Money-back guarantee: variable-annuity writers have rejuvenated their products by protecting buyers from the dark side of the markets.

How would you like to buy a product that lets you invest in the stock market, but if you mess up, it guarantees that you make money anyway?

That offer is basically the pitch some variable-annuity writers are able to make these days, and the message is apparently finding its mark among potential buyers. These prospects, usually in or near retirement, have been chastened by the rigors of the three-year bear market that ended in March 2003. Many need to recoup losses, but cannot afford to lose any more money.

Last year turned out to be very good for variable annuities. Overall sales rebounded to $126.5 billion, the second-highest annual total ever behind the $137.3 billion in 2000, according to the Finetre Corp.'s VARDS Report. Guaranteed benefits drove the sales. Three of every/bur new sales in 2003 were in contracts with one or more of the new guaranteed "living" benefits, said Rick Carey, managing director of research and founder of VARDS, the Variable Annuity Research and Data Service. Some 52% of new contracts came with guaranteed minimum income benefits, and 40% came with minimum withdrawal benefits, he said. The newest kind of living benefit, which guarantees some level of asset growth, rounded out what Carey called "the big three."

The guarantees are the newest addition to a product that has undergone a remarkable evolution in the first 12 to 15 years. At the beginning of that period, variable annuities were primitive by today's standards. Most offered only a few investment options and a rudimentary death benefit equal to the amount invested less withdrawals. Gradually, writers added investment options and brought in the offerings of outside money managers. Many enhanced their death benefits, either by a fixed amount annually or by locking in the highest anniversary-date contract values.

The First to Plunge

In the mid 1990s, the Equitable Life Assurance Society of the U.S. introduced the first guaranteed minimum income benefit, which determines the minimum amount of monthly income the annuity would generate if the owner decided to buy an income stream (annuitize). It does this by guaranteeing that the amount in the contract used for buying the income stream would grow by a specified amount, usually 5% a year, even if the underlying investments in the variable contract lose money. This guaranteed value would only count if used toward buying an income stream.

In August 2002, Hartford Life Insurance Co. became the first to guarantee that a policyholder could withdraw over a period of years all invested money even if underlying investments lost value. More recently, insurers guarantee a contract holder will achieve contract growth.

Rather than the latest fad, these new protections are likely to represent a fundamental change in the industry's primary asset-accumulation product. John Egbert, vice president and national sales manager at Manulife USA in Boston, said the changes are the "most profound" of his 20 years in the business. Carey said the living benefits were to variable annuities last year what technology stocks were to the Nasdaq index of stocks.

Also important is that guaranteed living benefits are helping bring more new money into the variable-annuity industry. According to the National Association for Variable Annuities, in 2003, about $46 billion, or 36.4% of total premium flows, was in money not previously invested in variable annuities; in 2002, the percentage was 26.7. Finetre reported the amount of new money invested in variable annuities had fallen from $58.6 billion in 1997 to $30 billion in 2001.

Egbert's enthusiasm can be traced to Manulife USA's surge in variable-annuity sales since adding its withdrawal benefit, Principal Plus, on Dec. 8, 2003. In the first two months of this year, sales climbed to 3400 million a month, up 33% from 3300 million. Egbert said five or six competitors increase the withdrawal benefit every five years, but that the Principal Plus rider steps up the value every three years. He said "the real kicker" is a minimum accumulation benefit that applies if the investor holds off taking the systematic withdrawals for five years. In that case, Manulife would increase the amount of the principal guarantee by 5% in each of those five years, not compounded.

"Think about a 65-year-old, the sweet spot of the broker-dealer community," said Egbert. "He's just rolled over $1 million from his 401(k) into an IRA. We can say to him that he can invest in the market, and we'll ensure that, worst case, when he reaches 70 1/2 and has to begin taking minimum required distributions, his million dollars will be worth $1.25 million. That's extremely powerful. We had never been able to say that, and mutual funds have never been able to."

Manulife charges 30 basis points annually for the withdrawal benefit, or 33,000 on 31 million. The investor also must agree to be in an asset-allocation lifestyle portfolio ranging from 80% stocks and 20% bonds to 80% bonds and 20% stocks. The most common choice so far has been 60% stocks and 40% bonds, Egbert said. Investors are allowed to change to a different portfolio as often as once a month.

Egbert said the rider allows buyers to invest a significant part of their liquid assets. "Think of all the investors that owned mutual funds in 2001 and 2002," he said. "They saw their nest eggs dwindle, and now they've seen them recover. We can go to those investors and say, 'Here's a way you can invest in mutual funds, allocate and diversify your assets, and not have to worry about the market.'" Many deem money covered by the Principal Plus rider to be safe, and then invest other money in other, possibly more-aggressive, ways, Egbert added.

Adding to Manulife's excitement about Principal Plus is that it is, "without question," bringing in new money rather than money that had been invested in another variable annuity. "This is going after the IRA money," Egbert said. "The appeal is that you have to take distributions from any IRA at age 70 1/2, and this is a guaranteed systematic withdrawal program."

