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Annuity Guarantees Don’t Make Investors Favor Risk, Says Prudential’s O’Donnell

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Just this week, Robert O’Donnell was named president of Prudential’s annuity business. Previously, he served as senior vice president, head of product, investment management and marketing for Prudential Annuities.

Before his promotion, O’Donnell (below right) spoke to about investor behavior within variable annuities, and how Prudential manages risk in a volatile market.

What the company has found through general industry research and its own experience is that the presence of a guarantee embedded in a variable annuity does not alter an investor’s basic investing preferences. “The investor, the person who owns this money, allocates their dollars according to their risk tolerance, and that is a very important element of the variable annuity experience,” he says.

In other words, a conservative or moderately risk-tolerant investor is not going to suddenly deviate from their core beliefs and start investing in riskier investment options just because there is a guarantee. They don’t like to see the value of their VA portfolio dip and dive, even with guaranteed income. Plus, “Using 2008 as an example, someone who is a conservative investor would not have been comforted by allocating to meaningfully more aggressive funds and losing tremendous amounts of market value by the existence of a lifetime income guarantee,” O’Donnell says.

Contrast that to managed accounts without a guarantee. In those instances, “meaningful amounts of assets deviated from the core investment profile during times of stress,” O’Donnell says. Meanwhile, with a guarantee, investors are more likely to stay the course in stormy markets, he notes.

That said, Pru’s VAs are set up with a more conservative investor in mind. “If you had a truly aggressive investor who wanted 100 percent of their money in equity investment options, they can come to Prudential but they cannot get these protection features with that type of investment objective,” O’Donnell says. Instead, they can place no more than 80 percent of their money in equities, and even if an investor puts say, 60 percent in equities, that amount cannot be invested in a single asset class, such as an international small cap growth fund.

Those risk-management strategies are fairly consistent with the industry as a whole, O’Donnell says. Prudential takes it one step further, however, by monitoring the value of the investor’s diversified pool of assets against the guarantee promised by the company. If the gap is deemed to grow too wide or when it exceeds a specified ratio, money is moved from the investor’s diversified pool of investments into an intermediate duration bond fund.

“The reason we put it into that type of an instrument is to put a theoretical floor on how far those assets can fall or separate from the guarantee,” O’Donnell says. “So they go into that bond portfolio if the chosen assets by reason of poor market performance separate from the value of the guarantee. That’s a mechanism we’ve used for quite a few years now, which we view as a requisite element of sustainability.

“Obviously, in 2008, we moved meaningful, substantial portions of money into the bond fund,” O’Donnell adds.

The mechanism works in reverse as well. “What people fear is that once it goes into the bond fund, that the investor is left with an expensive bond portfolio with a guarantee on it. There’s a good reason why we don’t want that, and there’s good reason why the investor doesn’t want that,” O’Donnell says.

Therefore, if the aggregate value of the investment options and the bond portfolio narrows the gap from the guarantee, money is shifted from the bond portfolio back into the directed investments of the investor and the investment advisor.

“When the interest rates dropped in late ‘08 and early ‘09, the value of those bond allocations rose and that closed the gap, and it moved the money back into equities, which then followed the bond earnings with a subsequent appreciation,” O’Donnell says.

In a sense, that was a “validating experience,” he says. Yet there were still questions about what would happen if rates fell even further. They did, and the system worked even in a volatile market. “The sequence of capital market’s performance has tremendous logic and that logic is built into the math not in a forecasting type of mechanism, but just in the underpinning and the principles behind it that say these bond positions will recover in front of the equity position because of the way capital markets work,” O’Donnell. “It has proved very effective.”

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