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Section 5
VARIABLE ANNUITIES

Both the individual and group markets have changed over time, from markets primarily for fixed annuities to markets with growing use of variable annuities. Fixed annuities provide a guaranteed nominal payout during their liquidation phase. They distribute a given principal across many periods, but they do not provide a constant real (i.e., adjusted for inflation) payout stream if the price level changes. When inflation is low, the real value of the annual distribution will not vary much over the liquidation period. But even modest inflation rates of 3-5 percent per year, if they persist throughout the liquidation period, can lead to substantial erosion in the real value of annuity payouts. At an inflation rate of 3 percent per year, for example, the real value of annuity payouts in the first year of an annuity liquidation period is more than twice that of the same nominal payout 24 years later. At an inflation rate of 6 percent per year, the real value of payouts is halved in only 12 years.

Variable annuities, by design, address the risk of purchasing power erosion that is associated with fixed nominal annuities. Unlike fixed annuities that promise a constant nominal payout, variable annuities provide an opportunity to select a payout that bears a fixed relation to the value of an asset portfolio. If these assets tend to rise in value with the nominal price level, then the payout on the variable annuity will adjust to mitigate, at least in part, the effects of inflation. Because variable annuities are defined in part by the securities that back them, they are more complex contracts than fixed annuities. In spite of their complexity, however, they have become one of the most rapidly growing annuity products in recent years.

THE MECHANICS OF VARIABLE ANNUITIES

Variable annuities are structured to have both an investment component and an insurance element. During the accumulation phase, premium payments are used to purchase "investment units," the price depending on the value of the variable annuity's underlying asset portfolio. For example, if this portfolio consists of common stocks and if share prices are high when a premium payment is made, then this payment will buy relatively few units, and vice versa. During the accumulation phase, variable annuities resemble mutual funds in many respects, although there are differences, and the assets in many recent variable annuity products are explicitly managed by mutual fund providers. The dividends, interest, and capital gains on the assets that underlie the investment units are reinvested to purchase additional investment units.

When the accumulation phase of the variable annuity ends, the accumulated value of the investment units is transformed into "annuity units." This transformation occurs as if the accumulation units were cashed out and used to purchase a hypothetical fixed annuity. The annuitant does not receive a stream of fixed annuity payments, but this hypothetical annuity plays an important role in computing actual payouts. The payout amount for the hypothetical annuity is used to credit the annuitant with a number of annuity units. Many variable annuities also allow annuitants the option of choosing a fixed annuity stream, or some combination of a fixed stream and a variable stream of payouts.

The actual variable annuity payout in each period depends on the number of annuity units that the annuitant is credited with and, over some range of asset returns, on the value of the assets in the variable annuity's underlying portfolio. If the value of this portfolio rises by more than the increase implicit in the assumed interest rate, after the annuitant has converted to annuity units, for example, because of rising nominal prices, then the payout will rise during the payout phase. If the value of the underlying assets falls, however, the value of the payout will also decline. The variable annuity's possibility of fluctuating payments is both an attraction (it provides potential protection against rising consumer prices) and, for some potential buyers, a disadvantage (the nominal payout stream is not certain).

Several product innovations during the last two decades have expanded the menu of investment options available for variable annuities. First, the range of portfolio investments that can be held through variable annuity policies has increased. Although the first variable annuities focused exclusively on diversified common stock portfolios, policies now offer variable annuities tied to more specialized portfolios of equities as well as to bonds or other securities. Variable annuities typically allow policyholders to move their assets among various policy sub-accounts, usually with different investment objectives, without fees or penalties. Second, virtually all variable annuities now offer lump-sum withdrawal options after the policy has reached a specified maturity date, as well as the possibility of withdrawing the principal in a set of periodic lump-sum payments. These features make it possible to use variable annuities as an asset accumulation vehicle without necessarily purchasing an annuity-like payout stream when the accumulation phase is over. This is because variable annuity contracts contain a purchase rate guarantee. Finally, some no-load mutual fund families have begun offering variable annuities in conjunction with some insurance companies in recent years. Schultz (1995) reports that investment management expenses for funds associated with variable annuities that invest primarily in diversified U.S. equity portfolios average 0.76 percent per year, which combines with the 1.23 percent average annual insurance expenses on these variable annuity products for a total expense ratio of 1.99 percent. Variable annuities and other investment alternatives are compared in more detail below.

