Resource Center Library | The Evolution of Variable Annuities by A. Scott Logan

1772 — First reference made to annuities in the United States by the Continental Congress Any history teacher will tell you that the forces enacted in history contribute to the development of the world we experience today. History is a bridge to the future and this precept holds for the history of annuities as well. The variable annuity today very much reflects the history of its development. As I put together notes for this talk, I searched the Internet and discovered that the first reference to annuities in the United States occurred in the Continental Congress of 1772. It applied to salaries of government representatives. It didn't have the same features and benefits that we see today, but annuities have a very long and distinguished past. Annuity legislation was formed in the late 1930's, soon after Social Security was established. Social Security payments were intended as a supplemental retirement program. It was always expected that individuals would provide for themselves. Annuity legislation was enacted for the purpose of encouraging individuals to save for their own retirement in a tax efficient manner. At that time, annuities were fixed with guarantees of principal and a stated interest return guaranteed solely by insurance companies, and earned fairly nominal rates of return. Fixed annuities supplied government workers and teachers with retirement income, but were hardly a good hedge against inflation. You are familiar, I'm sure, with TIAA, the Teachers Insurance and Annuity Association, and CREF, the College Retirement Equity Fund. TIAA-CREF is one of the largest pension organizations in the world today. TIAA-CREF also has the distinction of creating the first variable annuity in 1952 for teachers who participated in its CREF retirement plan. Soon after CREF established its variable annuity, financial planner John D. Marsh conceived of a variable annuity which would be available to the general public. Mr. Marsh began his quest in 1955 when he and a group of associates established the Variable Annuity Life Insurance Co. (VALIC). However, it wasn't until May 13, 1960, that the first commercial variable annuity prospectus became available in the United States, and, with it, the first insurance company separate accounts. The road that the variable annuity started down was long, though, and riddled with challenges. Some of the actions which influenced the development of the modern variable annuity: Revenue Ruling 77-85, which stated that individual investments in an annuity could not be owner directed. Revenue Ruling 79-335, which removed the tax-free step up in basis at death for the variable annuity. Revenue Ruling 80-274, which ruled that bank CDs could not be wrapped in an annuity. Revenue Ruling 81-225, which stated that publicly traded mutual funds could not be the underlying investments in a non-qualified annuity. Late 1930s — First annuity legislation enacted by Franklin Delano Roosevelt 1952 — First variable annuity created by TIAA-CREF for teachers who participated in its CREF retirement plan. 1955 — John D. Marsh conceived the creation of a variable annuity available to the general public. VALIC founded. For those of us in the annuity industry, those were challenging years. Thankfully, happier days lay ahead. The overhaul and definition of the annuity as we know it today began in 1982 with the Tax Equity and Fiscal Responsibility Act (TEFRA). The act reconfirmed the annuity as a long-term retirement planning vehicle and allowed annuities to keep their valuable status of tax deferral. It also laid the groundwork for annuities as we know them today. For example: Taxed annuity withdrawals on the basis of Last In, First Out as opposed to First In, First Out, thus withdrawals are treated as taxable earnings first. Provided a penalty tax on pre-59½ withdrawals. Reconfirmed favorable tax treatment of annuity payouts via the exclusion ratio for these payments to be part return of principal and part return of taxable earnings. Provided for the loss of tax deferral if an annuity contract was pledged as collateral for a loan. Provided for "grandfathering" of exchanged contracts under IRC Section 1035. Pre-TEFRA payments to a contract retained First In, First Out treatment when exchanged on a non taxable basis after the effective date of TEFRA. After TEFRA came the Deficit Reduction Act of 1984 (DEFRA). This act gave insurance companies more freedom in managing the separate accounts of their variable annuities by eliminating the capital gains tax at the insurance company level, thus eliminating the double taxation that existed for annuities. Two years after DEFRA came the Tax Reform Act of 1986. While this act defined further the role of the annuity, the most dramatic development in favor of annuity utilization was the reduction or elimination of most of the other options for tax-favored investing: Long-term capital gain income on stocks, bonds, mutual funds, and real estate was no longer preferentially taxed - taxed at ordinary income rates. Retirement plan contribution maximums for higher-income individuals were cut back. Tax-sheltered limited partnership programs were reduced or eliminated. Deductible IRAs for people participating in a qualified retirement plan were eliminated at income levels above $35K for individuals and $50K for couples. 1960 — The first commercial variable annuity prospectus becomes available on May 13, 1960. 1982 — "Modern" annuities created by Tax Equity and Fiscal Responsibility Act (TEFRA) enacted on August 14, 1982. 