Benefit performance: have lifetime withdrawal guarantees on variable annuities become too expensive for insurers?

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Earlier this year, Prudential Annuities and Trans america Life both introduced enhancements to their guaranteed lifetime withdrawal benefits on variable annuities.

That might not sound like significant news, given that in previous years, writers of variable annuities were competing intensely to offer better withdrawal benefits for life. In fact, these benefits were driving sales of variable annuities industrywide, according to a report by Conning Research & Consulting. No serious writer could afford to be without one.

But when the markets headed sharply downhill last fall, companies suddenly had to re-assess their offers. The guarantees of locked-in income were great for policyholders who had seen their contract values so rapidly decline. But the declines tested the financial resilience of the insurers, and most have spent this year scaling back benefits and/or raising fees on their new contracts. Some have even temporarily stopped selling variable annuities.

"The variable annuity benefits arms race produced a strategic landscape where competitive advantage was gained by offering numerous guaranteed death and living benefits," wrote Scott Hawkins, an analyst and author of the Conning report, Rethinking Individual Annuities: Key Challenges to Strategic Success. "In the emerging strategic landscape, this competitive advantage will continue, as will insurer efforts to de-risk their variable annuities."

Many large writers this year have either reduced benefits, charged more for them or restricted policyholders from aggressive asset allocations. Among those making such changes were Axa-Equitable, Allianz Life of North America, MetLife, Pacific Life, MassMutual and Hartford Financial Services Group.

There is a lot on the line for life insurers. "The VA business is part of the individual annuity line, which is one of the major, if not the major, lines of business for the industry in aggregate," said Hawkins. "Its performance has a significant impact on the life industry overall."

Bucking the Trend

Transamerica announced its enhancements in May, and Prudential's enhancements came in late February, just before the stock indexes' March 9 low. Prudential's move is evidence of the confidence it feels in the fundamental design of its dynamic asset-allocation risk management mechanism.

"We have continued to rely on it as a core element ... in the design of our products," said Jacob 'Jac' Herschler, senior vice president of Strategic Initiatives for Prudential Annuities. He added that the mechanism has proved its value to both the company and its clients during the financial crisis.

Still, in early June, the company backtracked slightly on the new design when it said it was planning slight modifications for mid-August.

"We continue to evaluate our offerings and the needs of our stakeholders to remain competitive in the current environment," Herschler said in a statement.

The industry's lifetime withdrawal-benefits guarantee stipulates that even if contract values plummet--as they did from September 2008 to March 2009--contract owners are allowed to take a steady stream of withdrawals based on a separately calculated benefit base. The withdrawals continue even if the contract value falls to zero. (Prudential calls this feature a protected withdrawal value).

The benefit base can't shrink lower than the original investment, but can ratchet up if the contract value grows. Usually, an insurer locks in growth in a product's benefit base if the contract value is higher on an anniversary, or quarterly or monthly. In its Highest Daily Lifetime 7 product and its upgrade, Highest Daily Lifetime 7 Plus, Prudential offers perhaps the most aggressive guarantee by locking in a higher benefit base on any day the contract value is higher. If a contract value declines or grows slowly, companies usually guarantee that the benefit base will grow by a certain rate. Prudential's is 7% compounded annually up to the first lifetime withdrawal.

The ability to make these guarantees comes from a contract provision that allows Prudential to use a predetermined algorithm to dynamically change a policyholder's allocation of assets. In down markets, the mechanism moves money from aggressive investment options into a bond fund. In up markets, it moves funds into aggressive investments. Herschler said the mechanism had a dampening effect during the down market, which was "something investors appreciated in the past year."

No Human Judgment

The real locations are triggered by a mathematical formula and involve no human judgment. At the most, policyholders can have up to 80% invested in equities or 90% in bonds. Amounts transferred depend on the difference between the account value and the protected withdrawal value; how long a client has owned the living benefit; the amount invested in, and performance of, the permitted subaccounts and bond portfolio; and the impact of additional purchase payments or withdrawals.

So, while the formula may add to one policyholder's bond fund, it may on the same day add to another policyholder's equity funds, Herschler said.

Prudential priced the Highest Daily Lifetime 7 Plus benefit at 0.75% of the protected withdrawal value annually for an individual and 0.90% for owner and spouse--both 15 basis points higher than for the original benefit. The company also reduced the issue age to 45, in order to reduce producer uncertainty over which prospects are qualified.

Transamerica's Retirement Income Choice rider offers compounding 5% growth based on the previous year's highest "monthiversary" value. It also uses a method to manage policy value in relation to the rider's guarantees.

Herschler said that, on average, people invest more in lifetime withdrawal products industrywide than in traditional products that produce lifetime income through annuitization. Traditional products require investors to give up the asset in return for the income stream. Often, the purchases of lifetime withdrawal products are a substantial part of their retirement savings, said Herschler.

Attracting New Money

Prudential's variable annuity sales are down year-over-year, as are sales industrywide. But Prudential's net sales flow--a measure of new money being invested--is up. The discrepancy is due simply to individuals having less money.

