CHAPTER FOUR - MANAGING ASSETS & OTHER VARIABLE PRODUCTS
RISK TOLERANCE
Also like mutual funds, separate accounts offer a choice in investment strategies and objectives. For instance a money-market fund may be the right choice if the party is security-minded and the interest rates are declining, similarly for a bond fund. If the interest rates are high and the market is doing well, a contract holder may have the objective of taking more chances and receiving a higher return on their assets by investing in corporate bonds or preferred stock. It is very important that a representative marketing variable products understand what the consumer’s objectives are and that they understand the various degrees of risk.
This is called “risk tolerance” and polls have shown that the consumers consider this as a very important responsibility of the representative selling variable contracts. The client will have to make choices as to investment objectives, so determining where the assets should be invested depends greatly upon the risk tolerance of the individual, in addition to the separate account’s investment objectives. This can be difficult to determine, and companies who offer variable contracts usually can be of assistance to the representative to determine the risk tolerance of their clients.
THE PROBLEMS OF SUBACCOUNT FLUCTUATIONS
It must always be kept in mind that with a variable contract, there can be substantial changes in the cash value. A good business executive will always want to know the “down side” before making an important decision, so that he will know his choices in case things do not work out as intended. This same attitude should be held by those who are making investment decisions, including whether or not to purchase a variable annuity, and if so, what will happen if the market collapses and investment returns plummet—important and logical questions.
ASSET ALLOCATION
Of all of the various methods for a annuity owner to manage the value of their investments, the asset allocation procedure has the most effect. There are different approaches to asset allocation and they may seem rather technical, however the concepts are really not that difficult and should be understood by those who market variable annuity products.
Basically, the asset allocation is a process of determining what percentage or amount of the assets to be invested by the customer best suits him—taking into consideration his objectives, the length of time that the investments are to be managed (time horizon), and his risk tolerance. In effect, the asset portfolio is divided between various classes of assets that best match the annuity owner’s objectives and his risk profile so the capital can be protected against negative developments; while at the same time, taking advantage of developments that can affect the assets positively.
Each of these assets—stocks, bonds, cash, etc.—can be determined to have a potential return and a particular level of risk, and it usually behaves in a manner in response to market (and other) changes that are different than the response of other asset classes. Asset allocation is generally considered as the most important decision made by an investor—where to invest the assets and in what proportion—and further, it has a more meaningful impact on reducing total risk than by selecting the “best” investment in any single asset category.
Obviously, assets can be allocated in any percentage that is believed to meet the needs of the annuity owner and still stay within the risk-tolerance area of the individual. There are basically three approaches, one for each aggressive, moderate and conservative investor.
- Fixed weightings, which is an allocation that is based on maintaining a fixed percentage of the portfolio in each of the three categories of assets.
- Flexible weightings is where the allocation “floats” between selected subaccounts in response to the changes in the market as they occur, such adjustments are made based upon either an analysis of the market or market timing.
- Tactical asset allocation is limited mostly to portfolio managers because it requires large investment portfolios.
The first two approaches, fixed and flexible weightings, differ mostly by the nature of the proportion of the assets in an investor’s portfolios. It is possible to involve a combination of these two—or all three if the portfolio is large enough—but it is usually more practical just to use one approach.
Fixed Weighting Asset Allocation
Simply put, this system uses a fixed percentage of each of the categories of assets (stock, bonds or cash) and they remain relatively stable over time. However, since the asset values fluctuate with market trends, the percentage must be adjusted from time to time so as to keep the desired fixed percentage allocations. As an example, a portfolio might be 50% stock, 40% bonds, and 10% cash. The adjustments are usually made manually, however they may be adjusted automatically, as described later.
