An enormous amount has been said in the debate over whether variable annuities represent a better long-term investment vehicle than mutual funds. The annuiphiles point to the tax-deferred protection afforded the annuity product, while proponents of mutual funds trumpet the high fees often associated with annuities and the fact that once money is withdrawn, it is taxed as income rather than at the far cheaper capital gains rate. Even the National Association of Variable Annuities, which would like to downplay the comparisons, recently commissioned a PriceWaterhouse study examining the relative merits of each product.

That said, it’s worth noting that variable annuities normally come up deficient in their comparisons to mutual funds. Aside from only a few annuity products like those offered by TIAA-CREF and Vanguard, the high costs associated with VAs render them a most unappealing investment option. Even the chairman of TIAA-CREF, John Biggs, noted in an July 1999 Investment Advisor spotlight of his own company’s product that he wouldn’t invest in VAs until after first exhausting the deposit maximums for other investment instruments like 401(k)s and IRAs.

Yet in this debate there is something very fundamental being overlooked by most of the participants: “Variable annuities are not investment vehicles; they are insurance products,” sternly notes Peter Joyce, vice president of marketing for Boston-based New England Financial Distributors, a subsidiary of MetLife. “A serious misperception has developed that variable annuities should be compared to mutual funds.”

Embracing Insurance

Indeed, it seems that many in the insurance industry are beginning to take umbrage at the persistent comparisons between mutual funds and variable annuities. To do so, they say, is to perpetuate an already severe case of mistaken identities. Says Jeff Botti, spokesperson for Nationwide Financial of Columbus, Ohio, “We’ve had some discussions within the company about unfair comparisons between mutual funds and annuities. We need to embrace the insurance protection features of our product like never before.”

A VA Primer

Are they insurance or investment? Here are the facts on variable annuities

Much of the confusion over the identity of a variable annuity can be traced to its lifespan being divided into two distinct parts: the accumulation phase and the payout or annuity phase.

When one buys an annuity, he normally invests a single amount into the contract known in the insurance industry as a “single premium.” There are times, says Thomas Mitchell, actuary for the St. Louis insurance consulting firm Aurora Consulting, that the client will elect to space out the “premiums,” over time, yet this is a decidedly rare occurrence.

Following the purchase of the contract, the money will be invested in “subaccounts.” These are pools of money managed by the same managers who oversee the investments of mutual funds. The reason for this can be traced to the passage of an early 1980s law that forbids direct participation in public funds by variable annuities.

The contract will then be assessed an investment management fee just as is the case with a mutual fund, with that cost being deducted on an annual basis. Also, the insurance company will charge an administration fee for the maintenance of the contract that will run from $30 to $50, or 15 basis points per year, according to NAVA.

In addition to this, the insurance company will exact what is known as a mortality and expense (M&E) fee, which is allotted to provide the contract’s death benefit. A death benefit will ensure that should a person die before withdrawing his or her funds from a purchased variable annuity, then they will receive the greater of the original contract value or the policy’s current amount. Some new benefits, including what is known as an enhanced earnings benefit, will raise the death benefit to the highest value the contract ever reaches. That said, the average M&E cost is 113 basis points, according to NAVA.

Accumulation Phase

The money will then be allowed to grow tax-free, enjoying the same tax protections as regular life insurance products. The funds, however, will most likely have to be left in the annuity for a period of time to avoid paying what is known as a “surrender charge” upon withdrawal. A typical surrender charge begins at 6% of the contract value in the first year and then usually descends a percentage point in successive years until reaching zero.

All of this constitutes the accumulation phase, the part of a variable annuity’s lifetime that has been most compared to a mutual fund. Looking at the components of this phase, it’s not hard to see from whence misperception of the VA as an investment vehicle sprung: mutual fund-like subaccounts, tax deferred growth, and so on.

Payout Phase

Consequently, when the money is needed, most clients simply decide to withdraw the money from the VA in either a single lump sum–which carries high tax implications–or take a series of withdrawals. The other option, selecting to enter the payout phase, is never even reached. Yet it is this neglected phase that truly defines the annuity. Here, the contract holder chooses to transform the contract’s value–that which was built tax-free during the accumulation phase–into a lifetime income stream. The holder then receives checks whose size is based on the contract’s value at the time of “annuitization” for the rest of the holder’s life. This option provides insurance against outliving one’s other assets since the checks will always arrive.

One might wonder what would happen if someone died after receiving only one or two checks, since the death benefit ends at the time of annuitization. But for 30 or 40 basis points, one can ensure payments will continue for 10 years even if death should occur. Also, there are refund annuities, Mitchell says, where at least the value of the contract at the time of annuitization will be returned at death if that amount has not been already paid out in income.

