Annuity Primer

How does the annuity company invest the funds in the contract?    (con’d)



Variable Annuities


From the contract owner’s point of view, the accumulation of funds in a fixed annuity is certain and the contract owner's principal is secure.   The annuity company bears the investment risk.  Because fixed annuities provide a specified benefit payable for life (or any other period the annuitant desires), they offer security and financial peace of mind. However, since the benefit amount is fixed, annuitants may see the purchasing power of their income payments decline over the years due to inflation. For investors concerned with inflation (or purchasing power) risk, variable annuities might be preferable.


Inflation poses a real threat to those relying on a fixed income.  Even relatively modest rates of inflation can seriously erode the purchasing power of those fixed income payments – for example, at 4% inflation, prices will double in less than 20 years.  What once might have seemed an adequate retirement income, may no longer maintain an adequate standard of living.      In the early 1950s, an association representing teachers reviewed the fixed annuity assumptions of their pension plan.— and to address inflation risk, they developed the concept of a variable annuity.


Variable annuities shift the investment risk from the insurer to the contract owner. If the investments supporting the contract perform well (as in a "bull market"), the owner will probably realize investment growth that exceeds what is possible in a fixed annuity. However, the lack of an investment guarantee means that the variable annuity owner can see the value of his or her annuity decrease in a depressed market or in an economic recession.



Separate Account


The distinguishing feature of a variable annuity is the “separate account”, also called the "subaccount".  The contractholder’s premium contributions are credited to a separate investment account – not the annuity company’s general account.  Historically, separate accounts invested in securities designed to protect against inflation, primarily common stocks.  Today, most annuity companies offer a wide variety of investment options ranging from money market funds to real estate-backed securities. (Most contracts also offer the variable contractholder a "fixed" investment alternative, which mimics the guaranteed interest rate of a fixed annuity.)   Some companies offer only "proprietary" separate accounts, that is, accounts managed by their in-house investment advisors; other companies employ outside money managers, often the same managers that offer mutual funds to the public.   Contractholders may choose to diversify their investments by directing their premiums into a variety of separate accounts and many companies offer services to periodically reallocate investments within the separate accounts to maintain desired investment balance.  The contract owner may also decide to change investments from one separate account to another at little or no cost as market conditions change.   During the accumulation period, the value of the contract will vary according to the investment results in the separate account(s).  When the contract is annuitized, and annuity payments begin, the size of those payments will also be based on the investment results of the separate account.  This exposes the annuitant to investment risk. Variable annuity payments are subject to changing market conditions – but that was the intent of variable annuities in the first place.


Equity investments, such as common stocks, represent shares of business ownership, and they tend to change in value with changing economic conditions.  The market price of a stock is set in the marketplace by willing buyers and sellers – based on forecasts of the company's earnings, dividends and future growth. If the company prospers, its shares of common stock will increase in value; if the company does not prosper, its shares will generally decrease in value and may even become worthless. This contrasts with debt instruments, such as bonds, which carry fixed rate of return on investment. The value of a bond depends more on its interest rate relative to other debt obligations than on the growth of the issuing company. Bonds also have a fixed maturity date on which the principal amount will be repaid.  The anticipation of eventual repayment tends to keep bond prices more stable than stock prices.   But bonds are also very susceptible to inflation risk.


There are no guarantees that common stock prices will keep pace with inflation, but in general, over long periods of time, that has been the trend.    It is important to note that in the long term, stock prices tend to keep pace with general price levels, but this is not necessarily the case in the short-term. No investment, including a variable annuity, is a perfect inflation hedge during all economic periods.


Text Box: Regulation of Variable Annuities

Variable annuities are based on non-guaranteed equity investments, such as common stocks.  When first introduced, the Securities and Exchange Commission (SEC) asserted control over these products as “securities” – and the Supreme Court concurred.  So variable annuities are subject to dual regulation:  at the state level as an insurance product, and at the federal level as a security.  In Florida, companies issuing annuities, fixed or variable, fall under the jurisdiction of the Office of Insurance Regulation.  One requirement of the Office is that investments in a variable annuity’s separate account must have a “readily determinable value” — that is, they are marketable securities.   Insurance companies wishing to operate a separate account must register the account with the SEC as an “open end investment company” under the Investment Company Act of 1940.  Mutual funds are also registered under this federal law, and it is convenient to think of separate accounts as mutual funds.  In fact, many annuity companies now use the investment expertise of mutual funds to manage the assets in their separate accounts.  Under federal law, a prospectus — a document explaining the details of the investment -- must accompany all sales of mutual funds, variable insurance and variable annuities. 

To sell variable insurance products, an individual must hold a life insurance/variable annuity license granted by state authority and a registered representative's license granted by FINRA (Financial Industry Regulatory Authority, the successor to the NASD). Some states may also require a special variable insurance license or special addendum to the regular life insurance license. In Florida, agents who have fully satisfied the requirements for a life insurance license, including successful completion of a licensing exam that covers variable annuities, may sell or solicit variable annuity contracts.  Since 1990, the Florida life agent examination has included variable annuities.  Life agents who were licensed prior to 1990 did not automatically obtain the variable annuity license.  For these agents, or agents who have let their variable annuity license lapse, there is a separate variable annuity examination.  In Florida, a variable annuity license does not exist by itself – a variable annuity license is valid only if the agent is also a holds a valid life insurance agent license.

To accommodate the variable concept, a new means of accounting for both annuity payments and annuity income was required. The result is the accumulation unit, which pertains to the accumulation period, and the annuity unit, which pertains to the income payout period.