With variable insurance products, the balance of assets can be adjusted as often as quarterly or as infrequently as annually as determined by the annuity owner. It should be kept in mind that asset allocation adjustments are made after any major market move. For instance, if the stock market jumps, the example previously quoted could be adjusted to reflect such a move by increasing stocks to 60%, reducing the percentage of bonds to, say, 32% and cash to 8%. However, in order to maintain the asset allocation percentages of the client, the stocks would have to be reduced back to 50%. While the total value of the assets has increased, the percentage remains the same, so the dollar value of the stocks would be reduced—although the overall value has increased—so the bond holdings and the cash would both be increased in value also while still being returned to the original 50-40-10%. An example can perhaps explain this better:
Original portfolio
Asset Asset value Asset allocation
Stocks $100,000 50%
Bonds 80,000 40%
Cash 20,000 10%
Total $200,000 100%
After a drastic stock market increase, now the assets are valued:
Stocks $150,000 60%
Bonds 80,000 32%
Cash 20,000 8%
Total $250,000 100%
Adjusted in keeping with the original intent:
Stocks $125,000 50%
Bonds 100,000 40%
Cash 25,000 10%
Total $250,000 100%
This method of asset allocation is relatively simple as it just reacts to changes in the portfolio classes and automatically rebalances it when investment activity makes it necessary so that the investor will always hold the same percentage.
Flexible Weighting
Flexible weighting is much more flexible, as the name implies, as it involves adjusting the selected weight for each asset in the portfolio at specified times and based upon the market analysis or market timing.
To explain this method better, using the same assets as before
Asset Asset value Asset allocation
Stocks $100,000 50%
Bonds 80,000 40%
Cash 20,000 10%
Total $200,000 100%
For purposes of this exercise, assume that inflation rates are expected to drop, and with such a drop this would usually result in increased (domestic) stock prices. Therefore, the investor may want to anticipate this increase by changing the percentage allocations so as to expect a greater return in his portfolio. The new asset allocation may look something like this:
Asset Asset value Asset allocation
Stocks $150,000 75%
Bonds 40,000 20%
Cash 10,000 5%
Total $200,000 100%
Tactical Asset Allocation
This system is actually appropriate only for large institutional investors, but it is still noteworthy. This is similar to the flexible allocation system described above, however it employs stock index futures and bond futures, e.g. when stocks are not as attractive as bonds, the stock futures are sold and bond futures are purchased, and vice-versa.
This system is rather sophisticated and it relies upon financial models to alert the investor as to the market movement, therefore it requires a large portfolio.
ASSET CONCERNS
While these assets under discussion here consist of stocks, bonds and cash, in reality there are all types of each asset. For instance, stocks can be common stocks, preferred stocks, stocks that are considered as “blue-chip,” international growth fund stocks, etc. Bonds also have different classifications, such as municipal bonds, corporate bonds and US Government bonds. Cash may be in the form of CDs. passbook savings, money market funds, etc.
If the individual is aggressive with his investments, so as to maximize income, he must be aware that he will have to take substantial risk to accomplish what he wants. Usually the annuity owner will not have to access the cash values for 10 or more years to any large degree, and therefore the cash value of the policy should consist of funds that are allocated to the stock subaccount. The lengthy period of time that the funds are invested help to minimize the risks as much as possible.
If the annuity owner has a shorter investment period in mind—5 to 10 years—then a moderate growth allocation is in order with stocks dominating the portfolio, but bonds and cash will be larger in proportion than the aggressive portfolio. The moderate investment portfolio is usually more diversified than the aggressive portfolio.
If a conservative growth portfolio is desired, then they should prefer a low turnover portfolio with mostly blue chip securities. This would be appropriate for a annuity owner who may need access to his funds for a short period of time—3 to 5 years—and the ultimate goal is nearly always the preservation of the portfolio. Generally stocks are still the predominant investment, but of the blue-chip type.
REBALANCING THE ASSETS AUTOMATICALLY
Under the assumption that the assets are balanced according to the wishes of the annuity owner, then when they are “out-of-balance” because of the increase or decrease of any of the assets due to market conditions, they must be returned to their original balance. In actual practice, automatic reallocation is easy and cost-free.
Market activity can “unbalance” the portfolio so that it no longer expresses the wishes of the annuity owner. The preceding example of a portfolio that was out-of-balance because of market changes demonstrates how this is accomplished. This is mentioned again because the next investment strategy discussed is not available with the automatic asset rebalancing.
