Matching company risk to client reward

Making sense of a market-challenged annuity business

by Ray Caucci

Mr. Caucci is Vice President, Product Management, for Penn Mutual. He can be reached at

The annuity has rarely been more popular than it is in today’s investment environment. At the same time, some of the large institutional providers of annuities are exiting that business at the height of client demand.

It is reasonable to ask why.

To answer that question requires, first, that we understand a little of the history of annuities, their popularity and what drives investors toward them in different periods.

Annuities have been around since the time of the Romans and their appeal has always been heightened during times when other forms of traditional investments have become more suspect.

The appeal of annuities was further enhanced in 1986 when Congress allowed unlimited investments in annuities that could be tax-deferred. In the decades since, interest in various forms of annuities,  including fixed, indexed and variable (with varying levels of guarantees and risk)- has waxed and waned with investors and with providers.

Much of the difficulty that providers of annuities face has to do with the same issues that make annuities popular in various economic environments. The recessionary period we are still struggling to get out of dramatically reduced the portfolios of many investors, but particularly baby boomers nearing retirement age.

Consequently, investors are pulling out of the market, particularly equity mutual funds. The 2012 Fact Book of the Investment Company Institute said that $100 billion was withdrawn from all mutual funds in 2011. Net withdrawals from equity funds, according to the same source, continued for a fourth straight year, with 2011 withdrawals from equity funds at $130 billion. Domestic equity funds, at the end of 2011, had suffered $471 billion in withdrawals over the past six years.

In one week in August, after a downgrade of the U.S. credit rating by Standard & Poor’s, mutual funds suffered a net $40.3 billion in withdrawals. Investors continue to flee uncertain markets in general. According to Bloomberg, trading in U.S. stocks for the year ended 2011 fell to its lowest level since 2008, based largely on individual and mutual fund withdrawals. The initial disappointing performance of Facebook’s high-profile IPO did little to inspire individual investor confidence. While the market downturn reduced investment portfolios, the housing crisis damaged another traditional retirement planning staple- home equity. Investors began scrambling for financial instruments that offered guarantees that outperformed bank rates on CDs but carried less risk than the markets.

The difficulty for some providers is that the risks inherent in earlier product series that they sold with rich guarantees cannot easily be mitigated by option contracts in this historically low interest rate environment.  At the time, the client could pursue fixed guarantees as an alternative, which the provider could continue to support more easily in this environment.  However, investors are naturally wary of any investment that locks them into rates that could appear low in periods of inflation or rising interest rates.

For providers, guarantees could be supported by making increasingly riskier portfolio bets or entering larger hedge positions against continued low interest rates. Recent history suggests that such a strategy can carry truly devastating consequences.

For a publicly held insurance company, the challenges are sometimes magnified. Public companies are faced with holding enough capital to support the guaranteed benefits offered while at the same time seeking to minimize equity levels and maximizing earnings to improve ROE.

Much of the difficulty that providers of annuities face has to do with the same issues that make annuities popular in various economic environments. The recessionary period we are still struggling to get out of dramatically reduced the portfolios of many investors, but particularly baby boomers nearing retirement age.

Such companies often cannot satisfy all their audiences because they cannot execute a long-term plan that allows for quarters where guarantees reduce profitability on a short-term basis. Many of those companies are pulling out of the variable annuity business and, according to LIMRA, that pullback by large players in the variable annuity business resulted in a 7% decline in sales for the first calendar quarter of 2012.

Some companies can remain in the annuity business, particularly mutual companies that don’t have to face shareholder demands and that can offer diverse product lines, which include traditional life insurance and other profitable insurance products.

Mutual companies often manage risk with more of a long-term view and a very strong commitment to guarantees. That doesn’t mean that they, too, haven’t had to find different ways to manage risks of annuity benefit guarantees in the recent volatile, low interest rate economic environment.  All annuity product guarantees are based on the claims paying ability of the issuer.

We have seen the emergence of a new generation of  of variable annuities in response to ongoing client demand for annuity products that can be custom-tailored in a challenging market environment.  At my company we recently launched what we call our ‘Smart Foundation’. A variable annuity is a long-term financial retirement vehicle, subject to market fluctuations and may lose value, and is subject to certain fees and expenses which are not normally associated with other investment vehicles.

The most traditional offering is the basic variable annuity product for those just starting retirement planning who don’t see immediate need to access account values.

Conversely, there are new variable annuity options for clients nearing retirement who may, indeed, need to access their account values shortly after purchase.  Withdrawals in excess of the annual free withdrawal amount may be subject to surrender charges in addition to tax consequences.

Another variation is to offer the opportunity for greater accumulation over a long period through a purchase payment enhancement on deposits made into the contract. This annuity is of the type that can be particularly appealing to clients planning to roll over larger amounts from other funding sources or those consolidating multiple accounts, provided they can delay access to their account values.

Once clients choose an annuity they also have a choice of optional guarantees in the form of risk protection and/or death benefits for an additional cost.

Our Guaranteed Growth and Income Benefit, for example, offers guaranteed growth of 8% of net deposits applied to the withdrawal benefit base during the deferral phase of the contract and guaranteed annual lifetime income when withdrawals begin, ranging from 4-6% of the withdrawal benefit base and available as early as age 55.

A Guaranteed Minimum Accumulation Benefit guarantees the return of purchase payments made during the first year of the benefit period after 10 years and it can be ideal for clients concerned with market volatility and losing their deposit.

An Enhanced Death Benefit provides added protection where heirs will receive the greater of the Standard Death Benefit or the highest anniversary account value.

As clients get more and more risk averse such an array of annuities, benefits and risk protection gives clients options, while also allowing companies with strong risk management practices a chance to continue serving client needs.

Those companies that can earn trust through long periods of outstanding performance, coupled with constant market vigilance, are the ones who can and will remain in the annuity business.