 Accumulation Units


During the accumulation period of a variable annuity, contributions made by the investor  (less a deduction for expenses) are converted into accumulation units and credited to the selected separate account. Each additional contribution will purchase more accumulation units. 


The value of each accumulation unit varies, depending on the value of the underlying portfolio of stocks.  In this way, accumulation units are similar, but not identical, to shares of a mutual fund.


For example, assume that the accumulation unit is initially valued at $8, and the holder of a variable annuity makes a payment of $200. This means she has purchased 25 accumulation units. Six months later, she makes another payment of $200, but during that time, the underlying stocks have appreciated and the value of the accumulation unit is now $10. This means that the $200 payment will now purchase 20 accumulation units.


One popular investment strategy, known as dollar cost averaging, applies to periodic investments of the same dollar amount – which is very common in the case of flexible premium deferred annuities.  By investing the same dollar amount periodically, the investor will purchase more units when the price is down, and fewer units when the price is high.  As a result, more units are purchased at lower costs, and at the end of the investment period, the average cost of the units acquired will be lower than the average price of the units over that period of time.  Using the example above, the investor purchased 25 units at $8, and 20 units at $10.  The average price of the units is $9 ($8 + $10 / 2).  She purchased 45 units for $400, so her average cost is only $8.89 ($400 / 45).    Contractholders can take advantage of dollar cost averaging by making equal investments periodically, and many variable annuity contracts offer investors an "automatic" dollar cost averaging program.  In these automatic programs, the contractholder places a lump sum in the contract's fixed account and each month the company will transfer a fixed amount to the separate investment account(s) selected by the contractholder. Over the course of six to twelve months the entire premium will be invested in the separate account so as to average out the cost of the shares purchased over that period.


The current value of one accumulation unit is found each business day by dividing the total value of the company's separate account by the total number of accumulation units outstanding. Thus, if a company had $200 million in its separate account, and a total of 20 million accumulation units outstanding, the value of one accumulation unit would be $10. As the value of the investment portfolio rises and falls, the value of each accumulation unit also rises and falls. [Mutual funds calculate their share prices, or NAV (net asset value) daily using a similar formula.  It is important to note some differences, however, between accumulation unit prices and mutual fund NAVs.  Mutual funds must distribute accumulated dividends and realized capital gains to their shareholders periodically, and mutual fund NAVs are reduced when these distributions are made.  If the investor chooses to reinvest the distributions, the investor acquires more shares (valued at a lower NAV).  In a variable annuity, those accumulated profits are automatically retained in the unit price so the investor continues to hold the same number of units, but those units will have a higher value.  Variable annuity holders do not have a choice of taking the distribution in cash.] 


Many annuity companies offer a “family of separate accounts”, that is a collection of portfolios with varying investment objectives, e.g., conservative growth, aggressive growth, balanced, etc.  During the accumulation period, the contractholder may switch among the various accounts or allocate the premium to be invested in more than one account.  This allows the contractholder flexibility to adjust his or her investments as market or personal conditions change.  



Annuity Units


When the investor decides it is time for the variable annuity benefits to be pay out in monthly income payments, the accumulation units in the participant's individual account are converted into annuity units – or the contract is said to be “annuitized”.  At that time, the annuity company calculates the number of annuity units for that contractholder.   From then on, the number of annuity units remains the same for that annuitant. The value of one annuity unit, however, can and does vary from month to month, depending on investment results.


When computing the number of annuity units, the annuity company considers the accumulated value of the account (total number of accumulation units multiplied by the current value of one accumulation unit).  The company then takes into account the annuitant’s age and the method of payout the annuitant selects. (Variable contractholders have the same payout options as fixed annuities: straight life, period certain, joint and survivor, etc.  There is one slight difference in terminology – instead of cash refund option; variable annuities offer a unit refund payout.)  Using tables similar to those for a fixed annuity, the company determines the size of the initial monthly payment.  Then it converts that amount into annuity units by dividing the initial monthly payment by the value of one annuity unit. 


Continuing our earlier example, let's assume that our contractholder has purchased 10,000 accumulation units in her account by the time she is ready to retire at age 55.  The value of one accumulation unit has grown to $25, so the value of the account is $250,000.  She selects a joint-full survivor annuity covering her and her 65-year old husband.  Based on their ages, the annuity company uses tables to find that she is entitled to $4.08 in monthly payments for every $1,000 of accumulated value.  Her initial monthly check will be for $1,020.00 ($4.08 x 250 “thousands”).    The annuity company will convert that value into annuity units.  Assume that an annuity unit at that time is worth $10.  The $1,020 payment is converted into 102 annuity units ($1,020 divided by $10).  That number is fixed for the rest of their lives – it will not change. What does change is the value of the annuity units, depending on the investments in the underlying separate account. For example, if the annuity unit were to grow to $11, her monthly check would grow too – to $1,122 (102 units at $11).


Each variable annuity contract will have an assumed interest rate (AIR).  The varying value of annuity units depends on how the investment results in the separate account compare with that assumed interest rate.  If the growth in the account equals the AIR, the value of an annuity unit will not change.  If the investments in the separate account do better than the AIR, the value of the annuity unit will grow. If investment results lag the AIR, the value of the annuity unit will fall.  Please note: the assumed interest rate in a variable contract is a threshold against which to compare investment results in the separate account – it is not a guaranteed rate of return. 


Each variable annuity contract will outline the formula used to determine annuity unit values.  Some contracts may rely solely on investment experience only (how the portfolio performed versus the AIR), while formulas in other contracts may reflect mortality and expense experience too.


Text Box:  © 2008 Wall Street Instructors, Inc. No part of this material may be reproduced without the written permission of the publisher.

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