THE GROWTH OF VARIABLE ANNUITIES

Variable annuities were introduced in the United States by the Teachers Insurance and Annuities Association-College Retirement Equity Fund (TIAA-CREF) in 1952. The first variable annuities were qualified annuities that were used to fund pension arrangements. Variable annuities grew slowly during the next three decades-in part, as Green (1977) explains, because of the need to obtain regulatory approval for these products from many state insurance departments. Because variable annuities are usually backed by assets that do not guarantee a fixed minimal payout, such as corporate stocks, the reserves that back variable annuities are maintained in separate accounts from the other policy reserves of life insurance companies. Maclean (1962) notes that no major insurance company other than TIAA-CREF had issued a variable annuity policy as of 1960, primarily because state laws prohibited insurers from supplying a new class of products backed by common stock assets that were segregated from the insurer's other assets. Campbell (1969) provides a detailed account of the introduction and growth of variable annuity products, with particular attention to the regulatory hurdles that had to be cleared to market these products.

The slow growth experienced in the 1950s and 1960s has been reversed in recent years. The growth rate of variable annuity premiums during the last decade has been second only to health insurance premiums among insurance products. Between 1989 and 1993, individual annuity premiums (measured in 1994 dollars) increased from $58.6 to $71.8 billion, largely as a result of growth in variable annuity sales.

Table 6 chronicles the growth of the variable annuity market. It shows the increase in the number of variable annuity contracts in force, as well as the growth in variable annuity premium payments. The number of variable annuity products in force and the premiums received on these policies have grown rapidly, but since many of these policies are not yet mature, payouts have not increased commensurately. One open question is whether a substantial fraction of the assets currently accumulating in variable annuity contracts will ultimately be used to purchase life annuity contracts, or whether it will be withdrawn as lump sums or in other forms.

Table 6 shows only 670,000 contract owners in variable annuity policies in 1977, compared with 3.7 million in individual fixed annuity contracts that year. By 1993, the number of variable contract owners had increased to 5.25 million, and the number of fixed contract owners had grown to 21.5 million. Both variable and fixed annuities grew rapidly between the late 1970s and late 1980s. In more recent years, variable annuities have grown faster than fixed annuities as Table 6 illustrates. Variable annuity premiums increased roughly fivefold between 1991 and 1994, compared with only a 15 percent increase in premiums for individual fixed annuities.

Table 7 further documents the growth in variable annuities and shows that both individual and group variable annuity policies have expanded in recent years. It shows the growth in capital reserves that life insurance companies hold against variable annuity products. The early growth of variable annuity policies was concentrated in group policies. As recently as the late 1960s, more than 95 percent of the reserves for variable annuity policies were held in group policies. Individual variable annuity policies, however, have grown more quickly than group policies during the last two decades. The policy reserves for individual variable annuity policies surpassed those for group policies in 1987; by 1993, the last year for which data are available, individual variable annuity reserves were more than twice those for group policies.

PROSPECTS FOR VARIABLE ANNUITIES

Several factors have contributed to the recent growth of the individual annuity market in general and to the variable annuity market in particular. These factors will likely continue to generate strong demand. First, the opportunity annuities provide for tax-deferred savings is not unique, but it is becoming rarer. The Tax Reform Act of 1986 limited the opportunity for tax-deferred saving through individual retirement accounts. For married couples with adjusted gross income of more than $40,000 and individuals with adjusted gross income of $25,000 in 1994, IRA contributions were not fully deductible. For couples with incomes above $50,000 or for individuals with incomes above $35,000, no deduction was allowed for an IRA contribution. The Tax Reform Act of 1986 also reduced the amount of tax liability that could be deferred through qualified pension plans by lowering marginal tax rates, and it limited to $150,000 the amount of income on which taxpayers could base contributions to qualified plans. Subsequent legislation has continued the pattern of making qualified retirement plans less attractive means for saving and has even introduced a 15 percent surtax that applies to withdrawals in excess of $150,000 per year from qualified retirement plans. As these plans have become less attractive, annuities have become relatively more attractive.

Second, demographic trends and the nature of the current budget policy environment suggest continued interest in annuity products. As the baby boom generation reaches late middle age, when households traditionally begin planning for retirement, products designed to provide retirement income are likely to draw attention. There is some anecdotal evidence (see, e.g., Covaleski 1994), that baby boomers have been an active market for variable annuity products. The current uncertainty surrounding the future of Social Security, and the question of whether Social Security will provide as generously for the retirement of aging baby boomers as for that of their parents, is likely to generate additional demand for retirement-oriented saving products.

The growth of variable annuities in recent years is probably related in part to the increase in stock prices, and the coincident decline in long-term interest rates, that has stimulated investor interest in annuities that offer returns linked to equities rather than fixed income instruments.

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