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Section 6
ANNUITIES IN A COMPETITIVE MARKET

Insurers offer a range of different annuity products; these compete in turn with a range of other financial products offered by other financial institutions. As the foregoing discussion emphasizes, different types of annuities are designed to achieve different objectives, and there are trade-offs in the comparison of annuity products with other investment and insurance vehicles. The central trade-offs that investors must evaluate are the benefits of the insurance that annuities offer, the costs of potential annuity surrender charges, the potential tax advantages of annuities, the different transaction costs, and the investment options associated with various financial products.

THE INSURANCE COMPONENT

The insurance feature of annuities distinguishes them from many other financial products. All annuities offer insurance against the risk of outliving the value of one's resources; some also offer insurance with respect to the rate of return on invested capital. Both fixed and variable annuities insure mortality risk; they are the only products that permit buyers to contract for a guaranteed income for the remainder of their lives. However, while the duration of the income stream is guaranteed for both fixed and variable annuities, the amount of periodic payments is only guaranteed for a fixed annuity.

Many annuities also offer other types of insurance. Some contracts promise that the estate of a purchaser who dies before the accumulation phase has ended will receive the full value of the purchaser's contributions to the annuity. These contracts provide insurance against poor returns on the investments that back the annuity (see Gentry 1994). The nature of such insurance is often quite complex. In January 1994, for example, AIG Life Insurance was marketing a variable annuity policy that provided a death benefit equal to the maximum of the accumulated premiums less withdrawals, the contract value, or the greatest contract value at any sixth anniversary of the policy, plus subsequent deposits net of withdrawals. Valuing such insurance is difficult and requires information on both mortality risk and the random character of investment returns for the assets backing the variable annuity. Gentry and Milano (1994) present illustrative calculations of the value of this insurance to individuals of different ages and under different assumptions about the nature of portfolio risk.

Individual annuities typically also provide insurance with respect to changes in the insurance market. Deferred annuities must guarantee the participant the right to purchase an annuity on particular terms some years in the future. This insures against changes in aggregate mortality risk that result in changes in the pricing of annuities, as well as against changes in expected rates of return that result in modified terms in newly issued annuity contracts.

The cost of providing insurance affects the pricing of annuities, and insurance value must be considered in evaluating potential annuity investments. The management expenses associated with variable annuities typically average between 100 and 150 basis points per year, substantially higher than the comparable expenses for many mutual funds. Variable annuities are therefore most attractive to individuals who value the insurance associated with them and who are prepared to pay for this insurance, or who value the tax-deferred "inside build up" associated with these accounts.

SURRENDER CHARGES

Annuities, unlike some other financial products, typically have a surrender charge. These charges, found in many but not all deferred annuity contracts as part of the initial contractual agreement between the buyer and the annuity provider, stipulate that an annuitant who decides to cancel the policy before its maturity date, e.g., five or ten years, must pay a fee to the insurer. Insurers justify these provisions as needed to recover the commission and other production costs associated with annuity products. When assets are held in an annuity product for a long period until the maturity date, the insurer can cover these costs through the annual management fees and expenses of the annuity. When the annuity contract is terminated prematurely, however, the total collected from such management fees is reduced, so the insurer collects a surrender charge to compensate for these lost fees.

The combination of surrender charges and income tax penalties for premature withdrawal of annuity assets makes long-term investors who do not expect to need their invested assets in the short term the natural market for deferred annuities. Black and Skipper (1994) report a standard surrender charge of 5-10 percent of the accumulated value, typically with a declining schedule and ceasing after a fixed period of years. These charges can substantially reduce the rate of return on annuity assets for those who terminate their contract prematurely. In addition, the federal income tax levies a 10 percent penalty tax on premature withdrawals from both qualified and nonqualified annuities by individuals under the age of 59½. This tax applies only to the income that has been accumulated in the annuity contract. These withdrawal penalties, which are very similar to those on early withdrawals from qualified retirement plans, further encourage annuity investors to accumulate for the long term and reduce the return earned by those who withdraw their assets.

