Top 50 Annuities - Summit Financial

Barron's Cover

| MONDAY, MAY 27, 2013

Top 50 Annuities

By KAREN HUBE

The once-dominant variable annuity is getting a bit of competition from cheaper iterations. These stripped-down products offer some surprising advantages, though.

Armand Baughman, 71, a retired Continental Airlines pilot of Valley View, Texas, has always viewed annuities as too complex, illiquid, and expensive to warrant his consideration. But last year, he socked $200,000 into a tax-deferred variable annuity, calling it "the best thing since Cracker Jacks." What changed? As part of an effort to lift sagging profits after years of challenging market conditions, firms are giving the oft-maligned annuity a makeover: an ultralow-cost, variable annuity that offers a broad array of alternative investments, including hedge funds, currency funds, managed futures, and other strategies. Annuity companies are trying to make a comeback after years of struggling to remain financially sound under the cloud of low interest rates and high stock-market volatility. With annuity sales down 8.4% last year, to $211.8 billion, the lowest level since 2005, annuity providers are aggressively designing and marketing annuities that -- like the low-cost variable annuities -appeal to very specific investor goals or needs.

Thomas Reis for Barron's

"For years, companies offered products that tried to do everything at once -- give the highest rates, best liquidity, best income guarantees, and benefits," says Ken Nuss, founder of , which has free listings of fixed index and income annuities. "But that's over. They're getting better at fulfilling a specific goal more effectively."

To help sort through a breadth of products, Barron's surveyed annuity companies and industry experts to come up with the 50 most competitive contracts in popular annuity categories. The results, based on common investor assumptions and goals, are detailed in the table, right.

Low-cost variable annuities with alternative investments earned a new category entry in the top50 survey this year, thanks to the growing number of these contracts and their potential benefits to investors.

ANNUITIES, WHICH ARE TAX-DEFERRED INVESTMENT vehicles that allow you to turn on an income stream either immediately or years from now, come in two basic categories: Variable annuities have payouts that fluctuate along with their underlying investments; fixed annuities offer a guaranteed interest rate for a specified number of years.

Variable annuities are basically tax-deferred wrappers for mutual-fund-like investments, and charge an insurance and administrative fee bundled into one annual contract fee, which averages 1.5%, according to Morningstar. Investors also pay an average 1% investment-management fee on the funds they select within their contracts. Like assets in an IRA, those in an annuity are subject to a penalty if withdrawn before age 59?, but unlike IRAs, there are no required minimum distributions at age 70?.

Any type of annuity can offer a dizzying selection of a la carte features, such as living benefits that guarantee a lifelong minimum income, death benefits that pay your heirs any remaining principal if you die prematurely, inflation-adjusted payouts, liquidity options, and riders to pay for nursing-home care.

But the market volatility and low interest rates since 2008 have made many of these benefits more costly for insurers, and almost all firms have cut benefits, raised fees, or closed oncepopular annuity contracts to new investors. Even so, 90% of variable-annuity contracts are still sold with income benefits that carry an average cost of 1%. Add that to the average 1.5% contract cost and 1% investment management fees, and investors are looking at annuity contracts costing upward of 3.5%. Most also come with surrender charges, which are insurers' penalties for withdrawing money early, usually starting at about 7% and declining to zero after five to seven years. No wonder advisors have been less and less likely to recommend them.

But with annual contract costs often much lower than 1% in total, on average, the new breed of stripped-down, low-cost annuities has a lot of appeal for advisors and individuals. About a halfdozen firms, including Symetra Life Insurance, Nationwide, and Jefferson National Life Insurance, now offer them, and more are on the way.

These low-cost annuities don't offer the same array of a la carte features, but they do come with some unexpected benefits. For instance, by not offering income guarantees, these annuities can

include a wider range of investment options. Alternative investments can be very volatile, and therefore very costly to hedge. "Removing the benefit rider means we don't have to hedge, which gives the insurer the ability to offer greater investment options," says Doug Dubitsky, vice president of retirement solutions for Guardian Life, which has designed a simple variable annuity that is under review with the Securities and Exchange Commission.

Insurers are also able to charge less by selling these annuities through fee-only advisors, rather than commission-based insurance agents. "We don't have to worry about paying commissions. That re-engineers the whole value proposition," says Jefferson National CEO Mitchell Caplan.

The low cost and availability of alternative investments has reignited advisor interest. Joe Spada, a financial advisor at Summit Financial Resources in Parsippany, N.J., says that after his wealthy clients have maxed out their other tax-deferred options, such as 401(k)s and IRAs, he advises them to put their most tax-inefficient investments in a low-cost variable annuity.

His current choice is Jefferson National's Monument Advisor variable annuity -- "because it's the lowest-cost one with lots of alternatives and traditional investments," says Spada, who has invested $1.5 million of his own money in the annuity. He says he tries to ensure that most investments throwing off short-term capital gains -- which are taxed at a total of 43.4% under this year's higher tax rates -- are sheltered. The contract charges investors a simple fee of $20 a month. On the average $230,000 contract, that translates to 0.11% a year. On Spada's $1.5 million, the fee is 0.02% a year.

