A Changing Variable Annuity Landscape -- The Consumer Perspective

This is the first part of an interview with Ryan Hinchey.

Ryan is a consulting actuary and expert in the variable annuity industry.  Ryan specializes in financial risk management with a focus on variable annuity guarantees. He advises large multi-national insurance companies in the areas of variable annuity hedging, pricing, and product development.  Ryan also maintains a blog which can be viewed here.

Q: Insurers who offer variable annuity products have been in the eye of the storm with the financial crisis.  Most have had to react aggressively and some have accepted bailout funds from the federal government.

Common current themes among variable annuity providers seem to include price increases and benefit reductions.  Can you comment at a high level on this current trend?

Ryan: Insurers can either raise prices or reduce benefits—in certain respects they are different levers for same goal. 

There are a couple reasons why variable annuity insurers are pursuing these objectives.  First, the raw materials to manufacture variable annuity guarantees are much higher than pre 2008.  In large part this is attributable to a low interest rate environment coupled with high levels of capital market volatility.  High volatility coupled with low interest rates is a worst-case scenario that is not supposed to happen according to a historical view of the market.

Second, insurers need to hold more capital in reserve.  Reserve requirements have increased due to loss of capital so insurance companies are looking to design variable annuity products that require less capital.

Insurers have also been hurt due to decreasing asset values.  Variable annuity providers derive income from holding assets.  Income decreases as asset values decrease, so insurers will need to build higher margin into products going forward. 

Last, insurers will be looking to minimizing risks that they are not able to hedge.

Q: How is what you are describing actually evident to the consumer? 

Ryan: First, variable annuity products that were available a year or so ago are simply no longer available. 

Also, prices are a bit higher.  Higher prices are evident in M&E fees and rider charges that are 25 to 50 basis points higher than this time last year.  While the low end used to be 50-100 basis points, the current environment would be in the range of 100-150 basis points. 

Rich bonus and roll-up features have disappeared. 

Mutual fund offerings have been reduced.  There are more passive versus actively managed fund offerings, and more dynamic asset allocation programs to manage equity volatility and risk exposure. 

Q: Would you, as a consumer, wait out this interest rate environment?  In other words, if you were considering the purchase of a variable annuity would you hold-off for a year or two until interest rates increase and volatility decreases?

Ryan: There are two possible scenarios.  In the first scenario, things stay the same or even get worse with more volatility and continued low interest rates.  If this is the case, then current product options might be attractive.

In the second scenario, the recent upheaval turns out to be a shorter-term trend that will correct in a year.  In this case, it would make sense to hold-off on a product purchase.

Since nobody really knows where markets will go, it might be wise to seek products with no surrender charge.  Products that afford more flexibility such as a variable annuity guarantee without a surrender charge could make sense, although you may have to pay for this flexibility with higher M&E fees or an upfront load. 

A number of investors have been switching to fixed products – some with shorter horizons, to be in a position to reassess the markets 5 years from now.  However, historically this approach has not been a great bargain with the low interest rates. 

All of the above said, there is a different answer for each investor’s specific set of circumstances and risk tolerances.

Q: Could you offer some words of advice for a consumer who is just starting to look at variable annuity products?

Ryan: First, get comfortable with the insurance company.  Understand whether they are a strong company that is in it for the long-term.  Now more than ever it is best to stay on safe side with strong company.

Looking at the current mix of products, it is really a trade-off between upside potential and lower fees versus paying-up for enhanced downside protection. 

It is also important to assess the level of flexibility you desire in a variable annuity product.  An example would be the variety of fund choices and your level of control over the funds. 

Look at more than one insurance company and do not be afraid to get a second opinion from a different advisor if your initial advisor is not providing you with adequate options

Q: Can you comment on 1035 exchanges?  Is a 1035 exchange something that a current variable annuity owner should consider in the current environment?

Ryan: If they have a guaranteed benefit, chances are they are better off holding on especially if the contract is in the money—in other words the guarantee value is higher than the account value. 

Possible exceptions come into play if they do not have a guaranteed living benefit, or would like to lower their fund drag (expense) with one of the new low-fee products that are being marketed.  However, I would be wary of an advisor pushing a consumer to trade in a benefit with a guarantee rider without a convincing argument.  In these cases it I would recommend getting a second opinion before considering a 1035 exchange.