Bushís proposed tax law could force major changes in their strategies.

When it comes to winning the hearts and minds of independent financial advisors, variable annuities seem to be in a never-ending uphill battle. Many advisors don't trust them, while others see only limited uses for them.

Now the variable annuity business is approaching its own High Noon. For years, marketers of these hybrid vehicles have stressed the benefits of tax deferral, often ignoring other more salient features for potential clients. If enacted, the new Bush tax law, with its potpourri of retirement savings alternatives, will render the tax deferral advantage of variable annuities almost moot, since investors will have other choices when it comes to tax-deferred investments.

To continue to enjoy the growth they have experienced in the past decade, annuity marketers will have to stress other features, such as the benefits of annuitization and minimum-income guarantees. Until now, they have opted to de-emphasize these benefits, reasoning that tax deferral held more appeal to potential investors.

Other challenges abound as well. The SEC and NASD also have stepped up enforcement of inappropriate variable annuity sales, often involving elderly people and others who may not be aware of the fees and illiquid nature of the products. The SEC, for example, issued an investor alert in 2000 that warned of high fees associated variable annuities. John Newcomer, managing partner of the law firm James, Hoyer, Newcomer & Smiljanich in Tampa Bay, Fla., says his firm frequently represents elderly clients in cases involving deceptive variable annuity sales.

"The typical cases we are handling are individuals who are well into their retirement years and have taken their entire nest egg, excluding their home, and thrown it into a variable annuity," he says.

The bad publicity, however, didn't stop variable annuity sales from climbing through the 1990s, finally dropping off at about the same time the equity markets collapsed. From 1991 to 2000, variable annuity sales went from $17.3 billion to $137 billion before dropping to $112.8 billion in 2001, according to the National Association for Variable Annuities (NAVA).

Through the first three quarters of 2002, variable annuity sales were down about 1.5%, according to NAVA. The longest bull market in U.S. history was one reason the products became more attractive. But other changes in the marketplace also enabled variable annuities to pick up some fans-in particular, the introduction of guaranteed minimum living- and death-benefit features that guarantee customers a return of not only their principal, but up to 6% annual interest on their money.

"Over that period of time, the benefit was improved dramatically," says Bob Cassato, president of Manulife Wood Logan Inc. In fact, advisors who do indeed make use of variable annuities for some clients will often say it's the guaranteed minimum benefits that they see as the primary attraction.

But now there's a new rub to these benefits: They may be diminished. Chalk it up as another ripple effect of the three-year slide in the stock market. Not all insurers, it turns out, backed up these enhanced minimum guarantees with adequate reserves or reinsurance. Financial problems at issuers such as Conseco and Allmerica Financial have underscored the concerns.

"Every day, the industry makes payouts on death benefits that are higher than account value," says Cassato. As a result, he and others in the industry expect the new trend will be lower guaranteed minimum-benefit levels, with added basis points attached to the features. The 6% guarantees on principal that are now common may disappear in favor of 4%. "I think we're going to see them continue to be a cornerstone; however, I think that they are going to be more expensive."

How that influences the decision-making of cost-conscious financial advisors remains to be seen. As it stands now, however, some advisors view guaranteed minimum benefit features as a useful tool for risk-averse clients.

Herb Daroff of Baystate Financial Planning in Boston says variable annuities were never a part of his practice until about 1999, with the introduction of several riders that he felt represented a major shift in the industry. The most important new feature, he says, was the guaranteed minimum-income rider. These riders typically allow annuity customers to choose one of three values when they retire: a 6% annual return on principal, current market value or the highest anniversary value of the account.

The cost? Daroff says expenses are currently running from 25 to 110 basis points, with the price largely depending on the funds used in the variable annuity's subaccounts. "So much of the literature for so long has basically said these things are carcinogens," Daroff says. "They're more like an aspirin. Not a miracle drug, but a tool that, when properly used and tuned in a client's situation, we're finding to be very, very effective."