The stripped-down, low-cost annuities are a bright spot in an industry still burdened by difficult market conditions. A notable change in this year's list of top-50 annuity contracts is that guaranteed payouts are somewhat lower than last year. Last year, for example, a 60-year-old man could put $200,000 into an immediate annuity and expect a lifetime monthly income from Pacific Life of $1,037.11 to begin right away. Now, the best contract would be from North American Life, paying $1,009.74 a month; Pacific Life's payments have dropped to $987.62 a month. Over 25 years, that adds up to $296,286, or $14,847 less than it would have been a year ago.

Insurers have lowered payouts under considerable pressure from a prolonged period of low interest rates, which make both new and existing contracts more expensive to manage. Insurers hedge the risk of their guarantees using interest-rate swaps, but this gets more expensive when interest rates are low. Since 2008, hedging costs have more than doubled, according to Milliman Financial Risk Management, a Seattle-based firm that performs risk analyses. And many insurers are still burdened by the rich lifetime-income guarantees they sold prior to 2008.

For example, MetLife, the third-biggest seller of annuities, has set capacity limits on its variable annuities to reduce sales and thereby scale back its interest-rate exposure. Earlier this year, the firm announced it was lowering the rate on its withdrawal benefit -- the amount investors can withdraw even if account values decline -- for the second time, to 4% of assets. The average rate is 4.5%, down from 5.5% a couple of years ago, according to Morningstar.

Some firms have also tampered with existing contracts. In March, AXA Equitable sent notices to investors saying it will replace certain actively managed stock funds with funds that allow the firm to change the underlying investments to avoid volatile returns.

THE DOMINANCE OF VARIABLE ANNUITIES is gradually being eroded by several variations of fixed-type annuities, all of which are included in Barron's top 50: fixed index annuities, which offer guaranteed payouts, plus the potential to participate in stock index performances; deferred-income annuities, which require upfront lump sums to guarantee specified income streams years or decades down the road; and immediate annuities, which turn lump sums into income streams right away.

As insurers have been tightening or eliminating income guarantees on variable annuities, they've been adding income benefits to their fixed index annuities, and investors are snapping them up. Even as overall annuity sales declined last year, fixed-index-annuity sales increased by 3.7% and hit a record $34.2 billion, according to Beacon Research, an Evanston, Ill., firm that tracks annuity sales.

Though almost unheard of five years ago, now 60% of fixed index annuities are sold with living benefit riders.

Douglas Wolff, president of Security Benefit, says insurance companies have an easier time containing costs and limiting the risk of income guarantees in a fixed index annuity than in a variable annuity. "Variable annuities with an income benefit are trying to hedge against longevity risk and equity-volatility risk, and that ends up being expensive," Wolff says. "With fixed index annuities, you don't have the equity-market risk, just longevity risk, which is easier to hedge, and can translate into a better benefit."

With fixed index annuities, insurers buy bonds and options on the index the annuity is pegged to. If the options do well, investors enjoy some of the index's upside. If not, the options expire with no impact.

The costs are partly embedded in caps on index participation. Caps are currently around 4%, down from 6% just a couple of years ago, meaning that even if the index has a double-digit return, your gain will be 4%.

Two factors are driving down cap rates -- low interest rates, which increase hedging costs, and the cost of options. "When stock-market volatility goes up, the option costs used to support many fixed index annuities go up, and higher caps become more expensive to support," says Matthew Gray, vice president of market management and product innovation for Allianz Life. Of the biggest index annuities providers, Allianz is one of the few that market contracts with guaranteed incomes that increase annually to keep up with inflation.

The best comparison for fixed index annuities, however, is not the stock market, but other fixedincome products. "When you consider five-year CD rates are paying around 1%, to have the ability to not lose money in an index annuity and potentially get 4% is value added," says Dan Guilbert, an executive vice president in Symetra's retirement group.

A NEW SEGMENT OF THE MARKET is giving fixed index and variable annuities with income guarantees some competition. Deferred-income annuities, sometimes known as longevity insurance, are funded immediately to set up a guaranteed annual income later in life.

A year ago, only a few companies, including New York Life, Symetra, and MetLife offered these. Since then, Western & Southern, MassMutual, ING, and Protective have jumped into the market. New York Life has some of the highest payouts, and is competing directly with the living-benefit riders sold with other kinds of annuities. "Our deferred-income annuities are guaranteeing 40% more income than the average variable-annuity income rider," says Matt Grove, a senior managing director at New York Life.

"In a variable annuity the insurer doesn't know when the investor will start taking income, so they have to take that uncertainty into account," Grove says. With these fixed products, an investors' income stream is set to begin on a specific date, allowing the insurer to invest more effectively in higher-return investments to support the guarantees.

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