Annuity Riders

Here we go again.  Several insurers are poised to enhance their variable annuity product offerings in their May filings with the SEC.  This list includes: Transamerica, Lincoln, John Hancock, and Metlife.  

But as opposed to the 2007 “Arms Race” where insurers competed on generous features, with less caution for a doomsday scenario (e.g. 2008), these products will be a combination of innovation while factoring in the lessons learned - a smarter bread of variable annuities.  

For example, I expect these products to limit the damage that can be done to a policyholder’s account value in a bad scenario, hence limiting the amount of claims that the insurer will pay out to cover the difference.  This in turn reduces the rider fee charged to the policyholder.

There’s a number of ways this can be done and I expect to see several variations:

• Charging a rider fee based on the portfolio allocation to equities vs bonds.  For example, a portfolio with 60% in equities would be cheaper than a portfolio with 70% equities.  The good: choice for the consumer - you pay for what you want & need.  Also, a bit more transparent than other options.  The bad:  This approach is more risky for the insurer, as they are more concerned with the fund’s volatility than just equity allocation.
• Dynamic Asset allocation: Prudential has been successful with this approach, and I wouldn’t be surprised to see more companies offering something similar.  With this technique, you have an asset allocation when the market is calm: say 70% equity / 30% bonds.  But when the market starts heading south, your allocation becomes more conservative in an attempt to weather the storm.  So in a 2008 scenario, your allocation may reduce to 30% equity and the rest bonds.  The good: you expect to lose less money in down markets than staying in equities.  The bad:  you may miss out on some of the gains when the market turns around because this strategy reacts to the market.  Also less control to the investor.
• Adding derivatives inside a fund.  This fairly new technique is meant to limit the volatility inside the fund itself.  Instead of investing in say the S&P500 index, this type of fund holds, a combination of the index and short futures or option positions.  I won’t go into further detail here, but the idea is that when markets go down, the derivatives offset some of the losses.  But when the market goes up, the the derivatives (or fees) offset some of the gains.  So the net result to the the investor is less volatility in returns, which means both your gains and losses will be reduced.  The good:  allows for a cheaper rider.  The bad: limits the upside and less transparency.

By utilizing one of these strategies, insurers will be able to either reduce the cost of the guarantee or enhance some of the features.  At a macro level, insurers will have a better handle on the risk they are taking, which means stronger financial strength. 

If you’re considering a variable annuity, it’s worth waiting until May to get a look at these new products.  And be sure to take a look at their financial strength (I recommend Weiss).  I would also consider diversifying your investment to more than one annuity company.