DOLLAR COST AVERAGING
The dollar cost averaging technique is basic to those who invest regularly, and simply put, when prices are lower more shares are purchased, and when they are higher—fewer stocks are purchased. This, when performed correctly, results in a lower average cost per share for the investor. Perhaps the biggest concern of those who invest in accounts and subaccounts, is that if funds are transferred from one subaccount to another and then the value of the subaccount falls rapidly—this is certainly a legitimate concern. This can easily happen because the value of variable subaccounts does fluctuate—that is the nature of the beast.
The purpose of dollar cost averaging is to provide the policyholder an average cost per share that is lower than the average price per share over the same period of time as the market fluctuates. It does this by purchasing more units of the subaccount to which the funds are being transferred when the unit value is lower—and conversely, fewer units when the unit value is higher.
This concept can be best explained by the following example: In this example, the annuity owner investor transfers $1,000 each month from the bond subaccount to the stock subaccount. For this example, the stock subaccount’s unit value fluctuates as indicated below.
Stock Stock
Date Amount Subaccount Subaccount
Transferred Unit Value Unit Value
Jan. 1 $1,000 $8.50 $117.65
Feb. 1 $1,000 $8.00 $125.00
Mar. 1 $1,000 $7.50 $133.33
Apr. 1 $1,000 $7.00 $142.85
May 1 $1,000 $6.50 $153.85
Jun. 1 $1,000 $7.00 $142.85
Jul. 1 $1,000 $8.00 $125.00
Aug. 1 $1,000 $8.50 $117.65
Sep. 1 $1,000 $9.00 $111.11
Oct. 1 $1,000 $9.50 $105.26
Nov. 1 $1,000 $8.50 $117.65
Dec. 1 $1,000 $9.00 $111.11
Total $12,000 $1,503.31
AVERAGE PRICE PER UNIT $8.08
AVERAGE COST PER UNIT (12,000 ¸ 1503.31 $7.98
Therefore, the average price per unit over the 12-month period was $8.08; the actual cost per unit was $7.98 — $.10 each for 12,000 units equal $1,200 total!
FWhile transfers may usually be made from any variable subaccount to any other account, dollar cost averaging transfers from the fixed account are not allowed.
As a general rule, there is no cost to the annuity owner in respect to dollar averaging, and the annuity owner can use this strategy over and over. As stated above, automatic rebalancing and dollar cost averaging may not be implemented at the same time.
INTEREST SWEEP FEATURE
Many variable insurance products allow the “interest-sweep” feature where the insurer reallocates the interest credited to the fixed account to one or more of the variable subaccounts. If the interest is to be “swept” into one or more account, the annuity owner must indicate the subaccounts to which the interest should flow, the percentage allocation to each of the subaccounts and the time that the interest sweep is to occur (monthly, quarterly, semiannually or annually).
The benefit to the annuity owner is similar to the dollar cost averaging benefits, as the annuity owner uses the interest that is credited to the fixed account and uses it to purchase variable subaccount units. The funds that are reallocated using this method do not vary greatly, fewer units of the variable subaccounts are purchased when the value is higher and, conversely, more units of the variable subaccounts are purchased when the unit value is lower. Therefore, the cost per share is lower than the per share price in a market that fluctuates with the result that the total value of the policy is likely not be much affected by any negative movements in the market.
F NOTE: For Senior Citizens – those age 65 or older – there is a 30 day cancellation period by law, during which the annuitant or insured may rescind the policy with full refund of all premiums. For variable annuities the premiums may be invested only in fixed-income investments and money-market funds, unless the investor specifically designates that the premium be invested in the mutual funds underlying the variable annuity contract. If this occurs, then cancellation shall entitle the owner to a refund of the account value.35
IMMEDIATE VARIABLE ANNUITIES
While most variable annuities are deferred annuities, the immediate variable annuity has emerged as an interesting vehicle for some investors. Immediate variable annuity fees vary by company, but one survey indicated that they approximate 1.8% (by comparison, some mutual funds will only charge 0.3 percent).36
When an immediate variable annuity is purchased, the customer pays a lump sum to an insurance company and immediately starts receiving monthly payment. The payments will rise or fall, just as with a deferred variable annuity. And, comparing the immediate variable annuity to immediate fixed annuities, some investors like the idea of receiving different amounts each month, depending upon the performance of the stock market. It is generally believed that investments in the stock market will always beat inflation, therefore an immediate variable annuity will provide inflation protection that a fixed immediate annuity will not.
