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Variable annuities: What's hot, what's not

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Advisors and their clients are increasingly relying on variable annuities as a tax-deferred accumulation vehicle, while insurance companies are pushing VA contracts with few or no optional benefits but a broader array of investment choices. Sound familiar?

These are two of the key factors shaping the variable annuity landscape entering 2015. And if they inspire a feeling of déjà vu, that’s because, when it comes to variable annuities today, ”What’s old is new again,” according to Ray Caucci, senior vice president, product management, underwriting, and advanced sales at Penn Mutual Life Insurance outside Philadelphia.

There’s much more to the variable annuity story than merely recycled headlines, however. Amid ever-shifting investor priorities and preferences come fresh new twists on the product side, and with them, a fresh batch of acronyms and buzzwords, including the IOVA (investment-only variable annuity), the VA+DIA (variable annuity with a deferred income annuity rider) and the structured product variable annuity, or spVA. Here’s a snapshot of what’s in and what’s out in a variable annuity market where sales remain steady, even as product innovation has slowed and other types of annuities garner most of the headlines.

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IN: Simple, stripped-down products and features. The new wave of IOVAs epitomizes an overall move to variable annuities “with not a lot of bells and whistles,” says John McCarthy, product manager, annuity solutions, at Chicago-based Morningstar, whoestimates that some 85 percent to 90 percent of IOVAs offered today come with no death or living benefits.

In most cases, these no-frills IOVAs are “sold strictly for tax-deferred accumulation,” explains Frank O’Connor, vice president of research and outreach at the Insured Retirement Institute, an industry group that promotes and tracks annuity products.

While inflows into IOVAs have been relatively modest to this point, McCarthy says he expects interest to grow as IOVA products proliferate from companies such as Jackson National, Jefferson National, Nationwide, MetLife, Principal and SunAmerica.

See also: 8 annuity tax facts you need to know

OUT: Complex, shape-shifting features and benefits. Having choices is generally a good thing for consumers, but lately, the complexity involved with many living benefits and other variable annuity features, from multi-tiered pricing to a huge range of step-ups, withdrawal percentages and other moving parts, is enough to make one’s head spin. The new breed of IOVA makes life easier for advisors and their clients, relieving them of the task of trying to digest and understand “a prospectus that’s as thick as an 80-page novel,” says Caucci.

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IN: Scaled-back living benefits. “Variable annuities with guaranteed income benefits still represent by far the lion’s share of [VA] sales,” says O’Connor. “It’s still very much a guaranteed income story.”

However, as much as the guaranteed living benefit (GLB) story may still resonate with VA buyers, the bulk of today’s optional income and withdrawal guarantees come with higher fees, tighter investment restrictions and greater complexity relative to the GLB riders of years past, factors that appear to be curbing GLB sales. According to the LIMRA Secure Retirement Institute, the election rate for VA GLB riders, when available, was 76 percent in the third quarter of 2014, down from a high of about 90 percent as recently as 2012.

OUT: Trumped-up living benefits. The living benefits arms race of years past is a distant memory. Indeed, with many insurers watering down or withdrawing GLBs to protect their bottom lines in the unrelenting low interest rate environment, advisors increasingly are looking to other vehicles like deferred income annuities, indexed annuities with GLBs and single-premium immediate annuities as income generators for clients in the distribution phase. While not an all-out exodus from income-producing GLBs, “living benefit activity is not at the level of 5 to 7 years ago,” Caucci observes.

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IN: VAs built for RIAs. The channel to post the largest VA sales gains from Q3 2013 to Q4 2014? According to the latest Morningstar data, it’s independent investment firms and their RIAs. It’s by no means a sea change, but a trend worth noting—and one that could gain further momentum going forward. Variable annuities “are seeing some renewed vigor and additional traction” in the RIA channel, says O’Connor.

In the drive to help clients diversify and grow assets more tax-efficiently, and to access guaranteed sources of retirement income, RIAs who historically have steered clear of insurance products are “now more open to variable annuities,” adds McCarthy, noting that insurers lately have unveiled more fee-based variable annuities to cater specifically to the RIA segment.