Focus on a Date

Lincoln Benefit Life Co., a subsidiary of Allstate Corp., is also hoping to attract lump-sum, time-horizon business through the Feb. 24 introduction of its Consultant Solutions Variable Annuity Product Suite of four annuities. They feature an accumulation-benefit rider that is applicable to premium received during the first year. To earn the guarantee, investors must choose a time horizon of eight to 20 years. A term of eight years guarantees the principal and each ensuing year assures a gain of 12.5%. That means, for example, growth of principal would be 125% after 10 years up to a maximum of 250% after 20 years.

The guarantees are not valid until investors are in the product for the time they have chosen, said Tim Vander Pas, assistant vice president at Allstate and head of retail annuity product management. However, Lincoln Benefit offers a "trade-in capability," he said. "Let's say you've chosen a 15-year guarantee, and you're eight years into the contract, and the markets have done very well for you," said Vander Pas. "You could then trade in your contract and do a restart. In effect, you lock in the gains, cancel the old rider, and lock in a new one." The annual price of the rider, which is currently 50 basis points, might be different at the time of a trade-in, he said.

Investors seeking the guarantee also must adhere to an asset-allocation of 70% fixed-income and 30% equities rebalanced annually, but they are free to move among the investment options within that allocation framework. The suite of annuities offers 50 fund options managed by 12 money managers. Investors may alternatively choose a 70% equities and 30% fixed-income allocation, but the guarantees then start at 100% of principal "after 10 years and rise by 10% a year from years 11 through 20, for a maximum of 200%.

Technically, the product is flexible premium, but money added after the first year is not eligible for guarantees. Instead, the product is designed to help people plan around a retirement date "so they are not suddenly hurt by a downturn in the market," said Vander Pas.

Lincoln Benefit expects its new guarantees to generate a "substantial uptick" in sales regardless of the performance of the investment markets. "Certainly, we will use a 50% increase as a benchmark," he said. "If the equity markets do well, variable annuities will benefit, and we'll ride that tide. But these features jump out when people are most concerned about what the markets may do."

Big Surge in Sales

Jackson National Life Insurance Co., Lansing, Mich., sold nearly $3.2 billion of variable annuities last year, shattering ++++ its company record in 2000 by 22% and boosting sales over the 2002 total by 55%. Minimum death benefits are still the company's most popular guarantees, but withdrawal benefits and income benefits are growing more quickly, said Jim Livingston, senior vice president of product management with Jackson National Life Distributors, based in Denver. The company does not offer a minimum accumulation benefit "because we have not been able to get comfortable with the pricing," he said.

Jackson's variable-annuity buyers range mostly from age 50 to 75 with many close to retirement. Buyers are looking to take risk out of their portfolios as they approach retirement, and they remain interested in what they will bequeath to their heirs, Livingston said. Jackson's five kinds of death benefits help drive that feature's popularity, he said. Interest in minimum withdrawals and minimum income are part of the increasing interest in principal protection since the bear market and the September 2001 terrorist attacks, he said.

The company added its withdrawal benefit in early 2003 to its Perspective II Fixed and Variable Annuity. Since then, the withdrawal benefit has moved ahead of the income benefit in popularity among buyers, Livingston said. He expects that even those choosing the income benefit use it as a safety net in their accumulation product, then plan to annuitize for income. "Clearly, if we have a horrible market, they will annuitize," he said. "But people want to be able to continue to control their assets and to have liquidity, so we don't consider it a sure thing that many will annuitize. "The minimum income guarantee does not become effective until 10 years from contract issue, Livingston said.

Livingston said he believes benefit guarantees will have long-lasting, rather than temporary, effects on the industry and drive the growth of variable annuities. "Insurers have always been poolers of risk, and as people get into retirement, they'll be looking at their longevity risk and asset-performance risk," he said.

Confidence Breeds Prudence

Managing such risks may actually help investors to follow more prudent strategies. Matthew Keyes, a financial representative at the Columbus, Ohio-based independent firm Clark-Guy & Associates, said guarantees on variable annuities help his clients to regain their courage and invest again in an appropriate amount of equities. Keyes deals primarily with individuals 40 years or older, typically owners of businesses, with high incomes and net worths of at least a half million dollars. Many fear getting back into the market, he said. "They benefited during the market bubble, but then they saw the market tumble," he said. "Some jumped ship, and some believed in the market and stayed in it. The beauty about a product like Lincoln Benefit Life's is that they're not in it to time the market."

The guarantees also encourage investors to see the big picture and diversify. Keyes said he had long urged his clients to diversify, but many had nothing in their portfolios but tech stocks during the market bubble. "I would love to think clients will keep their diversification strategies going strong," he said. "We as individuals, however, don't always make the best choices when we should. But clients are becoming more educated and smarter, so this [style of investing] may last for a long time."

Barbara Pietrangelo, a Prudential Financial representative in Grand Rapids, Mich., said that a few years ago she helped a new 66-year-old client consolidate investments he had scattered in mutual funds into a variable annuity in the Prudential Strategic Partners Annuity One series. His account fell in value during the bear market, but when he died at age 72, his widow and children were pleasantly surprised when Prudential was able to deliver on a death benefit greater than the account value, Pietrangelo said. She specializes in comprehensive planning with an emphasis in retirement planning, mostly with small-business owners in or near retirement.