Surrender charges were more prevalent in the 1930s and 1940s than at present. In fact, some annuity products marketed in recent years do not include surrender charges. Pallay (1995) estimates that approximately one-fourth of annuity reserves are currently accounted for by annuities with no surrender charges, although some of this includes contracts on which surrender charges have expired. A somewhat dated illustration of the potential effect of surrender charges on the returns earned by those who terminate their annuity contract before maturity is provided by Gilbert (1948), who focuses on the types of annuities that were common in the early postwar years. He focuses on a typical deposit annuity in the 1940s, which imposed a loading charge as well as an early surrender charge. If the annuitant could directly earn the 3 percent rate of return assumed in the annuity, then the capital fund an investor could build by contributing premium contributions to a personal account would grow faster than the surrender value of the annuity. In each of the first 11 years of a typical annuity policy, Gilbert (1948) showed, the surrender value was less than the sum of the nominal premiums that the annuitant had paid. Whether an individual can match the return promised in an annuity contract depends on existing investment opportunities and the degree to which the insurance firm offering the annuity provides valuable investment direction.

Annuities are not the only products with surrender fees. Some mutual funds impose a special charge on investors who withdraw their assets before a specified holding period. The nature of surrender charges and their effect on the investment return for these products are important factors to consider in comparing annuities with other financial products.

TAX TREATMENT OF ACCUMULATION

The tax treatment of annuities is an attractive feature that has undoubtedly contributed the most to their recent growth. The income on assets held in a deferred annuity account generally is not taxed until the payout phase, which can be many years after the income accrues. Annuities therefore afford an opportunity for asset accumulation at a pre-tax rate of return.

People planning for retirement may purchase annuities with pre-tax or after-tax dollars. As with qualified pension plans, annuities that are "qualified" (part of a qualified retirement plan) may be purchased with pre-tax dollars; "nonqualified" annuities are purchased with after-tax dollars.

Between the time the annuity is purchased and the time the contract owner receives payouts, generally no taxes are due on the dividends, capital gains, or interest earned by the assets in the annuity portfolio. When payouts are received, taxes are due on the difference between the annuity payouts and the annuitant's policy basis. The key tax principle is the derivation of an exclusion ratio, an estimate of the ratio of the contract owner's investment in the contract to the total expected payouts on the contract. The exclusion ratio is multiplied by the annuity payout in each period to determine the part of the payout that can be excluded from taxable income.

Contrasting the tax treatment of annuities and mutual fund investments is helpful. Mutual fund investors pay taxes when their fund receives dividends or realizes capital gains. They are liable for both dividend and capital gains taxes even in periods when they do not sell their shares in the fund; when they do sell their mutual fund shares, they may also be liable for capital gains taxes or eligible for credit for capital losses. Annuity contract owners, in contrast, do not pay any taxes during the accumulation phase of their annuity, although they are liable for a 10 percent early withdrawal penalty and subject to income tax (see above). The annuity provider receives dividends and capital gains, but the annuitant only faces tax liability when payouts from the annuity policy are received. The liquidity of annuities is limited by the fact that the loan, pledge, or assignment of an annuity is treated as a taxable event.

All annuity payouts are taxed as ordinary income, whereas part of the return to mutual fund investments may be taxed at capital gains tax rates, which are lower than ordinary income tax rates for many taxpayers. At death, mutual fund investments are eligible for a step-up in basis and need not be liquidated, but, at death, annuities must be liquidated and the proceeds must be distributed and subjected to tax.

The opportunity to defer taxes on the investment income from assets held in annuities is a powerful tool for building asset balances. Consider, for example, a 35-year-old considering various saving options to fund retirement income, with retirement beginning at age 65. Assume further that this individual plans to invest in an asset with an expected return of 7 percent per year and that investment income faces a marginal tax rate of 28 percent.