IN: Products with a broad selection of subaccount investment options. People seeking the assurance of an income guarantee with their variable annuity have been forced to live with fewer investment options and tighter allocation restrictions to protect insurers from volatility. But with the IOVA, the pendulum swings back in the other direction, giving contract holders a broader range of investment options in which to place their assets. With more subaccount options, the IOVA gains appeal as a diversification and accumulation tool for younger, pre-retirement investors, Caucci points out.

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IN: Access to alternative asset classes. From real estate and commodities to hedge funds and funds of funds, the various types of investments defined loosely as “alternatives” often have one thing in common: They’re not especially tax-efficient. That’s one reason it makes sense to use them inside a tax-efficient structure such as the variable annuity contract.

These days, more insurers are doing exactly that, with VAs that give investors exposure to alternative asset classes via commodity funds, real estate funds, oil and gas funds and other alternatives-based exchange traded funds inside a tax-deferred vehicle. According to O’Connor, the marriage of VAs and alternative asset classes makes sense for three key reasons:

  1. It offers a means for advisors and their clients to access alternative investments on which an insurance company presumably has already performed extensive due diligence. That’s attractive to advisors who lack the expertise or the wherewithal to perform such due diligence themselves.
  2. It provides a tax-efficient home for investments that otherwise can be tax-inefficient.
  3. It provides a means to diversify with non-correlated asset classes, an increasingly important consideration in today’s volatile investment environment.

OUT: Fixed investment account options. A 50-basis-point drop in interest rates since the beginning of 2014 has further curbed investments in fixed subaccounts. As of the third quarter of 2014, 17.1 percent of all variable annuity assets resided in fixed accounts, according to Morningstar’s latest Variable Annuity Sales and Asset Survey. That share stood at 22.6 percent five years ago and 25.8 percent 10 years ago. “This long-term trend pairs well with the high election rate of living benefits to protect against down side risk,” Morningstar observes in its report.

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IN: Lower contract fees to put investment dollars to work for accumulation.

In some respects, variable annuities have come full circle and are once again being used largely as an outcome-oriented accumulation tool, observes O’Connor. Given their generally lower fees, IOVAs in particular free up more funds for contract holders to invest, adds McCarthy. “I think investment-only products are good accumulation vehicles for the right person.” Fees for IOVAs tend to hover in the 100-120 basis point range, depending on share class.

IN: Deferred income annuity riders attached to variable annuities. Hybridization and cross-pollination continue across the annuity landscape with the emergence of the DIA rider on a variable annuity chassis. This latest hybrid product provides advisors and their clients with another versatile retirement income option. In this case, funds from the variable contract are funneled into the deferred income rider to fund the future benefit, McCarthy explains, with the income stream typically beginning to flow later in retirement when the contract holder hits age 75, 80 or even 85. Principal is the latest insurer to unveil such a product, offering an IOVA that comes with a DIA attached as a standard benefit. Guardian also recently released a new ProSeries variable annuity that offers a similar rider at no cost.

IN: Structured product (or structured note, or buffered) variable annuities. Call it what you will, but the structured product variable annuity is making a name for itself in the marketplace for its ability to offer a combination of principal protection and growth potential. By using structured products (derivative instruments) to protect contract holders from downside risk, “they really behave like an indexed annuity, in that the contract’s change in value is a function of the change in value of one or more indexes,” explains IRI’s O’Connor. AXA’s Structured Capital Strategies VA, for example, allows investors to put money into a structured investment option whose performance is linked to a commodities or securities index, then to choose a buffer whereby the insurer will absorb a specified percentage (such as 10 percent, 20 percent or 30 percent) of loss in asset value, and the duration of that buffer (one, three or five years). Contract holders sacrifice a measure of upside potential to gain protection on the downside.

While only a handful of insurance companies currently offer spVA contracts, sales of these products have been “growing rapidly” relative to other VA categories, according to O’Connor. Whether they sustain enough sales momentum to remain an “in” product come 2016 remains to be seen.