F People who are approaching retirement and have a large sum of money, are the best customers for this type of variable annuity.
They have been around for several years, but only within the past 2 years have they grown in popularity. The reason, some experts believe, for the increased interest, is that older “baby-boomers” are willing to take on some risk, probably because the baby-boomer generation simply has not been saving enough, plus there is concern as to whether the Social Security program will continue when they reach retirement age.
However, most financial planners do not recommend an immediate variable annuity if the customer is not of retirement age. It is much less expensive for younger persons to maximize their 401(k) plans first. Actually, it may be cheaper for the person retiring with a substantial 401(k) to simply roll over the money into an IRA and it would be less expensive. It could also be rolled over to a mutual fund for less expense; however, the security of the financial strength of the insurer is not present.
The success of this type of annuities has not been as forecasted when the product was first offered for a variety of reasons, including the roller-coasting of the stock market. Another reason was because these annuities are difficult to understand, even for trained professionals in the investment field. Besides having a complex sales process for the marketing of an annuity, the explanation of how an immediate annuity works and the various payout options can be quite overwhelming at times.
FIXED AND VARIABLE PAYOUTS
FIXED PAYMENTS
When the liquidation phase begins the insurer starts paying income to the annuitant on a regular basis. The total cash value accumulated for the amount of the lump sum with a single premium payment is annuitized by the insurer using established procedures that consider:
- The annuitant's age and hence, life expectancy.
- Frequency of each income payment.
- Interest or account earnings that will continue to be paid on the diminishing annuity principal amount during the liquidation period.
- Guarantees the insurer has made (or not made) about the length of time income payments will continue. In some annuities, provisions are made to provide payments to the survivors after the annuitant dies. Obviously, guarantees such as this require each income payment to be smaller to make certain the accumulated funds last long enough.
The age consideration involves the annuitant's age when the liquidation phase begins. For example, an annuitant that wants to begin receiving lifetime income at age 55 will receive smaller payments than one who waits until age 65. In the former case, the insurer makes a commitment to pay lifetime income for what is assumed will be a longer period.
As discussed earlier, since some states use “Unisex” ratings, premiums would be the same for male and female. From all of the factors considered (as discussed earlier), the insurer arrives at a certain "fixed" dollar amount of income the annuitant will receive every time an annuity payment is made.
VARIABLE PAYMENTS
In their original concept of variable annuities, one of the "variable” parts of variable annuities was the amount of each income payment. However, many annuitants were unhappy with the uncertainty of each payment amount, so insurers now permit payments from variable annuities to be determined in the same way as fixed annuity payments, whereby each payment remains constant during the liquidation phase. The amount is based upon the value of the annuity when liquidation begins. Therefore, at the liquidation phase, the only remaining "variable" in the variable annuity is the interest rate, or earnings, paid on the remaining principal. While most annuitants (about 90% currently) prefer this type of payout, insurers will make variable fluctuating-amount payouts if the annuitant desires.
VARIABLE ANNUITY UNITS AT LIQUIDATION
Under the original variable payment method, variable annuities require a different means to determine the payout. When the liquidation phase begins, the insurer uses the number of Accumulation Units to arrive at a number of Annuity Units. Annuity Units are an accounting measure representing a fixed number of payout units rather than a fixed number of dollars. The determination of the exact number of Annuity Units resulting from the annuity’s accumulation value, is as follows:
First, the insurer determines the dollar value of the accumulation account by multiplying the number of Accumulation Units times the value of each. (This is the same calculation used to determine value during the accumulation period.) If the value of each unit is, for example, $5 and the annuitant has 50,000 Accumulation Units, the value is $250,000.
Then, using annuity tables that consider such things as age, sex (where permitted), the insured’s guarantees and any transaction charges or loading, the insurer then determines the dollar amount that will be paid per $1,000. For example, assume the payment will be made monthly and the tables indicate a payment of $10 for every $1, 000 of value. The annuitant in the example has $250,000 or "250 thousands" - $10 times 250 equals a monthly payment of $2,500, which is the amount the annuitant will receive for the first payment. Once the number of Annuity Units has been determined, that number remains the same during the entire payout phase. However, the value of each annuity unit varies according to the performance of the investments in the separate account. This means the amount of each payment can vary
In the previous example, the value of each annuity unit was $5. Dividing the $2,500 payment by $5 results in the number of Annuity Units - 500 in this case. From this point forward, the monthly payment is equal to 500 Annuity Units times the value per unit at the time the payment is made.
