Variable annuities had a tough 2008 and 2009 like everybody else.

The pricey, complex insurance contracts essentially did their job-paying out a steady stream of income to clients regardless of the plunging markets-but the companies that backed them took a hit.

In response, last year they began to reduce the benefits offered and raise prices. Many have overhauled the structure of their contracts altogether. Some industry observers take a glass-is-half-full attitude and say that the market turmoil gave the industry a gift by forcing it to recognize that its wares were too complicated and pushed it to create simpler products. "Nobody thinks prices up and benefits down is a good thing," says Frank Zafran, director of annuity products at Morgan Stanley Smith Barney. "But the industry simplifying its product line is a good thing."

Before markets headed south, insurance companies engaged in an arms race to provide the latest products with the greatest bells and whistles. The atmosphere was one of, "'I can do you one better,'" recalls Scott Stolz, president of Raymond James Insurance Group. One of the bells on the popular living benefit was called a "step-up" and it kept getting better and better. A step-up allowed clients to lock in gains even if the underlying portfolio decreased in value. At first, it allowed gains to be locked in every three years. Then the frequency dropped to every year, then every quarter, then every day. Zafran recalls joking that the market was going through "coffee-break step-up."

The carriers put generous benefits in place in an effort to keep buyers happy, and hopefully keep their money. But it was no easy task because investors were also blessed by the 1035 exchange rule, which allows them to easily move their money from one insurance product to another without triggering taxes. Whenever a more attractive benefit came out, investors would flock to that new product, leaving their old one in the dust.

"They went too far," Stolz says of the competing insurance companies. "And when the market tanked, it cost them a ton of money," he says. Say a client invested $100,000, and the account peaked at $150,000: the client's contract was for 5% of that amount to be paid annually, or $7,500. Then say the account withered to $80,000 after two years of bear markets. The client still collects $7,500 a year, but now on a base of $80,000. So he is suddenly scoring a 9% withdrawal rate. "That's not sustainable [for the company]," Stolz says.

Annuities generally restrict asset allocations to a 60%/40% or 70%/30% mix of stocks and bonds, assuming that the allocations would limit their exposure to unexpected moves in the stock market. But starting in 2009, that mix didn't help because bonds fell too.

Still, boosters like Zafran note that clients who were fortunate or clever enough to allot a part of their retirement portfolio to a variable annuity in 2008 are "sitting pretty compared to those who haven't." He notes that in the market volatility of 2008 and 2009, it wasn't unusual to see a 401(k) down 40%. "Imagine if you took a nice portion of that and bought a variable annuity where you locked the value in," Zafran suggests. "What you're basically doing is hedging your portfolio."

But despite having a useful, effective product for investors, net sales of variable annuities have been falling for years. Assets have been growing, but sales have shrunk steadily since 2007, according to Cerulli Associates. Net sales as a percentage of gross sales-that is, new money flowing into variable annuities, excluding exchanges-was at 15% for 2008 and the first three quarters of 2009. In 2004, that ratio was 30%.

In fact, the net sales of variable annuities has halved to $23.8 billion in 2008 from $46.8 billion in 1999. Lisa Plotnick, the Cerulli analyst covering annuities, says the industry has gone from "a low rate to an alarming low rate" over the last five years for a variety of reasons: sheer complexity of the products made advisors tune out instead of keeping up with constant changes in benefit provisions.

Zafran says that the financial crises of the last few years added a different wrinkle: "the great solvency debate." Fears that the insurance carriers would fail to pay benefits proved unfounded. But they still drove away some of the relatively small number of financial advisors who were willing to think about using variable annuities.

However, Plotnick says, the bear market at least reassured everyone that the insurance industry is well equipped to handle downturns. "Benefits continued to get paid," Plotnick says. "Carriers continued to write policies with living benefits on them. They were reducing the level of those benefits, and in some cases increasing the cost of those benefits. But at the same time, that's a tradeoff that has to be made to ensure those benefits will be paid in a few years. It's a much better tradeoff than having to eliminate benefits entirely."