Riding out the perfect storm

The variable annuity market is undergoing a tough time at present. J Penney Frohling asks, 'Where can these products go next?'

On 8 May, the Hartford shut its doors for business, officially exiting the UK four years after setting up shop. The move is a dramatic about face for arguably the most vocal advocate of variable annuities in the UK, hoisted on their own petard by the cost of unhedged guarantees.

The Hartford's withdrawal from the UK life and pensions market provides a good opportunity to rebase expectations around a product that in theory is appealing but that in practice has not been attracting the volume of assets that everyone had expected. Too few IFAs are prepared to recommend variable annuities to their customers; and too few consumers are prepared to choose one over a more mainstream annuity or drawdown product from a well known brand. A doubling of premiums sold from 2007-2008, from £539 million to £1,150 million, does show building momentum. However, concerns over guarantees and further additional exits could put a halt to this momentum over the short-term.

There are multiple variable annuity products currently on offer in the UK, all of them launched within the past 24 months and citing the same 'self evident truths' as proof of a large and growing market for their products: £150 billion+ in pension funds moving into decumulation over the next ten years; longer life expectancies; increased asset flows into unit linked products; larger pools of affluent and high net worth wealth (although these pools have shrunk over the past year). These self-evident truths, however, apply to the entire post retirement space. Variable annuities (VAs) fill a gap between two dominant categories - annuities, 85% of the market, and income drawdown, 15% of the market. VAs offer a combination of guaranteed income, capital appreciation, control, and death benefits that are unique in the market. However, these benefits come at a high cost and with a complexity, with result that they can compare unfavourably to annuities and income drawdown when you look at everything in aggregate.

The result is a product category that appears to be over-supplied and whose market potential - the most frequently quoted projection is up to £70 billion in assets by 2016 - may be over-stated by a considerable margin. We estimate that variable annuities could capture up to £4-7 billion of flow in new premiums by 2012, an approximate 'best case' 10-20% share of assets moving into decumulation that year (acknowledging that premiums will not come exclusively from the decumulation space). Our benchmark is the flow captured by asset backed annuities, £600 million in 2007, a category dominated by the Prudential with 80% share of the category. These projections may be quite optimistic given the significant barriers that variable annuities need to break down to stimulate consumer demand and IFA sales. However, Hartford's exit and the decision by several household names to postpone their VA launches give providers the opportunity to take stock of their current strategy.

In the course of the past year, we have done extensive work in the post-retirement space for a variety of players that has given us some insight into why variable annuities have not yet attracted the volumes that everyone anticipated:

- Upfront income is on average 30% lower than other annuities. No matter how rational the argument about longevity and inflation risk, the consumer's primary purchase consideration is income now - and as much as possible. Variable annuities on average provide less than 70% of the starting income of a conventional or asset backed annuity. This range is moderately less than a conventional with 3% RPI. RPIs continue to capture on average only a small percentage of the annuity market and have a far simpler product proposition than a variable annuity.

- Life-time income is up to 35% lower. Basic modelling shows that income provided by variable annuities is in the same range as that of a conventional annuity, but 15-35% below that of the top with-profits and unit-linked annuity players, who provide a similar value proposition in terms of principal security and upside at a lower cost, although they don't provide death benefits. This is a classic situation where costs eat into investment returns, with performance not high enough, and highly unlikely to ever be high enough, to compensate.

- Guarantees are too expensive. The cost of guarantees has priced variable annuities out of the market. Suppliers cannot provide them cheaply, particularly in this market environment. There is talk about potentially taking prices up, as major providers have done in the US. Our calculations show fees ranging from £15,000-45,000 over the lifetime of a variable annuity contract. Compare this to the £2,000 paid for a conventional annuity or £6,000 charge for Pru's with-profits annuity. It takes an extremely risk averse customer to pay this much money for principal security (and perhaps death benefits, a feature which is not trivial). How many people like this are there? IFAs are severely challenged to justify to a client what they are getting for this extra expense, particularly in the context of points one and two above. The potential compliance risk is too high, and there are better known products that are easier to explain.

- They do not fit easily with existing panel criteria. Although the majority of variable annuities are categorised as 'drawdown with guarantees,' they are a new product category that require entirely new panel criteria to be created. Demand has been insufficient to warrant this, which means that IFAs have to do ad hoc research on a product by product basis for those select few clients for whom a VA might be an option. This is time consuming, particularly given the number of options and underlying funds. For advisers, time is money.

- Advisers cannot compare variable annuities easily. Lack of comparability makes it difficult to claim that VAs are a category in their own right. The number of permutations offered within each product creates excessive complexity and makes it almost impossible for IFAs to compare one variable annuity with another. This does not fit with the typical advice process, in which a fact find will point to a particular product category to fulfil a set of needs and risk profile - SIPP, drawdown, conventional annuity, enhanced annuity - and then a drill down comparing different product providers. Variable annuity providers might consider replicating the approach taken by the leaders in the enhanced annuity sector in creating some type of standardisation to address this issue.

- Identifying the target market requires precision instruments. In the US, variable annuities are sold primarily to affluent and high net worth individuals (investable assets of $500k+) as a component of a broader asset allocation strategy. The compulsory purchase annuity regulations here in the UK create positioning challenges. Recent statistics published by Watson Wyatt show that 30% of variable annuities sold last year had premiums less than £75,000, with 40% of policies sold to individuals under 60. They drew the conclusion from this data that variable annuities could actually be more 'mainstream' than envisaged. Another conclusion from this data is that more affluent clients are using variable annuities in a way very similar to their US counterparts, as one product in a much bigger portfolio. A key question to ask is, 'Where are you putting the rest of your assets and what are they worth?'. The typical fifty year old mass market consumer has a pension pot of only £50,000 - which basically puts them out of the running for a VA. The mass affluent and affluent, with pot sizes of £120,000 and £170,000 respectively, have a bit more potential as targets, but there is significant work to do to overcome income/fee/complexity challenges. Variable annuities may achieve faster lift-off as part of a SIPP /drawdown wrapper that enables them to be part of a broader accumulation/decumulation solution. While several products currently on the market do just that, they encounter concerns about complexity and 'eggs all in one basket'. Given the market downturn, the combination of guarantees and capital appreciation will be very appealing to consumers of a certain risk, age, income, and wealth profile. The key is to pinpoint which ones.

Current market volatility and low interest rates have created a perfect storm for variable annuity propositions. We may see more players withdraw their offers from the market. Those that are prepared to tough it out need to cast a critical eye on their business cases, hedging techniques, product propositions, and distribution strategies in order to address what for many are significant barriers to trial. The benefits of a variable annuity remain very real - control over one's assets, flexibility in terms of investment choice, guaranteed income, the potential for upside. However, significant work remains to translate the promise of variable annuities into reality.