Insurers Abandon Rosy View of Variable Annuities

For the last few years, insurance companies have been luring investors with an irresistible product: an investment that guaranteed market gains, with no risk, and generous income payments for life. Surprise of surprises, that pitch has worked, reviving the lackluster variable annuity and attracting about $140 billion a year in investor assets.

But the guarantees on these variable annuities sounded too good to be true, and a few months ago SmartMoney asked insurance company executives to explain how, exactly, they planned to keep them.

As it turns out, it’s not so easy. A variable annuity is basically an investment portfolio with an insurance overlay – investors got tax-deferral and, usually, a death benefit, but paid high fees and big withdrawal penalties. But in the last few years, insurance companies have started marketing the investments as safe havens for people in retirement or close to it: a typical product lets investors stay in the market, but promises a lifetime income stream based on an account value that can only go up, often by as much as 7% per year. That means investors’ potential income rises regardless of what happens in the market.

How’s that possible? Apparently, it’s not. When we asked earlier this year, the insurance companies told us they had it all under control, guaranteeing the benefits with sophisticated models and elaborate hedging strategies that would hold up even in a severe market downturn. But now that we’ve had that severe downturn, several companies have stopped selling their most generous variable annuities or raised fees, citing “prudence in light of current market conditions” – code for “we didn’t expect this.”

MassMutual has stopped selling an annuity that guaranteed a 6% annual return; AXA-Equitable has taken a product with a 6.5% guarantee off the shelf and raised the prices on its existing product; other companies are doing the same. “In today’s market, a 6.5% guarantee just is not prudent,” said Steve Mabry, senior vice president of product development at AXA-Equitable.

In theory, investors who already own one of these annuities are still entitled to the benefits for as long as they hold their contracts. And lucky them: in today’s markets, a 6.5% annual return looks downright spectacular. The problem is, the guarantees are still only as good as the companies that insure them. And this most recent move – discontinuing products, raising fees – acknowledges that the companies’ models and hedging strategies aren’t as stable as they thought. The financial crisis has hurt insurance companies across the board -- AIG has already received federal bailout funds; the Hartford has taken steps to apply for them – and the question policyholders need to ask is, “Will my company be around in four or five years, when I want to exercise that benefit,” says John McCarthy, vice president at Advance Sales, an annuity research company.

There are backstops in place, of course, but if companies go out of business, it won’t look good for investors. “You may be able to collect your account value,” said McCarthy. “But you’ve paid for a guarantee that you’ll never get.” The insurance companies say that won’t happen. They point to the rules and regulations that require them to keep a certain amount of money in reserve. Also, most states require insurers to guarantee at least $100,000 in annuity benefits, but it’s not clear whether these variable annuity benefits qualify. “They might be covered today, and they might not be, and that might not mean anything five or 10 years from now,” says Mike Surguine, the executive director of the Arizona Life and Disability Guaranty Fund. “The laws could change.” And, says AXA’s Mabry, the company discontinued its most generous guarantee precisely to insure the financial health of the parent company.

But some companies are showing no sign of retreat, at least not yet. Prudential is still selling its most generous annuity, which guarantees a 7% annual rate of return under any market conditions. It’s not cheap – the all-in cost for an annuity with the guarantee is well over 3% per year – but in this market, it’s selling like crazy: In the third quarter of 2008, 75% of Prudential annuities carried the benefit. The company says it has no plans to raise its prices or reduce the benefit, and says it’s confident it can handle these commitments. In any case it’s a big guarantee – as long as they’re around to keep it.