Using the same example, if, during the next month, the value per unit has dropped from $5 to $4, then the monthly will be ($4 times 500) Annuity Units or $2,000. Later during the annuitant's lifetime if the value rises to $7, it would result in a monthly payment of $3,500. Throughout the “liquidation period” fluctuations continue as the separate account investments fluctuate.
HOW MUCH RISK?
Fixed annuities have been perceived as essentially risk-free in terms of safety of the principal amount invested. The primary risk associated with fixed annuities was inflation risk - the possible loss of purchasing power resulting from high inflation. Variable annuities, on the other hand, greatly increase the investment risk to the annuity owner with the hope of offsetting the inflation risk. To reiterate the obvious:
FThe higher the risk, the greater the reward.
As for risks involving future income, only an annuity can guarantee a lifetime income stream to the buyer. For example, money deposited in a savings account and withdrawn periodically during retirement can run out eventually. But the annuity buyer can be guaranteed lifetime income even if the annuitant is still alive when the original principal and interest amounts are depleted.
EQUITY-INDEXED ANNUITY
The Equity Indexed Annuity (EIA) is not only a newer product; it is a somewhat complicated product that is extremely unusual and useful. For starters, it is an insurance product that determines the annuity payments by the use of an index that is “geared” to the fluctuations of the stock market. So far, it is still considered as “insurance” and not as security, therefore an insurance-only agent can market the plan, and a securities license is not needed (although it may be recommended).
FThe Equity Indexed Annuity is NOT a security, and should never be directly compared to a security (stock, bond, etc.)
In particular, this product offers a unique planning opportunity for financial planners. However, there are many provisions and elements of this new product and many new options and changes are introduced with regularity.
WHAT IS AN EIA?
FAn Equity Indexed Annuity is, simply put: a fixed deferred annuity.
It is not a new type of annuity, it is not a security, it is not a Variable Annuity – it is a fixed deferred annuity with all of the guarantees and features. The biggest difference between an EIA and a “regular” fixed deferred annuity is how interest is credited to the contract.
Traditionally with a fixed annuity, the interest rate credited to the annuity is based on existing and current interest rates which is guaranteed by the insurance company and is guaranteed payable for the term of the annuity. Since most fixed annuities use a one-year period, they are renewed for another year, one year at a time. While it may have a guaranteed interest rate of, typically, 3 percent, it will use current rates each year, but never less than the guaranteed rate.
With an EIA, the interest rate is based on a formula linked to an independent stock market index – usually Standard & Poor’s Composite Stock Price Index (S&P 500). So, to summarize:
Fan Equity Indexed Annuity is a fixed deferred annuity that uses an external index that reflects the fluctuations of the stock market to determine the interest earned.
The EIA is not a security, indexed mutual fund, nor an investment in the stock market, nor a Variable Annuity; it is also NOT a substitute for any of these investment vehicles. However:
FThe conservation of the principal of the Equity Indexed Annuity is GUARANTEED!
Remember that it is a fixed annuity. A fixed annuity protects the annuitant from the risk of losing their invested money (principal) because of the vagaries of the stock market. This is the safety factor that has made fixed annuities attractive throughout the years and which are then used for “safe” investments that will not be accessed for a period of years. Remember also, as stressed throughout this text, risk and return work in tandem – as the risk increases, the return increases. Therefore, the security of a fixed annuity would indicate that the return would be provided at a low rate of return.
With an EIA, the investor is provided with an opportunity to share in increasing rates because of increasing values in the stock market, and still do so with a guarantee that the principal will not be touched. It can be used to provide the annuitant with a steady stream of income, and can be used to supplement other income like Social Security, pension plans and income from savings.
EIAs use several methods to measure the amount of change in the contract, called “indexing methods.” The most common methods are annual reset, high-water mark and point-to-point—and variations thereof. Each of these methods have advantages and disadvantages. For a more in-depth study of these methods, the Buyer’s Guide to Equity-Indexed Annuities, prepared by the National Association of Insurance Commissioners is highly recommended.
