The popularity of exchange-traded funds seems to know no bounds, and lately they’ve been increasingly finding their way into variable annuities (VA). But VA sales have been sluggish in recent years, leaving some observers to wonder if the inclusion of ETFs can save the flagging VA market.

“More insurers are offering ETF-based subaccounts for variable annuities,” says Adam Schenck, a principal and managing director in the portfolio management group of Milliman Financial Risk Management in Chicago. “Data from Morningstar indicate that the number of ETF-based subaccounts has doubled in the last five years.” (That data is based on some 1,900 VA subaccounts in Morningstar’s database that contain “ETF” in their name.)

In May, Boston-based researcher Cerulli Associates, along with the Washington, D.C.-based Insured Retirement Institute, surveyed insurers and found that more than half cited ETFs as a vehicle with high growth potential over the next three years.

VAs hold client assets in mutual-fund-like subaccounts. In recent years, sales have slumped as markets keep hitting new highs. That’s partly because VA stakeholders receive only a portion of market upturns, as well as downside protection—a prospect that becomes less appealing when market volatility is low. More recently, the U.S. Department of Labor’s fiduciary ruling has put a damper on sales by requiring full disclosure of fees and a “best interest contract” to ensure that clients understand exactly what they’re getting and what they’re paying for.

“VA sales have been impacted adversely following the announcement of the DOL’s fiduciary rule, so it is difficult to know precisely how the increased offering of ETF-based subaccounts is affecting VA sales,” says Schenck.

Nonetheless, industry watchers attest that a growing number of annuity providers are adding ETFs to their menu of VA subaccounts. “I’m seeing ETFs used more frequently in VAs,” says Wade Pfau, professor of retirement income at the American College of Financial Services in Bryn Mawr, Pa.

Dan Herr, vice president of annuity solutions for Radnor, Pa.-based insurance and annuity provider Lincoln Financial Group, says Lincoln has been expanding its range of ETF-based subaccounts for VAs for several years.

“Lincoln currently has 15 funds with over $2 billion in assets ranging from a 40% to 100% allocation to ETFs,” says Herr, who is based in Hartford, Conn.

The company’s latest offering, launched in February 2017, is a fee-based VA developed in partnership with BlackRock, the New York-based asset management firm. Called “Lincoln Core Income, built with iShares,” it is designed to meet the current demand for both fee-based asset management and low-cost passive investing.

“The increasing use of ETF-based subaccounts for variable annuities is helping advisors and clients by offering more choice, and in some instances reducing costs,” says Herr.

Lincoln is far from the only player to get in on the game. ETFs in VA subaccounts dates back at least to December 2010, when Western & Southern Financial Group released a series of VAs that offered 18 different ETFs from Vanguard and BlackRock’s iShares. “We were the first to offer a VA with individual ETFs, rather than a fund of funds, as investment options,” says Sheila Veits Berding, a spokesperson for the Cincinnati-based diversified financial-services provider.

And Charles Schwab’s VAs now invest primarily in ETFs, says Schwab spokesperson Alison Wertheim.

Different Flavors
It’s not surprising, perhaps, that the recent popularity of ETFs has fueled their growing presence in the VA world. “As advisors have increased their usage of ETFs outside of annuities, many have chosen to adopt a similar investment process within their annuity assets,” observes Herr.

And there are certain advantages that come with doing that. “Offering an ETF option within a variable annuity allows advisors and clients to receive some of the income guarantees, death benefits and tax deferral benefits [of VAs] that are not available outside of an annuity,” says Herr.

Another advantage: Within a variable annuity, advisors can have a manager allocate among ETFs and tactically adjust the tilts based on market sentiment, Herr explains. “This is a tremendous advantage and option offered by a variable annuity—providing expert allocation without the tax impact.”

But keep in mind that not all VAs with ETFs in them are alike. Some have a mix of ETFs and non-ETF investments, some have all equity ETFs, some have all fixed income. Some are all domestic or all international. Some even offer a choice between active and passive management.

And while some VAs invest directly in ETFs, many others use funds of ETFs. “For a variety of technical and operational reasons, as well as IRS restrictions, most VAs available to the broader market do not offer individual ETFs but instead offer funds of ETFs,” explains Laurence P. Greenberg, president of Jefferson National, now part of Nationwide’s advisory solutions business, in Louisville, Ky.

Key Differences
Advisors should recognize some key differences between traditional ETF investments and ETFs within VAs. For example, unlike stand-alone ETFs, these funds of ETFs are typically priced just once a day, like other mutual funds. This fact alone, says Greenberg, “undercuts some of the most attractive features of ETFs—eliminating intraday trading, eliminating the ability to select the underlying ETFs and increasing the cost.”

Nevertheless, he adds, the use of these funds of ETFs within VAs will likely increase. “To satisfy advisors’ and investors’ demands for lower cost and greater transparency, insurers will continue to offer this type of investment option, especially while the demand for ETFs continues to outpace the demand for mutual funds,” says Greenberg.

One example of an ETF-based fund of funds is The Optimized Portfolio System (TOPS), which produces risk-based funds of funds using ETFs from different issuers. TOPS portfolios in retail VAs represented more than $2.6 billion at the end of last year, according to Cerulli.

Akron, Ohio-based ValMark Advisers Inc. is the advisor to the TOPS ETF portfolios. “We have a whole business division that is built around the idea of ETFs in VAs and have created ready-made subaccount options to put into these products,” says Lawrence J. Rybka, president and CEO of ValMark Financial Group.

That doesn’t necessarily mean the sky’s the limit, however. Michael McClary, chief investment officer at ValMark Advisers, notes, “Other ETF managers look at our success and feel like the insurance space is begging for ETFs, which is not the case.”

Growth opportunities for ETFs in insurance products may be limited, he contends. “You have to understand the insurance space and have a competitive advantage,” says McClary. “I believe there is little opportunity for new entrants.”

Those who succeed, he posits, will be “providers who have had the foresight to be in the space for years and have a competitive advantage.”

Perhaps, but many industry participants feel that the increased use of exchange-traded funds in variable annuities will ultimately benefit all concerned. “We view the proliferation of ETFs to be a positive for the annuity industry,” says Schenck from Milliman. “They offer subaccount managers flexible and risk-efficient investment vehicles while also potentially helping to reduce the costs of owning a VA and, by extension, potentially helping advisors meet their fiduciary duties.”

Regarding costs, in late May 2017 Morningstar compared Lincoln iShares ETF portfolios with Morningstar’s overall roster of VA subaccounts that are open to new assets. The ETF subaccount fees were less than 0.29%, while the average annual expense ratio for other subaccounts was 0.76%. (Note that additional fees apply to cover death benefits and riders.)

To Schenck, this is also a positive for ETFs in general. “To the extent that ETF-based subaccounts represent additional ETF market participants,” he says, “they are beneficial to the ETF ecosystem, contributing to greater liquidity and price discovery.”

Given all these positives, Schenck is optimistic about the future of VAs with exchange-traded funds in them. “ETF usage inside VAs will continue to grow,” he predicts. “ETF sponsors will bring more products to market that are designed specifically to address the needs and risks specific to VA guarantees.”

Ben Mattlin, a frequent contributor to Financial Advisor magazine, is based in Los Angeles. His new book, In Sickness and In Health, will be out in January from Beacon Press.