U.S. insurers’ sales of variable annuities jumped 24 percent in the first quarter, led by policies that promise lifetime income and protect against market declines, at a time when investors are still wary of stocks.
The retirement products’ growth is driven in part by concerns that another stock market drop like the one in 2008 could wipe out savings, said Moshe Milevsky, finance professor at the Schulich School of Business at York University in Toronto. Consumers “fear that the S&P at 1,300 is a mirage and it’s going to go back to 700 for the rest of our lives,” he said.
Annuities are insurance contracts that offer a steady stream of income. With variable annuities, customers can choose their investments such as stock and bond funds and the account value will fluctuate with the market. For MetLife Inc. and Prudential Financial Inc., the top two U.S. life insurers, the hottest product this year also offers a guarantee of income for life, even if a customer’s account balance falls because of market declines. There’s an annual fee for the rider, which averages about 1.03 percent, according to Morningstar Inc., on top of the regular annuity fees, which average about 2.51 percent.
The high fees mean that “the upside potential” in these contracts is “fairly limited,” said Kenneth Masters, director of life insurance design and development for Pinnacle Financial Group in Southborough, Massachusetts. “Would I have been better off saving 370 basis points and being fully in the stock market?”
Difficult to Understand
About 96 percent of Prudential’s record $6.8 billion in sales of variable annuities in the first quarter were policies that included a lifetime income guarantee. At MetLife, 80 percent of their $5.7 billion of products sold in the quarter carried a guaranteed benefit.
It’s difficult for consumers to understand the conditions and limitations that come with the benefits of these guarantees, such as when an insurer can increase fees or restrict investments, said Milevsky.
Insurers may offer a rate of return such as 5 percent or 6 percent a year with these riders, which customers also may misunderstand, said Timothy Pfeifer, a consulting actuary and president of Pfeifer Advisory LLC in Libertyville, Illinois. “Customers might be told that their policy will provide a 6 percent annual guarantee and think that sounds great. That is not a lump sum you can take out.” The income promised for life can deplete if owners take out too much money or too fast, said Pfeifer.
Sales of variable annuities in the U.S. climbed to $39.8 billion in the first quarter, from $32.2 billion a year earlier, according to trade group Limra. Investors have withdrawn $50 billion from U.S. stock mutual funds in the 12 months through April, according to Chicago-based Morningstar, a research firm.
Terms of the riders attached to variable annuity contracts vary by insurer. Here’s how one from Prudential, the top seller of variable annuities, works: A customer puts $100,000 into a variable annuity and picks investments such as stock and bond funds offered in the contract. The Newark, New Jersey-based insurer promises that it will record the highest daily value the account ever reaches and that amount will increase at 5 percent annual compounded growth, until an owner starts taking out money.
“That number, to be very clear, is not available to cash in,” said Jac Herschler, head of business strategy for Prudential’s annuity division. “It’s only the basis for determining what they can withdraw from their account every year for life.”
Prudential customers agree to let the company move their assets into a bond fund if the investments they selected don’t perform well. The transfers are based on a mathematical formula in the prospectus.
Other insurers limit the amount customers may invest in equities if they opt for a rider or restrict the choice of funds, said Tom Idzorek, global chief investment officer for Morningstar Investment Management, a Morningstar unit. Limits on investments help reduce the costs for insurers of hedging against the risk that customers’ accounts will run out of money and the insurance company will have to use its funds to continue the payouts, he said.
MetLife last month started offering a “guaranteed minimum income benefit” that limits buyers to five funds: four have a mix of investments and one is invested primarily in bonds. The portfolio’s design means MetLife can promise 6 percent compounded growth annually regardless of the market’s performance, said Robert E. Sollmann, head of retirement products for the New York-based company. MetLife has a separate rider that restricts customers to a maximum of 70 percent in equities and a lower compounding rate of 5 percent, Sollmann said.
Individuals have a “tall task” when trying to identify the differences among riders from various insurers, said Idzorek. “Say you wanted to compare five products side by side, good luck.”
With the rider, customers can invest in equities and “sleep at night,” said Greg Cicotte, president of the sales and marketing unit of Jackson National Life Insurance Co. About 82 percent of contracts sold last year by Jackson National, based in Lansing, Michigan, had a guarantee of lifetime income, Cicotte said. “If the market does go down you know that the income you planned on for retirement is protected.”
Individuals shouldn’t put all of their assets in one of these products because “there are always unforeseen expenses,” said Masters of Pinnacle Financial Group. “Usually they do carry some severe penalties if you exceed your guarantee in terms of taking money out.”
Penalties may include surrender charges as high as 9 percent of the account balance for cashing out, according to Morningstar. And taking out more money than is allowed in the terms of the rider may reduce the future guaranteed income, said Pfeifer, the actuary.
The usual withdrawal rate on contracts with a rider is 4 percent or 5 percent a year at age 65, according to Ernst & Young. That percentage generally increases if customers wait to start taking out money. Some contracts allow withdrawals of 7 percent at age 85, data from the New York-based firm shows.
The New York State Insurance Department said in February it will require insurers to disclose how withdrawals in excess of those set percentages affect future payments.
“Many insurers were providing a general disclosure about excess withdrawals,” said James J. Wrynn, New York Insurance Superintendent. “That doesn’t really have the same kind of impact as saying that your $100 monthly payment for life will be reduced to $50 per month for life if you take this excess withdrawal.”
The riders may be worth it for the risk-averse investor who understands how the fees may affect their returns and as a partial allocation for an individual close to retirement without a long time for fluctuations in the market, said Masters of Pinnacle Financial Group.
More than a quarter of U.S. workers said they’re “not at all confident” about their ability to afford a comfortable retirement, the highest percentage in two decades, according to a March report by the Washington-based Employee Benefit Research Institute. Men have a life expectancy of 17 years at age 65, based on government tables from the National Center for Health Statistics. For women it’s 20 years.
Elinor and Robert Louis of California have about $1 million, or half their retirement savings, in variable annuities with a guarantee. “Without it, it’s like Russian roulette,” said Robert Louis, 62. “You don’t know what’s going to happen.”
The extra fees for the rider are worth it because the product provides the potential for growth, downside protection and the ability to pass money to their heirs, said Elinor Louis, 62.
Annual charges for the riders that provide withdrawals for life range from 0.3 percent to 1.7 percent, Morningstar data show. The average “all-in” cost of a variable annuity with such a guarantee is 3.54 percent, according to Morningstar.
Insurers also may raise fees when they increase the benefit base amount used to calculate the annual withdrawal or income, said Glenn Daily, a fee-only insurance consultant in New York in an e-mail. It may be impossible for individuals to determine if they should accept a “step-up” that adds costs “without hiring a quant to figure it out,” Daily said.