Another factor that is unique to this product is the participation rate. Terms vary by contract, but the full amount of the growth of the index, or a stipulated portion of the growth, may be credited to the contract—this is the participation rate. This rate may vary but typically the rate is less than 100 (which would indicate that all of the growth is credited). Some contracts place a “cap” on the amount of the index gain that would be credited to the owner, which could be a percentage of the index gain for the year or for the month.
There usually is an additional provision that requires that the contract be maintained for a minimum period before the contract is credited with the index amounts; such time requirements called “annuity term” or “policy term.” If the contract is surrendered before the expiration of the annuity term, no growth in the index will be credited. Contracts may offer multiple terms and the payment of a new premium may begin with the new term for that premium—six or seven years have been typical, but recently, longer, such as 10-15 years, have been offered.
This is a new form of annuity and as such, there are still questions being raised about the product, particularly in the area of proper reserves posting for the life insurance company, and the status of the plan under the federal securities laws. As of this date, it is considered as an insurance product and not a security, however, if uneducated or careless agents present it as a security, then eventually it could become a security.
STUDY QUESTIONS
1. It is important when marketing variable annuities that he understand what the consumer’s objectives are and that they understand the various degrees of risk. This is called
A. risk tolerance.
B. defensive marketing.
C. meeting SEC requirements.
D. avoiding chargebacks.
2. Of all of the various methods of managing the value of investments, the procedure that has the most effect is
A. dollar cost averaging.
B. asset allocation.
C. Barron’s Method of Investing.
D. simply reading the Wall Street Journal every day.
3. The system of using a fixed percentage of each of the categories of assets where they remain stable over time, is called
A. dollar cost averaging.
B. flexible weighting asset allocation.
C. tactical asset allocation.
D. fixed weighting asset allocation.
4. If an individual is aggressive with his investments as he wants to maximize income,
A. the more aggressive, the lesser the risk.
B. an annuity is the most risk-free and preferable method of accumulating funds for
retirement.
C. he must be aware that he will have to take substantial risk to accomplish what he wants.
D. he will, therefore, always have more funds at retirement than one who is more conserva-
tive in investing.
5. When assets are “out-of-balance” with the wishes of the annuity owner because of increase or decrease of any of the assets in the annuity,
A. the rebalancing the assets is rather expensive and difficult.
B. the rebalancing the assets is easy and cost-free.
C. then the owner must adopt another method of protecting the assets.
D. there is absolutely nothing, short of surrendering the annuity, to correct that.
6. When the insurer reallocates the interest credited to the fixed account to one or more of the variable subaccounts, this is called
A. fixed asset allocation.
B. flexible asset allocation.
C. rebalancing.
D. the interest-sweep feature.
7. For senior citizens, there is a 30-day cancellation period
A. and the insurer must refund all premiums paid, less a service fee.
B. during which time the individual must make a formal request to cancel with a notarized copy to the department of insurance.
C. when the annuitant or insured may rescind the policy with full refund of all premiums.
D. provided there has been misrepresentation or fraud involved in the sale.
8. With dollar-cost averaging, when transfers usually can be made from any variable subaccount to any other account,
A. dollar cost averaging transfers from the fixed account are not allowed.
B. dollar cost averaging transfers from the fixed account are encouraged.
C. such transfers are quite expensive because of the additional fees that must be paid.
D. such transfers must have prior approval of the Department of Insurance or the SEC.
9. Those who are approaching retirement and have a large sum of money, are the best customers for
A. deferred fixed annuities.
B. immediate fixed annuities.
C. immediate variable annuities.
D. deferred variable annuities.
10. The Equity Indexed Annuity is a fixed deferred annuity that uses an external index that reflects the fluctuations of the stock market to determine the interest earned, but most importantly
A. it is a security, regulated by the SEC and an agent must have a securities license.
B. the conservation of the principal is guaranteed.
C. it pays extremely high commissions.
D. it is sold primarily by banks.
CHAPTER FOUR:
1A 2B 3D 4C 5B 6D 7C 8A 9C 10B