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Time for More ETF-Based VAs

ETFs could help solve the high costs that dog variable annuities.

Scott Burns, 01/27/2010

At the recent Inside ETFs Conference in Boca Raton, Fla., I had the pleasure of serving on the "Choosing Between ETFs: What to Look for Beyond Performance" panel. Moderator Matt Hougan, editor of  IndexUniverse.com, did a great job setting the stage for the discussion, and we almost immediately jumped into questions and answers from the audience. While we had a lot of questions that pertained to ETF selection and dealing with some of the nuts and bolts of transacting ETFs, there was one question that came out of left field that really piqued my attention and stayed with me during the next few days.

The question was: "Do you see ETFs moving into variable annuity products?" I am by no means a variable annuity expert, but that didn't stop me from cracking a joke, saying, "From what I understand about variable annuities, keeping costs low isn't really a priority." Fellow panelist Stephen Cook from Bank of New York Mellon was quick to correct me that there was uptick in VAs using ETFs.

This all piqued my interest to investigate further. As of September 2009 there was $1.3 trillion in assets under management in VAs (according to the Morningstar VA Database). Given the controversy that surrounds these tax-efficient (for the rich) but generally expensive products, using ETFs sounds like a match made in heaven where providers and investors can both win.

The saying in the business is that VAs are products that are sold and not bought. In my opinion, any product that falls into that classification is ripe with conflicts of interest and investors are worse off than they should be--if not outright losers on the deal. But consider if smart VA providers or even new entrants decided to use ETFs to fill their wrap products. Gone are the onerous front-end loads and high fees that erode investor returns in these products, while the tax advantages still remain.

The question is whether a VA product that focused on keeping costs low and provided this tax advantage could turn into a product that was bought instead of sold. A VA lineup using ETFs could revolutionize the market dynamic with its low-cost proposition forcing the other participants to provide more competitive pricing and better investment options. For the current batch of insurance companies that produce these products, having lower-cost options in the fund would eliminate the major complaint about the products from their customers.

It turns out that SPDR Group and MetLife came to this realization at the end of 2008, partnering up to launch a pair of ETF portfolios for MetLife's lineup of VAs. Given the trillions of dollars up for grabs in this industry, I wouldn't be surprised to see more of these partnerships and a bigger push from low-cost entrants. From what I understand both Vanguard and Fidelity have index fund-based VAs that have attracted quite a few assets, further bolstering my thesis.

After all, a VA is a commodity product, and with a commodity product, the lowest-cost should gather the most assets. That is, if it is bought and not sold.

Scott Burns is director of ETF analysis at Morningstar and editor of Morningstar ETFInvestor.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.  

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