Herschler said assets flowing into Prudential variable annuities are coming from other kinds of investments, and these had fallen in value due to adverse market conditions. More of these new investors are choosing the optional lifetime withdrawal benefits; in the first quarter, 80% of Prudential VA buyers elected the HD 7 suite, up from 75% a year earlier.

Net flows have been low for the variable annuity industry, especially since the 2000-2002 recession, as reported by NAVA, the Association for Insured Retirement Solutions. Until the latest market downturn, sales had been increasing because existing policyholders were making tax-free exchanges of their variable annuities for new ones with the guaranteed withdrawal features, said Hawkins. With so many exchanges, the industry may be hard-pressed to find more existing policyholders to buttress sales, unless writers can create a compelling new benefit that prospects would consider an upgrade, he said.

That is but one problem the industry faces. Another is the damage the financial crisis has done to variable-annuity writers. Lower equity values have reduced income derived from underlying investments in the contracts. Lower interest rates have burdened writers that provide rate floors on their fixed accounts. And writers have also seen destruction of capital due to losses in their securities lending programs.

"Those losses were not specifically related to VAs, but they destroyed industry capital overall," Hawkins said. Insurers have had to add capital to back up reserves for the guarantees on VAs, he said.

VA writers will be challenged to rebuild capital and financial strength and manage risks around VA products, Hawkins said. They face several issues: the potential for increased federal regulation; managing general-account assets as people start to retire and move from asset accumulation to decumulation; and maintaining distribution even as the pool of producers dwindles.

Insurers also will have to keep consumers confident in the companies' ability to deliver on guarantees. Hawkins said that distributors will play a role because they have an increasing fiduciary responsibility to clients to vet the products they sell. "Phoenix is an example," he said. "As they were downgraded, their two major distributors removed them from their approved-product list."

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He said he has seen this theme pop up in earnings calls.

Pulling the plug Overseas

Variable annuity writers are also feeling pressure on their overseas businesses. The Hartford Financial Services Group and Allianz Life have stopped selling the products in Japan, and ING Group said in May it would stop selling single-premium variable annuities in Japan by August.

The Hartford was the top seller of variable annuities in 2008 (as measured by assets under management) with $26.5 billion. In a written response to questions, the company said it suspended sales "because of increased risks caused by the recent turmoil in the financial markets as well as the challenges posed by the increasingly competitive landscape." The company also suspended sales in the United Kingdom and will not begin sales in Germany.

"We are making changes to our variable annuity business globally to preserve capital and decrease risk," the company said. "We believe these trends will be with us for some time, but [we] may revisit the decision should conditions warrant."

Scott Hawkins, an analyst at Conning Research & Consulting, said The Hartford is one of several companies that saw a potential for a retirement asset-accumulation business in other markets. These firms leveraged their experience and knowledge around product design in the United States to adapt it in other countries.

"What happened with this particular recession was that we saw that economies are not independent of one another, but are interlinked," he said. "So you had similar sets of guarantees on similar products in different markets, and suddenly those markets simultaneously came under pressure."

Hawkins said the cessation of sales by multinational insurers does not necessarily mean they are abandoning particular products or markets.

"They may be leaving themselves in a position to re-enter a market once the economy stabilizes," he said. "But this financial crisis ... was unprecedented in the history of individual annuities, at least the financial impact."

* The Situation: The recession has exposed the risks life insurers were taking in variable annuities, perhaps their most important line.

* The Response: Many insurers have reduced their guaranteed lifetime withdrawal benefits and/or raised charges.

* What's at Stake: Insurers need to be major product providers that protect baby-boomer retirements.

Learn More

Prudential Annuities Life Assurance Corp.

A.M. Best Company # 08715

Distribution: Career agents, independent agents and brokers, broker-dealers, banks

Transamerica Life Insurance Co.

A.M. Best Company # 06095

Distribution: Career agents, stockbrokers, financial planners, independent agents, marketing companies

For ratings and other financial strength information visit www.ambest.com.

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Net Sales Rebound
Net variable annuity sales from first-time purchasers came out of their
2008 slump in the first quarter of 2009.

(Figures in $ millions)

                    Qtr. Ending   Qtr. Ending   Qtr. Ending
                     3/31/2009     12/31/2008    9/30/2008

Total Sales *         30,446         33,321       37,850
Net Sales **           5,085          4,153        4,944
Net as % of Total      16.7%          12.5%        13.1%

                    Qtr. Ending     Qtr. Ending
                     6/30/2008       3/31/2008

Total Sales *         41,953          41,644
Net Sales **           7,506           7,216
Net as % of Total      17.9%           17.3%

* First-time buyers, including inter- and intracompany exchanges, and
additional premium from exisitng owners.

** Total sales minus surrenders, withdrawals, inter- and intracompany
exchanges and benefit payments.

Sources: Morningstar Inc.; NAVA

VA Assets by Asset Class

% of total assets

Equity            42.1%
Fixed Accounts    27.6%
Allocated Funds   12.9%
Bonds             11.9%
Money Market       5.5%

As of March 31, 2009

Source: Morningstar Inc.