Complicating matters a bit are immediate annuities, which skip the accumulation phase entirely. (Annuities that have an accumulation phase are called “deferred annuities.”) In this case, one pays a single premium and immediately begins the lifetime stream of income.

So what really is a variable annuity? A good start is to think of it just as Botti advises–as simply an insurance product in the same genre as the collision and theft policy one might purchase for a brand new sports car. In fact, it could fairly easily be argued that the possibility a person is guarding against with a variable annuity is much more severe than of someone sideswiping his automobile. “A variable annuity, or any annuity, for that matter, is an insurance policy to protect against the possibility of running out of money before you pass away,” adds Joyce. “This is the way it should be viewed.” Joyce is referring, of course, to the ability of a deferred annuity holder to convert the value of the contract into a lifetime income stream. To evoke such a clause is referred to as “annuitization.”

Despite such contentions, however, no one seems to be listening. In 1999, for instance, only 0.7% of the $1.3 trillion that insurance consulting firm LIMRA International estimates was invested in deferred variable annuities was actually annuitized. In 1998, that figure was 0.8%, and in 1997, 0.9%. “Only a minuscule amount of people have actually annuitized their variable annuity contracts,” says Mark Mackey, president and CEO of NAVA. “The vast majority of people are using it for investment, and that’s not what it was originally intended for.”

Ironically, blame for this colossal misunderstanding should be placed at the feet of the very people who were responsible for the creation of the product in the first place–the insurance industry. Says Jim Doyle, a variable annuity consultant since 1985 and current vice president of professional services for Info-One/VARDS, a consulting company in Marietta, Georgia, “To a certain extent, we in the insurance business are responsible for the perception of the VA as an investment vehicle rather than as insurance. We’ve simply focused too much historically on accumulating assets in these products.” And industry stories bolster his point. During the 1990s, variable annuity salespeople arrived at brokerage houses sporting “no 1099″ pins, a reference to variable annuities’ absence of annual capital gains or income distributions. Adds Doyle, “The tax angle has been overdone.”

Bull Market Wonders?

In retrospect, though, it may be hard to blame the insurance marketing personnel who initiated the comparisons of variable annuities to mutual funds. How could one resist emphasizing the fashionable investment components of a product during the roaring bull market of the 1990s? But this marketing philosophy has now had an interesting effect. Because variable annuity providers hitched their stars to the stock market, they’ve suffered like everyone else in the equities business since those stars started falling to earth last spring. Variable annuity sales are way off. After an incredible run during the preceding decade that saw the industry go from an afterthought to a trillion-dollar market, sales are finally slowing down. NAVA says sales topped off at $36.5 billion in the first quarter of 2000–not coincidentally at the same time the Nasdaq was reaching its peak–only to decline to $33.8 billion in the third quarter of 2000, $30.6 billion in the fourth, and $28 billion in the first quarter of 2001. Having made their bed, VA marketers are now forced to sleep in it.

The VA industry, however, has shown an obstinate unwillingness to simply take the market downturn on the chin. Insurance companies are suddenly reframing variable annuities in the terms they should have been framed in all along–as an insurance product to guard against outliving one’s financial means. The effect is a sudden retooling of the income portion of the product with a host of features that only are useful should one annuitize. “Until now, the industry has only focused on the front end or the accumulation end of the product,” says Joyce. “All of the changes that you’re now seeing have to do with making the back end or the payout much more attractive.” In this spirit, Doyle reports a host of insurance companies calling his firm asking for advice on how to not only beef up the income side of the variable annuity, but market it differently as well. “The phone has been ringing a lot with those types of calls,” he says.

The effects are already being seen in a host of new variable annuity product offerings that encourage annuitization. For instance, in the past, the decision to annuitize was made at the expense of liquidity. Once opting to turn the value of the contract into a lifetime income stream, one could no longer access any of the assets within the policy. Now, VAs like the seven-month-old American Skandia Advisors Income Annuity allow for “commutability,” or the ability to access some portion of the contract value even after annuitizing. In the case of the Skandia product, contract holders can opt to take a lump sum of up to 85% of the original contract value even after receiving several years of annuity payments. “Most people aren’t going to use this option, but we found that retirees like the idea of being able to access their money in the case of an emergency,” says Jacob Herschler, Skandia’s VP of variable annuity marketing.

MetLife has gotten in on the trend as well, recently allowing holders of its American Growth Series VA much greater flexibility in transferring assets once the lifetime income stream has been evoked. “In the past, you could reallocate all you wanted on the front end but not once you annuitized,” says Joyce. “A lot of companies are now changing this format.”

