Introduction

A great deal of the interest in variable products has been due to their ability to keep pace with inflation. Among other advantages, variable annuities and life insurance products allow for the accumulation of retirement funds on a tax-deferred basis in a manner that minimizes the erosion of future purchasing power by inflation. To the wave of baby boomers moving toward retirement this is often an attractive combination.

Generally speaking, variable products are best suited to individuals who want control over their cash accumulations and need or desire increasing life insurance protection or retirement income. Since they will bear the full risk of their investment decisions, purchasers of these products should have a basic understanding of investments and, thus, believe they are making good investment decisions.

The advantages of variable products are numerous. First, owners have the ability to decide where their money is to be invested. Second, this investment allocation usually may be altered several times each year without additional cost. Third, earnings or interest on the investments underlying the variable contract accumulate on a tax-deferred basis. Finally, in addition to the investment control, most variable products offer the same options as traditional products, such as riders, settlement options and loan provisions.

Annuities Generally

Just as with life insurance, the protection provided by an annuity is against untimely death. The difference is that the untimely death associated with life insurance is premature death whereas with annuities, superannuation — living a very long time — is the feared peril. An annuity guarantees that the covered person (annuitant) will not outlive his economic resources. It is actuarially calculated to provide a monthly income no matter how long he lives.

While a life insurance policy usually covers only one person, annuities frequently provide income for the lifetimes of more than one annuitant. Since this feature affects the benefit schedule, it frequently is used to classify annuity contracts. A single-life annuity provides benefit payments during the lifetime of one individual. A joint-life annuity covers more than one person, providing benefits as long as both annuitants are alive. Another multiple annuitant form is the joint and survivor annuity under which benefit payments are made as long as any annuitant lives. All annuity benefits are terminated by the death of the last named annuitant.

Another way to classify annuities reflects the method of premium payment. Two categories are usually considered: single or periodic premium. As the name implies, the single premium annuity is paid at one time in a lump-sum. Theoretically included in this category are annuities for which all premiums are paid within a one year period even though received in installments. Such an arrangement is more likely to be used with a single premium variable annuity (discussed later) than with fixed benefit plans. Level periodic (monthly, quarterly or annual) payment annuities are, of course, plans for which premiums are spread over the entire period from inception to retirement or over a specific number of years.

A third contract feature which reveals the nature of the plan is the time when benefit payments begin. Here, again, there are two classifications — immediate and deferred. An immediate annuity generally begins benefit payments within one year from the date of purchase. It is always also a single payment annuity, though the reverse need not be true. With a deferred annuity, benefits begin at a specific date in the future (at least two benefit periods after purchase, usually to coincide with retirement) and continue as long as the annuitant lives. A deferred annuity may be purchased by either premium payment method.

A provision regarding disposition of any unpaid benefits is another important feature of annuities. Monthly benefits are higher if right to a refund is completely waived. The typical annuity allows survivors to claim the unpaid balance for only a certain length of time. The annuitant may choose the length of the benefit period — five years certain, ten years certain, etc. to twenty years — during which the right to the unused balance remains. The longer periods are most favorable to the survivors. Refunds may be taken as monthly payments until the period certain is completed or as a lump sum, but the lump sum refund is a slightly smaller total amount because the company loses interest income that otherwise would have been earned. The presence of a refund provision affects only the amount received monthly, not the length of time the annuitant may collect benefits.

Another category for classifying annuities concerns whether benefits are stated as a fixed dollar amount or as variable equity units. Fixed benefit plans usually are purchased in terms of a certain monthly benefit. For example, the contract amount might be stated either as $211 per month or as so many $10 benefit units, with 21.1 units resulting in a $211 benefit per month. In contrast, the contract amount of a variable annuity is stated in terms of accumulation units, the value of which fluctuates much like shares in a mutual fund. Thus, if an individual accumulation unit is valued at $7.315 at the time of purchase, a monthly contribution would purchase 13.67 units. The value of these units fluctuates as the value of the investments underlying the contract fluctuates. When benefit payments begin, the variable annuity contract typically offers the owner a choice of a fixed benefit based on the value of the units at the time of the initial payment or of a benefit amount which varies in accordance with investment performance.

Variable Annuities

The variable annuity is an equity vehicle — a security — in the same sense as are mutual fund shares or direct common stock shares. It is a plan for accumulating an estate for retirement with provision for a lifetime income. Premiums are invested in equities as a defense against inflation. Nevertheless, it is issued by life insurance companies and has all of the characteristics of regular annuities just discussed.

While the amount of each retirement payment is not guaranteed, variable annuities do offer contractual safety not found in other types of equity products. For example, benefit payout is guaranteed never to stop as long as the annuitant lives and the expenses associated with the plan are fixed by contract. Most plans carry a minimum death benefit — the value of units or total of premiums paid whichever is larger.

There are, however, some drawbacks to variable annuities. It is implied by the variable annuity philosophy that if the performance of the fund keeps pace with the cost of living that the individual's purchasing power is protected. Unfortunately, indicators such as the consumer price index (CPI) are based on a fixed group of consumer goods which may not be included in the annuitant's expenditures. It is possible for the index to drop while the annuitant experiences increasing costs.

From a psychological standpoint, annuitants have difficulty adjusting to the idea that benefits paid out by the plan may total less than premiums paid into it. This possibility is unsettling even if they are better off economically. For example, if an annuitant invests $1,000 and because of inflation of 25percent receives $1,250, he is satisfied. He is disturbed, however, if the reverse happens and he collects only $750 for his $1,000 investment. This drawback can be overcome by paying proper attention to the idea that the economy can experience setbacks without defeating the protection provided.