Under these assumptions, an investment of $10,000 at age 35 will cumulate to $45,356 (= 10,000 o exp(30 o 0.07[1 - 0.28])) at age 65, assuming that each year's asset income is fully taxed and that the after-tax income is reinvested. If the same $10,000 were invested in a way that permits tax deferral on asset income, for example in an annuity product, and if the pre-tax rate of return on this investment equaled that on the taxable investment, then the principal would cumulate to $81,662 (=10,000 o exp(30 o 0.07) at age 65. Assuming that the withdrawals from this account would be taxed at the 28 percent marginal tax rate and making the conservative assumption that the account value were withdrawn in a lump sum rather than paid out over the annuitant's life, which would permit further asset appreciation, the after-tax value of this account would be

$61,596 = 10,000 + (1 - 0.28) o (81,662 - 10,000),

where 10,000 denotes the principal invested. This amount is 35.8 percent greater than the amount in the after-tax investment. If the annuitant faces a marginal tax rate that is lower after retirement than while working, the implied rate-of-return advantage on the tax-deferred annuity vehicle will be even greater.

Table 8 presents additional comparisons between the rates of return on investments that offer tax deferral and investments that do not. It considers individuals with four different return horizons (10, 20, 30, and 40 years) and assumes four different rates of return (3, 5, 7, and 9 percent per year). The table reports the percentage increase in the value of an investment for an individual in the 28 percent marginal tax bracket, the 39.6 percent tax bracket, and a 20 percent marginal tax rate on investment income. The latter category might be representative of an investor who received investment income primarily in the form of capital gains during a period when capital gains tax rates were substantially lower than ordinary income tax rates.

The entries in Table 8 correspond to the 35.8 percent figure reported above. They are the additional value, in percentage terms, that an investor who invested in a tax-deferred rather than taxable format would have at the end of the investment horizon. The disparities are largest when the investment horizon is long, when the rate of return is high, and when the marginal tax rate is high. In some cases, particularly those with long investment horizons and high assumed tax rates and rates of return, the principal at retirement from investing in a tax-deferred account can be more than double that of investing through a taxable account.

EXPENSES AND LOADS

In a comparison of annuities with other investment vehicles, it is important to consider the investment management fees associated with each product. For annuities, these fees take the form of an expense charge that the insurer deducts each year. For a variable annuity, this includes a contract expense fee, as well as a fund expense fee. Other investments managed by fiduciaries also have expense charges. Mutual funds, for example, charge investors for management expenses, and they may also charge up-front loads or redemption fees.

Measuring the effective load on annuity products is complex and somewhat controversial, as the debate between Greene (1973) and Gifford (1974) with respect to variable annuities suggests. Annuity loads can arise in part from "adverse selection," the possibility that the mortality experience of annuitants is more favorable than that for the population at large. As noted above in the discussion of annuity pricing during the Depression, annuitants live longer on average than do randomly chosen individuals from the population at large. This implies that calculations that use the average population mortality experience to compute the expected present discounted value of annuity payouts will make annuities appear less financially attractive than they are for actual annuity purchasers. Friedman and Warshawsky (1988) present detailed estimates of the effective loads on immediate fixed annuities in the early 1980s, and Warshawsky (1988) reports historical information on these loads. Mitchell, Poterba, and Warshawsky (1997) present comparable information for the mid-1990s. These studies illustrate the disparity in the effective loads that are calculated using population and annuitant mortality tables. Friedman and Warshawsky (1988) conclude that the effective load on individual annuities in the mid-1980s was comparable to that on many other types of insurance. These studies all apply to the market for individually purchased annuities; group annuities may be subject to different effective loads.