Yet it’s the Skandia product that truly serves as the apotheosis for these emerging trends by also incorporating what’s known as a guaranteed minimum payout floor, or GMPF. This works by developing a cash value for an annuitized VA that is basically equal to 85% of the value of the contract when the decision to annuitize is made. If the contract is worth $100,000 when a client annuitizes, the cash value is $85,000. Accordingly, the GMPF guarantees that payments as part of the lifetime income stream will never fall below the value of the initial payment as long as the contract still has a cash value. For an extra 100 basis points annually, Skandia will guarantee that the payments will never fall below the initial check, even if a staggering bear market were to wipe out the entire value of the contract. “Senior citizens want to keep pace with inflation using equities, but they don’t like the value of their checks bouncing around,” Herschler says. “This ensures that they know how much money they’re getting each month.”

A final creative encouragement to annuitize is evidenced by the Nationwide Best of America Future Variable Annuity, which includes the increasingly popular guaranteed minimum income benefit, or GMIB. For 30 basis points per annum, Nationwide will guarantee that lifetime payments associated with annuitization will eventually be based upon the highest value attained by the contract on its previous yearly anniversaries. For instance, if the value of the contract began with $100,000, rose to $200,000 a year after its creation, but then sank to $40,000, the annuity payments will be based upon the $200,000 value. Also, for 45 basis points, Nationwide will guarantee that the contract will at least have accumulated a 5% annual return when the decision to annuitize is invoked. “These are options that are meant to provide insurance for those people who want to use the annuity not for investment accumulation purposes but for necessary retirement income they have to rely on,” says Eric Henderson, variable annuity product officer for Nationwide.

Outlasting the Assets

Product changes, however, are only part of the battle being waged by those who wish to return VAs to the realm of insurance: education over the need for this particular type of indemnity constitutes the second half of the equation. Fortunately for those who have to make this argument, though, its merits are fairly self-evident. Over the last 25 years, a great shift has occurred in the way Americans plan to finance their retirement. In the past, one relied on the lifetime pension that had been earned over decades of service to a single firm. Today, more consumers have to fend for themselves with 401(k) and IRA plans.

According to the U.S. Department of Labor, the number of workers participating in defined benefit pension plans dropped from 38% in 1977 to 22% in 1996. At the same time, the percentage of those participating in defined contribution plans rose from 7% to 23%. This has a twofold effect: In the case of defined benefit plans, the employer was responsible for the investment of money as well as providing pension payments for the life of the retired worker. When it comes to 401(k) plans, the onus is decidedly on the individual to not only invest his retirement funds but also ration them out so that it last as long as he is alive.

Defined contribution plans are far cheaper–they cost about half as much as defined benefit programs–and easier to administer. Also, they appeal to the wanderlust of modern workers who prefer control over their own investments and reject the notion of spending 30 years with a single company to receive a pension plan. Yet according to a 2000 study published in the North American Actuarial Journal by York University (Toronto) professors Moshe Arye Milevsky and Chris Robinson, a portion of individuals who rely solely on defined contribution plans to finance their golden years will run out of money, or as they put it, face the “probability of ruin.” Their figures indicate that depending on portfolio allocation, a 65-year-old man withdrawing only 7% per year from his retirement account has between a 17% and 32% chance of running out of money before dying. With their longer life expectancies, between 27% and 55% of women will come up short in the same scenario. (See table at right.)

There is also one other issue of which planners and future retirees should take note. Milevsky and Robinson’s figures and those of other similar studies are based on current life expectancies. According to the 2000 Social Security Trustee Report, a 65-year-old man in 2000 was expected to live another 16.4 years, while a 65-year-old woman was expected to live another 19.6 years. Yet a very respectable 17.5% of males and 31.4% of females who reach 65 will live until 90. “People don’t realize that they have a pretty good chance of having to fund a 25-year retirement,” says Doyle. “And that’s without [the] breakthroughs in science that are bound to occur.”

Divining what science will concoct in this new century may require a bit of foresight, but fortunately for the insurance industry, the results of their efforts concerning variable annuities already seem evident. Sales of immediate variable annuities, or those that annuitize as soon as they are purchased, represent the fastest growing portion of the market. Also, Mackey notes that NAVA has already noticed a distinct rise in the number of contracts being annuitized over previous years, and predicts that this trend will only increase. In 1999 the British magazine The Economist noted that “by providing financial protection against the 18th and 19th century risk of dying too soon, life insurance became the biggest financial industry of that century. Providing financial protection against the new risk of not dying soon enough may well become the next century’s major and most profitable financial industry.” This is clearly what the variable annuity industry is counting on.