Variable annuities are on the comeback trail now that the stock market is performing better.

Third quarter 2010 sales totaled $35 billion, up 9 percent versus third quarter 2009, according to LIMRA. But they are still down about 20 percent from pre-crisis second quarter 2008 sales.

“Sales stayed at depressed levels of around $30 billion per quarter throughout 2009 and are only slowly recovering,” says Frank O’Connor, Morningstar Inc.’s director of insurance solutions. “The VA is a bull market product.”

One of the most popular variable annuity features is the guaranteed lifetime withdrawal benefit. No matter how the underlying investments perform, policyholders typically are guaranteed at least 5 percent of their benefit base in income annually for as long as they live. Eighty-seven percent of those who buy variable annuities elect this rider, LIMRA says.

“From my perspective, variable annuity sales are definitely picking up,” says Kenneth P. Mungan, actuary with Milliman, a Chicago-based actuarial firm. “Customers are clearly attracted to the guaranteed living benefits, and I expect that trend to only increase over time.”

A May 2010 survey by Allianz Life Insurance Co. of North America conducted by Larson Research and DSS Research, found that the majority of the 3,200 respondents prefer a product with a 4 percent income guarantee over a mutual fund expected to return 8 percent.

Some carriers are doing better than others at attracting investors in this precarious financial environment. O’Connor says firms such as Hartford and Allianz backed off from the variable annuity market to re-tool and simplify their products. Other companies, such as Prudential and Jackson National, have seen very robust sales growth. In general, those companies that came closest to preserving pre-crisis benefit designs grabbed significant market share, O’Connor says.

During the 2008 financial crisis, the guaranteed lifetime withdrawal benefits were aggressively priced at an average of just 60 basis points. The average variable annuity domestic stock funds dropped nearly 50 percent, while policyholders with 50-50 stock-bond mix in a variable annuity lost only about 20 percent, according to Morningstar. During the bear market, that cost seemed well worth the expense, considering that a policyholder knew he or she could get at least 5 percent annually in guaranteed income.

In the wake of the financial crisis, insurers charged more for the principal guarantee. Some insurers have reduced benefits and limited the percentage of assets than can be invested in stocks.

“It varies as there has been a mix of cutting the `richness’ of the benefits (i.e. lower withdrawal percentage or roll-up rates) vs. increasing costs,” O’Connor says.

There was about an 11 percent increase in average lifetime guaranteed minimum withdrawal benefit expenses between the time Morningstar first started tracking them in the first quarter of 2009 and the second quarter of 2010, he says. Those expenses rose from 0.882 percent to 0.978 percent.

Total annual costs for a variable annuity can reach more than 300 basis points, including mortality and expense charges, fund management fees, and living and enhanced death benefit riders.

Pricing, however, may be stabilizing due improving economic conditions. During the third quarter of 2010, variable annuity providers continued to roll out new annuity products and living benefits. They also changed features and pricing on existing products, but at a slower pace than in prior quarters.

Hartford and RiverSource introduced new variable annuities during the third quarter of 2010, while MetLife, RiverSource and Transamerica introduced new living benefits, says Gerry Murtagh, product manager at Ernst & Young. Companies such as Integrity, John Hancock, Nationwide, Pacific Life, Penn Mutual, and Sun Life, filed prospectuses during the third quarter for new products or living benefits they expect to introduce later in 2010.

“Companies pulled back on their riders and features immediately after the crash in November 2008,” Murtagh says. “But in the past nine months, they’ve been coming out with new living benefits and variable annuities.”

In the future, new products are likely to be simpler, but have longer waiting periods before the guaranteed living benefits kick in, according to Milliman. Advisors might come across products that have deductibles on living benefits. There also may be caps on the guaranteed percentage of the benefit base that can be paid out to policyholders.

O’Connor of Morningstar remains skeptical of the appeal of living benefits to financial advisors. Many still view the product as a high cost, illiquid tax-deferred accumulation product tied to the stock market. Currently, 46 percent of variable annuities are sold by independent broker-dealers, according to Annuity Intelligence, which Morningstar recently acquired. Regional broker-dealers and wirehouses account for just 20 percent of sales.

“I think living benefits are only slowly gaining more credibility with advisors that have not historically sold (variable annuity) products,” O’Connor says.

Milliman’s Mungan says that there are no statistics on cash claim payouts for variable annuity principal guarantees. The reason: Most guaranteed living benefits pay out over a 10-to- 20-year period. Claim payments are still well in the future. However, insurers must hold reserves for future claim payments as soon as the policy has been sold.

A Milliman analysis showed that variable annuity hedging programs were 93 percent to 94 perent effective in achieving their goals during the financial crisis. Variable annuity hedging programs helped stabilize the life insurance industry during a period of unprecedented financial turbulence. As a result of this performance, insurers have expanded their use of hedging in the management of variable annuities.

“VA's performed very well during the crisis from several different perspectives,” Mungan says. “Customers clearly benefited from the peace-of-mind provided by the guarantees. Insurers who hedged the market exposure associated with their variable annuity guarantees did very well. As a result of the financial crisis experience, the industry has now accepted that a comprehensive hedging program is a requirement to manufacture variable annuities.”