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while proponents of mutual funds trumpet the high fees often associated with annuities and the fact that once money is withdrawn, it is taxed as income rather than at the far cheaper capital gains rate.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.”
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.
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.
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.