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Variable Annuities Offer Safety, at a Price

By: Joseph B. Treaster
New York Times, July 7, 2002

As if variable annuities, the insurance industry's version of mutual funds, were not bewildering enough, insurers have added a batch of features intended to protect investors from a stock market that lately has not seemed to know which way is up.

Some companies are offering guarantees that an investor will break even, while others lock in a gain, even when the market is declining. But these protections increase the already considerable expenses of variable annuities — costs that, in a rising market, usually make them less attractive than comparable mutual funds unless they are held for many years. The money put into most variable annuities must be locked up for 7 to 10 years, with penalities of up to 20 percent for early withdrawals.

Even so, the new protections could give nervous investors — in a market that is falling for the third consecutive year — the assurance that they can invest in stocks without the fear of losing their capital.

The insurers are struggling to attract customers. Last year, gross sales fell nearly 18 percent, to $112.8 billion. And the industry has been cannibalizing itself. The Financial Research Corporation of Boston estimates that more than 60 percent of sales last year involved switching policies from one insurer to another, usually in response to an offer of new features and, often, a cash incentive.

Analysts say many investors do not want to commit to an investment for up to 10 years. Some also say the industry is hurting itself with its new gimmicks. "The products are becoming more difficult to understand," said Lisa Plotnick, an analyst at Financial Research.

The variable annuity, like the 401(k) account, was intended to accumulate money for retirement and usually consists of an assortment of stock and bond funds. But it also includes insurance. If the investor dies, the heirs get at least the amount invested, even if the value has declined. For investors who retire, the insurance guarantees a stream of payments for life, although most cash out at once or over a few years.

Some of the new protections were created when the market was roaring, but they have never been more relevant. These features put a new twist on an old concept. Now, the original investment can be preserved not only for survivors but for investors themselves.

Last June, American Skandia Life Assurance of Shelton, Conn., introduced a feature providing that after seven years, investors will have at least what they started with.

"This is just the thing for older people who don't have enough years left to earn back big losses in the market," said John Meunier, an executive at Cogent Research, a consulting firm in Cambridge, Mass., that helped develop the feature for Skandia, a unit of Skandia Insurance of Stockholm.

"It's also ideal for the investment jock whose wife says, `I'll kill you if you put money into anything risky these days,' " Mr. Meunier said.

How does Skandia manage this feat? It permits investors to put their money into a range of investments and tracks the money. When the annuity starts heading into the red, a computer shifts money into fixed-income investments with a sufficient yield to meet the break-even target. Other insurers guarantee that investors will not lose their initial stake by requiring them to put two-thirds of their money in fixed-income accounts. The rest goes into stocks.

Another kind of guarantee provides for annual growth of, say, 6 percent for 10 years, which would increase an investment of $100,000 to $179,084.80. In yet another option, the variable annuity's value fluctuates, but, at the end of 10 years, it is credited with the highest value it has reached on any anniversary of the investment during that period.

These last two guarantees come with a significant restriction. Once the 10 years are up, the investor may not take the money in a lump sum or in smaller payments over a short period. The payout must take place over the rest of the investor's life, allowing the insurer to keep earning a profit on the client's money.

One company, G.E. Financial Assurance in Richmond, Va., a unit of General Electric, has taken an approach that seems simple on its face. It asks clients just two questions: How much money do you want to receive in retirement, and when do you want to start receiving it? Then G.E. figures out how much has to be paid in to reach the goal.

In one example, G.E. says that by paying $713.95 a month for 25 years, a couple, each 40 years old, could receive at least $2,000 a month for life, beginning at the age of 65. If the money grew faster than an assumed 5 percent, the monthly payment would increase.

The hard part is that an investor must determine how much money will be needed 25 years in the future and, no matter what happens in his or her life, the goal cannot be changed. As with other variable annuities, there is no provision in the payout for inflation. There is also a stiff penalty for backing out within 10 years and, in a provision not found in other variable annuities, a charge equal to 1 percent of the investment for canceling anytime after that.

While many of the new features may sound inviting, they add to the cost of a variable annuity. And while they reduce the risk of investing in stocks, they also limit gains.

Often, the features do not pay off because investors bail out early. Cynthia Saccocia, a senior analyst at Cerulli Associates in Boston, said that nearly 80 percent of customers switch to another annuity, promising greater rewards, within five years. "If you do this," Ms. Saccocia said, "you've paid five years for a benefit that will never be realized."

Some people simply decide that they need the money for something else. But if they take their money before a specified time — up to 10 years — they pay a penalty of as much as 10 percent to the insurer. If they are under 59 1/2, they pay an additional 10 percent to the government.

Variable annuities have consistently been criticized for their cost. According to Morningstar Inc., the average annual fee is 2.21 percent of the value of the investment, compared with 1.39 percent for a mutual fund. While variable annuities have the advantage of being sheltered from taxes as they grow, the added eight-tenths of a percent means they have to be held for a long time — at least 10 years by some calculations, much longer by others — to come out ahead of mutual funds.

Insurers, however, say that most people who invest in variable annuities are cautious folk who are not shooting for the moon. Many of these investors would not venture into mutual funds or individual stocks.

"The alternative for some of these investors would be bank C.D.'s," said Jacob Herschler, American Skandia's marketing director. "But with C.D.'s, they are going to get hammered by inflation. They need to be invested in equities for the long term. They're seeking options and benefits that give them peace of mind."

The insurers acknowledge that variable annuities are complex. They do not expect most buyers — usually people in their late 50's or early 60's with annual incomes of $75,000 or less — to try to figure them out on their own. "Our company's distribution is based on the fact that a qualified financial adviser is going to help you with this," said Michael Wells, the vice chairman of Jackson National Life, a Lansing, Mich., unit of the British insurer Prudential.

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