AXA says, many of the new investors are attracted to the commodity funds.

“About 28% of all IRA participants have elected to put a portion of assets into the gold and oil indices,” says Steve Mabry, AXA’s senior vice president of annuity product development. “And we’re pleased with the client profile: About 20% of the investors are over age 70, 25% are under 55 and the rest are between 55 and 70.”

Investors who can do without the buffers but desire a greater selection of investment choices, adds Mabry, might opt for AXA’s top-selling VA: Retirement Cornerstone. Debuted in January of 2010, the product features dual accounts: one is focused on long-term accumulation and offers 90-plus actively managed funds; the second provides a guaranteed income benefit option that invests in asset allocation and index portfolios to offer downside protection.

The GMIB option also features an adjustable “roll-up” rate that provides an annual percentage increase to the benefit base, enabling the income benefit to grow in a rising interest rate environment.

All well and good. But the investments on offer in AXA’s two VAs come with a mutual fund wrapper. Those clients who want to park assets in exchange-traded funds will need to look to other carriers.

Among them: MetLife. The New York-based carrier offers two “fund of funds, including (1) a Clarion Global Real Estate Portfolio, a fund that normally invests at least 80% of assets in equities of real estate companies; and (2) a Van Eck Global National Resources Portfolio, which invests in oil, gas, solar, gold and coal funds, and other commodities.

The ETFs’ diversified portfolios are not their only distinguishing feature. Elizabeth Forget, a senior vice president for MetLife, says the portfolios offer two key advantages over many actively managed mutual funds. One is reduced cost: Because the ETFs passively replicate a benchmark, they boast lower expense ratios. Also, MetLife’s ETFs are “tactically managed:” Asset allocations are adjusted more frequently than are “strategically managed” mutual funds, thereby allowing asset managers to be more responsive to changing market conditions.

“People are really gravitating to these portfolios; at the end of 2010, we had $2.6 billion in the two ETFs,” says Forget. “Investors are looking for ways to eek out additional returns. And they see these portfolios as being able to provide that.”

A VA for Rollovers

MetLife is not alone in availing its VA customers of exchange-traded funds. A new entrant to the ETF market is Cincinnati-based Western & Southern Financial Group. In January, two member companies of the carrier, Integrity Life Insurance Company (Cincinnati) and National Integrity Life Insurance Company (Goshen, New York), unveiled VAROOM or Variable Annuity for Roll Over Only Money. As the name makes explicit, the VA is strictly an IRA for tax-qualified rollovers; the vehicle is thus targeted to job changers and retirees.

The product offers investors and access to 19 subaccount options (18 individual ETFs and a money market portfolio) from iShares (BlackRock Inc.), San Francisco; and The Vanguard Group Inc., Valley Forge, Pa. But unlike MetLife’s fund-of-funds approach, the Western & Southern product lets investors select individual ETF subaccounts representing a broad range of equity, fixed income, international and alternative asset classes.

Mark Caner, president of Western & Southern Financial Group Distributors, the Western & Southern Financial Group division that is rolling out the new solution, says the direct investment approach yields a cost advantage. Depending on the guarantees selected, management fees will range from 0.09% to 0.50%.

“Our product with a basic living benefit option has an average expense of 15 basis points; and if you do a self-style allocation, the average is about 21 basis points,” says Caner. “Our approach is much less expensive than a fund of funds or traditional mutual fund allocation. Over time, the cost difference can really add up.”

No doubt. But observers, including Daniel Hayes, head of funds management for Radnor, Pa.-based Lincoln Financial Group, note the additional basis points paid on a fund of funds may be worth the extra cost for investors who prefer to delegate the selection and oversight of their ETFs to a professional money manager.

Hayes says Lincoln offers professionally managed fund of funds (including an SSgA Global Tactical Allocation Fund of ETFs), that employ tactical asset allocation and sport a range of investments options inside several of the company’s VAs. In addition to various commodities, the alternatives include Treasury inflation-protected securities, real estate investment trusts, variable insurance trusts and floating rate funds that invest in, among other things, investment-grade corporate bonds.

The last, says Del Campbell, a variable annuity business leader at Lincoln Financial, has been well received because of the fund’s consistent returns and low volatility.

“We felt that most people invested in a fixed income portfolio would benefit by being well diversified across the global income marketplace,” he says. “So the floating rate fund blends together the selections of both aggressive and conservative money managers. The product has been incredibly successful.”

A DC Plan with Lifetime Income

While Western & Southern is targeting the rollover market for 401(k)s, 403(b)s and SEP plans, an unusual partnership of three life insurers and the New York-based investment management firm Alliance Bernstein is bringing the benefits of VAs to the plans themselves. The catch: There’s no actual VA. The product is a target date fund–a mutual fund that resets the portfolio’s asset mix according to a selected time frame–that automatically invests in the GLWB. The insurance provides plans participants with a guaranteed lifetime income stream and access to their account balances at all times.

Why this approach? Seth Masters, a senior vice president and head of defined contribution and blend strategies at Alliance Bernstein, says this strategy addresses the concerns of individuals who want the assurance of a lifetime income, but are averse to giving up control of money to secure the guarantee.

“With Secure Retirement Strategies, we’ve engineered an insurance product that people are willing to live with,” says Masters. “The product makes the target date fund carrying a GLWB guarantee the default option inside the DC plan. The beauty of this pairing is that the amount of lifetime income can increase in good markets, but not decline in poor markets.”

Plan participants might also be pleased to learn, adds Masters, that the GLWB is multi-insured. Three insurers now back the product: AXA Equitable, Lincoln Financial Group, and Nationwide Financial. Others may be invited to participate in a future iteration depending on plan sponsor needs.

Whatever the number, the companies will be competing against one another for a share of employee contributions to the GLWB plan benefit. If, say, company “A” is prepared during a given quarter to offer a higher payout or crediting rate than companies “B” and “C,” then company “A” will enjoy a higher proportion of the business. Should company “B” offer best payout rate in the next quarter, it will get the most business.

“Our view is that competition is a good thing–not just for plan participants and sponsors, but also for the insurers,” says Masters. “If a carrier’s balance sheet is exposed to a lot of GLWB risk at the end of year one, then in year two the insurer can simply reduce the payout rate a notch. So the insurer can gracefully adjust capacity so as not to disrupt the business model.”