Among the clients he's used them for is one he describes as a "recovering seven"-a man who, before the market collapse, ranked his risk tolerance as a seven on a scale of one to ten. After suffering double-digit losses managing his investments on his own, he now rates himself a three. This client, Daroff says, viewed variable annuities, and their associated expenses, as a tradeoff for downside protection and a 6% minimum guaranteed benefit.

In another case, a woman wanted to diversify her portfolio with the inclusion of international and small-cap growth funds. "But she was petrified of losing it," Daroff says. He addressed her concern by putting her into a variable annuity just for the small-cap growth and international portions of her portfolio.

Another new feature that has had a major impact is the estate protection rider, Daroff says. Designed to address variable annuities' lack of step-up in basis upon death, these riders essentially pay the income tax on a death benefit by increasing the underlying annuity 40% to 50% upon death.

Jim Barnash, vice president of Lincoln Financial Advisors in Chicago, says other types of clients who might benefit from variable annuities are those who have maxed out their qualified plan options and are looking for additional tax-deferred savings. Also benefiting might be someone who is getting money from a pension or minimum required distribution and wants a tax-deferral vehicle.

"Like Kodak film or any other type of product out there, they all have their uses in certain situations," Barnash says. "It's whether they are used appropriately or not that makes the difference."

Barnash does expect, however, that advisors are going to have to get used to more plain-vanilla annuities-largely as a result of issuers who were overly aggressive with their guaranteed minimum riders without figuring in the possibility of a prolonged market downturn. "I'm pretty much seeing that they're stepping back and pulling some of these aggressive features," he says. President Bush's proposal to eliminate the dividend tax also could lessen the need for variable annuities in some cases, he notes.

Todd Bauerle of Bauerle Financial Inc. in Deland, Fla., says variable annuities can be a good way to save clients-or their families-from excessive spending. Variable annuities often have surrender charges that can be as high as 10%, and they can be a good fit for clients who have problems controlling spending, he says. "If I have a client who I think is a spendthrift, it could make sense to put them in something that would be difficult for them to come out of," he says.

Perhaps the best use for annuities, he notes, is creditor protection for high-profile clients or those in litigious professions. But protection from creditors varies from state to state. In some states, including Florida, variable annuities are exempt from being tapped to pay court judgments.

In most cases, however, Bauerle says he considers the expenses and restrictions of variable annuities unsuitable for clients. If he puts a client into a variable annuity, in most cases it's because he's moving them out of another annuity that he considers too expensive.

Such tax-free exchanges, allowed by Section 1035 of the Internal Revenue Code, sometimes require a client to cough up a surrender charge but are still worthwhile, he says. "I had a man come in here a year ago who had all his money, $900,000, in five variable annuities," he says.

"He did it all at one time with one agent." Bauerle was able to take most of those assets and put them into a TIAA-CREF annuity with an expense ratio of about 30 basis points, compared with an average of 160 basis points on his original annuities. "If you have to stay in an annuity, the lower you can get those expenses, the better off you are," he says.

So many independent fee-only advisors are involved in Section 1035 exchanges that some issuers are trying to cultivate this segment of the market. Ameritas Life Insurance Corp., for example, offers a no-load variable annuity, which carries no surrender charges, with an expense ratio of about 0.55%. That's slightly less than half the industry's average mortality and expense charge, says Patty Reiners, manager of Ameritas Direct Advisor Services. The annuity, available since 1997, has doubled in assets during the past year-largely due to its use in Section 1035 transfers.

Another use for the no-load annuity, she says, is in cases in which investors have no further use for the death-benefit protection of a life insurance policy. This is particularly true in cases where the policy's cash value is worth less than its cost basis, she notes. She cited the example of someone who has put $50,000 into a universal life policy that has a cash surrender value of $10,000. The $10,000 may be transferred to a variable annuity under Section 1035, and another $40,000 in future earnings-representing the balance of the cost basis-would be tax sheltered. The one drawback to such an exchange, she noted, is that death benefits pass on to beneficiaries tax-free, while the value of the annuity would be subject to income taxes upon death.