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Why It's Time for Variable Annuities to Change

Philip Moeller

Variable annuities, often called mutual funds with an insurance wrapper, are going through some tough times. The products have been a salesman's dream. They pay high sales commissions and have lots of sexy (in financial terms, that is) bells and whistles that can be pitched to consumers. Because annuity gains are not taxed until withdrawn, they appeal to tax-averse investors, a group that should pretty much include all investors.

Along with those high commissions and cool product features, however, also came high fees and steep penalties for investors who wanted to get out of their variable annuity (VA) contracts before periods as long as seven years. Products became hard to sell so the industry began offering inducements to get consumers to keep buying and funding those high commissions and management fees. The main carrots here were performance guarantees and minimum payout promises, and the promises escalated into an arms race between competing insurers.

Such promises seemed easy to honor in the pre-crash days before the recession hit and market values plunged. That period has been followed by years of extraordinarily low interest rates, supported by Federal Reserve policies. Low interest rates make it very hard for insurance companies to lock in decent yields on safe investments and nearly guaranteed that many of their payment promises on variable annuities would turn into money-losing propositions. Some of the best-known companies in the industry were forced to run away from their VA businesses and even cut their losses by trying to buy out contracts with those costly performance guarantees.

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With all due respect, these problems are music to the ears of Larry Greenberg, president of Jefferson National, a tiny life insurance company based in Louisville, Ky. Since 2005, the company has been peddling a different kind of variable annuities. Jefferson National's primary focus is signing up fee-based investment advisers to sell what are essentially no-load VAs.

Fee-based advisers earn their money by charging fees to clients, not by earning commissions from insurers and other investment firms for selling their products. Jefferson National has built a very inexpensive VA platform that offers advisers online access to the VAs they have bought for clients, permitting them to manage a VA's fund holdings and tailor the client's portfolio much like they would do with mutual funds.

VAs typically offer 30 to 40 fund choices, Greenberg says, and many of these funds are proprietary to the insurer. Jefferson National offers 400 funds so that advisers can build holdings within their clients' VAs that reflect very tailored portfolio objectives. But the biggest difference in Greenberg's product is its very low fees. First off, he doesn't have an army of salesmen on commissions, so his selling expenses are relatively low.

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In terms of fees, the largest VA expense component is the insurer's "M&E" charge, which covers the mortality or life insurance component of the VA contract plus the expenses of managing the funds within the contract. "On average, across all variable annuities, that's about 130 basis points [1.3 percent of the VAs assets]," he says, "and it's a charge that must be paid every year."

VAs also may levy a smaller annual charge for administrative expenses. There is also a charge for the costs of those appealing product guarantees. They vary broadly but according to industry reports, average about 100 basis points a year.

"We charge a flat fee of $20 a month" for all M&E charges, he says. "It's the same whether you put in $200,000 or $2 million. We have no administrative fees. Our average VA account balance is about $240,000, so that works out to about 10 basis points."

Lastly, Greenberg thinks performance guarantees are way overblown as a needed safety feature, so his VAs don't include them. When the math is all done, a mainstream VA might cost its owner 200 to 250 basis points a year, or about 10 times what Jefferson National charges.

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Beyond these low fees, Greenberg says, his VAs have returned to emphasizing the traditional tax benefits of a VA--its tax-free build-up of investment gains. Investors who own mutual funds in taxable brokerage accounts must pay taxes every year on their mutual fund gains. The Jefferson National product can permit advisers to build nearly identical portfolios using VAs, and avoid all taxes until the VA is annuitized and retirement funds are withdrawn.

These withdrawals need not happen for a long time. Investors who do not need VA funds withdrawn to support their retirement income needs may use their ongoing tax deferrals as an estate preservation strategy.

If Jefferson National has a better mousetrap here, Greenberg openly admits it's a very small one. "It's a shadow of the large, traditional market," he says. The company's no-load VAs total about $1.3 billion in assets under management, he says, spread across roughly 6,000 client VAs. In 2011, industry-wide VA assets were more than $1.5 trillion.

Pointing to the growth of fee-based advisers, however, Greenberg says demand for no-load VAs is growing strongly. Further, the overall appeal of VAs as a tax-deferred investment will grow if, as expected, Congress increases taxes to help reduce federal deficits.

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