REGULATORY AND LEGAL ENVIRONMENT

The legal and regulatory environment for annuity products is complex and constantly evolving. The substantial regulation of insurance products in general is partly a result of the long-term nature of the commitments associated with many types of insurance. This is particularly evident in annuities, where purchasers make large up-front payments in return for promises of long-term benefit streams. Fixed annuities are regulated as insurance products, but variable annuities are regulated both as insurance products and as securities. Variable annuities are subject to federal security regulation as well as to state insurance regulation. An active current policy debate is centered on the question of whether insurance companies should be the only financial institutions permitted to sell annuities or whether other institutions such as banks should be allowed to enter this market, and, if so, how they should be regulated.

The history of annuity regulation is intertwined with that of life insurance regulation. Until 1850, there was little regulation of the insurance industry in the United States. Several insurance scandals led to pressure for regulation, and in 1850, New Hampshire became the first state to appoint a commissioner of insurance. Many other states followed suit in the next two decades, and by the early 1870s the insurance industry in virtually all states operated under regulatory control, as described by Trieschmann and Gustavson (1995). The primacy of state regulation of insurance markets was confirmed when the U.S. Congress passed the McCarran-Ferguson Act in 1945. State insurance regulations are not uniform, and this can affect the scope of annuity products available to consumers in different places. Greene (1977) attributes the slow early growth of variable annuities, after their introduction by TIAA in 1952, in part to the requirement that such products receive regulatory approval in each state.

Insurance regulation arose historically in part because of the complexity of insurance products and the relative lack of sophistication on the part of many insurance buyers. Most annuities, like whole life insurance, involve investment decisions as well as decisions about mortality risk. Insurance regulation involves restrictions on the types of policies that can be offered, constraints on how policies can be explained to potential buyers, limits on what constitutes an acceptable expense, and regulations on the capital that insurance companies must have and on the types of investments that they can purchase with assets that are held against future policyholder claims. Insurance regulations are designed to increase the safety and security of income streams purchased by policyholders.

Black and Skipper (1994) discuss the investment regulations that affect insurance companies, in particular the presence of "legal lists," which describe the set of securities that insurers may invest in and the fraction of their assets that may be held in different securities. These regulations have implications for the rates of return that insurance companies can offer on fixed annuity products, since they typically restrict the amount of high-risk (and potentially high-return) securities in insurance portfolios. The foregoing regulations apply to fixed annuities. Group fixed annuities are subject to additional regulations from the provisions of ERISA, largely concerning the structure of contract terms for these products.

Variable annuities are regulated differently than fixed annuities, with insurers maintaining separate asset pools as reserves against variable annuities. This prevents poor returns on the variable annuity portfolio from affecting the capital base for other insurance company products. Variable annuities, because of their investment component, are also regulated in part under the federal securities law. These products are subject to provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. The first two acts are largely concerned with the prevention of fraud in the issuance and trading of securities, and the ICA of 1940 empowers the Securities and Exchange Commission to regulate the insurance industry's sales of insurance products with a substantial equity component, such as variable annuities and variable life insurance.

Because annuities are both an insurance product and an investment product, there has been a long-standing debate over the set of financial institutions that should be permitted to supply financial products that qualify for annuity tax treatment. The historic rationale for insurance companies underwriting and selling annuities was that they involved precisely the features, such as risk sharing and indemnification, that are the traditional role of insurance contracts. The current debate concerns the evolving nature of annuity products and centers on whether the insurance component of many of the currently popular annuity products is large enough to warrant restricting their provision to insurance firms.

Two issues are currently under active policy debate. The first, the subject of the recent NationsBank v. Variable Annuity Life Insurance Company (VALIC) case, concerns the right of national banks to sell annuities as agents of insurance companies. The Supreme Court's decision in this case upheld the authority of banks to sell both fixed and variable annuity products. The second issue concerns annuity underwriting. In late 1994, the U.S. Comptroller of the Currency, who regulates the products that banks may offer, tacitly approved the offering of some annuity-like products by some banks. Proposed banking reform legislation places limits on the authority of the Comptroller to authorize such investment products, and the tax treatment of some annuity-like bank products is also a topic of current policy debate. These unsettled issues are subject to frequent new developments.

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