Yet another drawback, common among lifetime income contracts, is in the long term commitment to receive the benefits upon maturity. Once retirement age is reached, the annuitant has the option to take a lump sum withdrawal or the lifetime periodic income and once the annuity income payments commence, the annuitant may not surrender the contract. The drawback comes in that frequently elderly persons will change their minds on long term plans — a retirement residence is unsatisfactory or they think a different period certain would be more beneficial — only to find the contract inflexible at this point. Just as much care should be exercised in selecting options as in initially purchasing the plan.

Licensing for Variable Annuities

With few exceptions, licensing requirements for selling variable annuities are the same as those for selling mutual funds, except that licensees are required to hold a life insurance license in the state in which they do business. Producers must satisfactorily pass the National Association of Securities Dealers (NASD) test, and state securities test where required, register with the Securities and Exchange Commission (SEC) and affiliate with a registered broker-dealer. In addition, certain continuing education and compliance requirements must be met on an on-going basis.

Generally, the NASD examinations cover all of the various federal regulations — Securities Act of 1933, Securities Exchange Act of 1934, Investment Company Act of 1940, Investment Company Act of 1970, and commission rulings based on these — as well as the producer's understanding of investment terms and concepts.

Just as with other types of securities, the potential purchaser must receive a copy of the prospectus. The prospectus requires careful reading. Contained in it, in addition to financial data, management information, and a statement of the goals of the plan, is a cautionary statement of situations which could adversely effect the investment. The prospectus, registered with the Securities and Exchange Commission but carrying no government endorsement, is to help the purchaser make an informed decision.

Another regulation designed to protect the public from improper investment is the NASD and SEC requirement that producers make an evaluation of the suitability of the purchaser's decision in light of his occupation, marital status, income, assets, investment objectives and source of the funds to be invested. Failure to make proper inquiry as to these characteristics can lead to disciplinary action.

Markets for Variable Annuities

One of the primary markets for variable annuities is in tax-sheltered pension plans. They are used for both corporate funded group pension programs and retirement plans for self-employed persons. Employees of public schools and certain tax-exempt organizations are also finding variable annuities a satisfactory income deferring device qualifying for tax savings or, at least, tax postponement. Additionally, variable annuities are often used to fund individual retirement arrangements (IRAs). Selling variable annuities to these buyers requires extensive knowledge of tax laws and personal situations. A total financial services producer, possessing the necessary knowledge of his customer's personal situation, often works with a tax consultant or lawyer (the client's if possible) in presenting proposals for qualified tax-sheltered annuities.

There is also a substantial market for individual plans in which tax considerations are less complex. Persons coming into large sums of money other than as salary — athlete's bonuses, contest winnings, inheritances, invention royalties and advances, etc. — are prime prospects for single payment plans. Parents and grandparents find variable annuities an ideal vehicle for large contributions to their heirs' estates. Unlike paid-up life insurance, another favorite device, these contracts have the potential of protecting the purchasing power of the gift; making it as relatively valuable at maturity as when given.

Another use, though less popular, is as a substitution for life insurance for persons rated because of health reasons. Because physical condition is not important in underwriting a variable annuity, the person interested in the forced savings aspects of insurance company products coupled with the benefits of an equity investment will find this an acceptable alternative.

The variable annuity can also appeal to prospects for mutual fund plans who would rather have more of a contractual commitment (to themselves) to make deposits and also have the financial strength of an insurer to rely upon. These psychological advantages are complemented by the fact that with the variable annuity the person need not cash in the securities at retirement to purchase desired settlement options; this is automatically available with the annuity contract. Also, the annuity offers tax deferral of interest earned on underlying investments, where the mutual funds or other investments if owned outside the annuity produce taxable income yearly.

Variable Life Insurance

The basic concept of variable life insurance is similar to that of variable annuities — the value of equity investments is used to offset the effects of inflation. One major difference is that variable life insurance provides primarily a death benefit. Thus, fluctuations in unit values have their primary effect upon beneficiaries rather than the insured. However, the death benefit generally cannot decrease below the initial face amount of the policy, as long as all premiums have been paid.

In the case of a variable life policy, the policyowner allocates the premium, after certain deductions are made (administrative and sales expenses, any state premium taxes, and the cost for the mortality element), to a particular sub-account held by the insurance company. Among the types of sub-accounts which may be permissible, (depending on the particular company's product) are a money market type account, a growth stock account, a bond account, and a balanced fund account. And, depending on the insurance company, the choices may be changed several times a year. The major attractiveness of such a policy is that the policyholder can direct where premium dollars are to be invested as contrasted with typical whole life or universal life policies where the policyholder cannot make such direction. On the other hand, to gain this flexibility, the policyholder assumes the risk of loss with the variable life policy whereas it is the insurance company who assumes this risk with non-variable life policies.

Similar to traditional policies, riders such as waiver of premium or accidental death and dismemberment may be added to the basic contract. Also, if the insured lives to retirement the policy settlement options provide the same choices as with ordinary life insurance, though variable options may also be possible.

Unlike any other type of insurance, the sale of a variable life insurance product must be accompanied by or preceded by a prospectus approved by the Securities and Exchange Commission. Variable life must also be marketed by licensed security dealers.