The Annuity One 3 product offers a choice of three enhanced death benefits. With the 5% annual roll-up, a beneficiary receives the greater of current contract value or the total of purchase payments increased annually by 5%, less withdrawals. The annual step-up locks in investment gains on each contract anniversary, or pays contract value, if it is higher. And a combined rollup and step-up offers the greatest of those two or the current contract value. For beneficiaries of many contract owners, the death benefit "has been a godsend," Pietrangelo said. A step-up or roll-up costs 0.25% of contract value annually; the combined benefits cost 35 basis points.

The contract's guaranteed minimum income benefit protects the contract value that will be used to determine payouts if the owner annuitizes. The protected value is equal to purchase payments increased by 5% annually. It is capped at 200% of purchase payments, and an owner cannot exercise the benefit during the first seven years. If strong investment returns cause the contract value to be greater than protected value, an owner is twice allowed to "reset" the protected value to a higher level. Each reset starts a new 200% cap and seven-year waiting period. The benefit costs 0.45% annually of the protected value.

Customized Asset Allocations

Prudential has no asset-allocation requirements in its minimum income benefit, but Pietrangelo said she does not use the guarantee to invest client money in an overly aggressive manner. "I work with clients to make choices consistent with their objectives and with what their investment policy statement says," she said. Pietrangelo said she sets up asset allocations for each client goal and that the variable annuity product is excellent for retirement planning.

Annuity One 3 offers two other benefits. The income appreciator benefit can be activated any time after seven years. It pays a percentage of contract earnings--15% in contracts seven to nine years old, 20% in those 10 to 14 years old, and 25% for 15 years or more. Contract owners can receive the benefit as a 10% increase in automatic withdrawals over 10 years, as money reinvested into the contract over 10 years, or to boost contract value at annuitization. The benefit costs 0.25% of contract value annually.

Pietrangelo said she has found that variable annuities help round out a good financial plan, "and with the guarantees, they give you permission to sleep well at night."

VAs with Guarantees vs. Index Products: Competitors or Apples and Oranges?

The new variable-annuity sales pitch sounds similar to the one used in equity index annuities. Both offer buyers the upside potential of the stock market and guarantee they cannot lose money. But which product is better?

The answer is not easy because there are many product versions in each product line. Point-to-point equity index annuities may be the closest in design to accumulation guarantees in variable products, for example, in that they calculate their minimum guarantees from policy issue to some certain time in the future. In that case, variable annuities would offer greater upside opportunity because index annuities limit returns through participation rates or caps, said Tim Vander Pas, assistant vice president at Allstate Corp. and head of retail annuity product management. But index annuities with annual-reset mechanisms calculate interest they pay--and guarantee they won't lose money--in each year.

"What it comes down to is that an annual reset resets annually," said Jack Marrion, president of Advantage Compendium, which tracks the index annuity industry. "As moronic as it sounds, that's brilliant."

Marrion said he has looked at every version of variable annuity with minimum withdrawal benefits or accumulation benefits, and he is convinced an annual-reset index annuity offers better protection and potential. Index annuities are fixed annuities that invest a percentage of premium into options to track the stock market. The exercise of those options allows issuers to credit interest into index annuities. Issuers invest most of the premium into bonds, which are used to guarantee at least a return of principal.

According to Marrion, variable annuities with guarantees compete against index annuities that represent less than 15% of the index-annuity market--term point-to-point. "Against them, it comes down to a pure fee type of thing, and they can compete," he said. "But 85% of people who buy index annuities aren't trying to buy a fixed variable; they're trying to get a better fixed." Marrion added that the introduction of guarantees into the variable-annuity market has had no measurable effect on the index market because index products are sold almost exclusively by life-insurance agents, and those agents do not need securities licenses to sell them. Variable annuities are sold mostly by independent brokers who have securities licenses. Marrion said sales of index annuities were up 20% in the fourth quarter of last year, even as sales of fixed annuities overall declined.

One other argument variable annuity writers can make is that index options cannot capture dividends paid by the underlying stocks. Over the past 70 years, dividends have accounted for 40% of the increase in value of the larger stock indexes, Marrion said. But the effect of the annual reset, which is to eliminate negative returns in down years, makes up for the loss in dividends, he said.

Variable Annuity Sales

New guaranteed living benefits are attracting new money into the
variable-annuity industry. In 2003, $46 billion of total premium flows
was in money not previously invested in variable annuities, compared
with $30.7 million in 2002.

        New Sales    Net Flow

1994      $46.7        $42.8
1995      $47.7        $39.0
1996      $69.1        $54.8
1997      $82.1        $58.6
1998      $92.9        $51.1
1999     $114.3        $46.8
2000     $128.0        $43.9
2001     $106.7        $30.0
2002     $112.3        $30.7
2003     $124.5        $46.0

Note: Table Made from bar graph.

Source: Finetre/VARDS