1984 — Deficit Reduction Act of 1984 (DEFRA) enacted, eliminating the capital gains tax at the insurance company level. While annuities benefited from the clarification provided by these tax acts, legislation in 1988 tended to be "overkill" in reacting to a planning method designed to reduce the impact of the Last In, First Out tax burden. This was done by establishing two or three contracts for a client instead of a single contract. As an example, let's take a client with $100,000. If this client invested $100,000 in one contract and it grew to $200,000, any withdrawal that the client could make (up to $100,000) would be fully taxable. However, if the client were to split that money into two annuity contracts each with $50,000 of the principal, and they each grew to $100,000, when the client liquidated one of the contracts, taxes would be paid on only the $50,000 of earnings. This may seem like a harmless example, but one or two companies took this idea to the extreme. They would issue contracts in $1,000 blocks. This would result in a client with a $100,000 purchase being issued 100 contracts. This procedure clearly was not intended and equally unacceptable. The Tax and Miscellaneous Revenue Act of 1988 (TAMRA), became known as "anti-abuse" legislation and stated that any contracts issued by the same company to the same policyholder in a 12-month period would be treated as one annuity contract for tax purposes. (This language has since been amended to read "within the same calendar year.") If we consider where all of these regulations and statutes leave us, the following provisions are now basic to all variable annuities: Annuities are completely tax-deferred, both at the insurance company and the individual owner level. The 59½ withdrawal penalty provision ensures that annuities are long-term retirement vehicles. Annuitization payments receive favorable tax treatment. There are tax-free transfers among variable account options. Annuity funds in a separate account cannot be accessed by the insurance company creditors. There was more to the development of the annuity than tax legislation which provided definition of and certainty to the role of the annuity. Additional differentiation was provided in annuity product features. Originally, the variable annuity offered no death benefit guarantee during the accumulation period. In order to address the investors' concerns about their families, particularly when putting assets at risk in the market, annuities began to offer a death benefit, which would guarantee the original principal in the event the owner died during the accumulation period. Competitive forces moved to a market value increase after a certain number of years, usually the end of the surrender charge period, and after that, a guaranteed percentage increase every year. These creative alternatives are characteristic of the annuity industry, which has, time and again, met the needs of a growing and more sophisticated client base. Other features were developed to gather assets. Flexible systematic withdrawal provisions, shortened surrender charge periods, automatic bank draft investment programs, and dollar cost averaging were designed to ensure that the needs of the client were met. I am sure that I am leaving out much, but that is a brief history of annuities. Now I would like to turn attention to the annuity marketplace today. The wonderful thing about this industry is that some creative mind is always devising features that can make the product more appealing to the contract owner. But I submit to you that it is the fundamental superiority of the annuity product as a retirement planning vehicle with tax deferral during the accumulation phase and the guarantee of income you cannot outlive during the payout phase which explain the growing success of the annuity. Sales of annuities continue to grow, projected at an estimated $87 billion in 1997, which is an 18% increase over 1996 (according to VARDS). Clearly, investors are realizing that the annuity is a necessary tool for building a solid retirement foundation.1 1Variable annuity sales in 1999 were $120.8 billion. Baby Boomers, especially, face a triple threat: paying for their children's college education, their own retirement, and the care of at least one aging parent. Further, they are facing this threat with less support from the government than ever before. According to 1994 data from the Social Security Administration, the average American will be responsible for providing approximately 70% of his or her own retirement income. For most people approaching retirement age, this realization comes as quite a shock. Fortunately, annuity companies are providing approaches which may help investors maximize their investments. Some of the newest improvement to the accumulation phase of the contract include expanding the range and improving the quality of investment management and portfolios, incorporating Modern Portfolio Theory applications formerly available only to the large institutional investors, and adding asset allocation and rebalancing features. 1986 — Tax Reform Act of 1986 enacted. 1988 — The Tax and Miscellaneous Revenue Act of '88 (TAMRA) enacted to curb abuse of the loophole created by the Tax Reform Act of 1986. 1997 — Sales of annuity contracts projected to reach $87 billion. As an industry, we have focused on the accumulation phase to the detriment of the annuitization phase. Some companies have started to develop better options for annuitization. These contracts are designed to provide payments, which reflect underlying investment performance while at the same time leveling payments to reduce the impact of market volatility. They also include features that provide a degree of liquidity after the contract has been annuitized. You should be aware of new contract designs such as the no-surrender charge annuity, the principal enhancement (bonus) annuity, and the equity index annuity. The no-surrender charge annuity offers full liquidity to clients at any time, without any up front or continuous sales charge. These annuities are popular with older owners who do not want the restrictions of a six- or seven-year withdrawal charge in meeting unexpected requirements and changes in their objectives. The principal enhancement or bonus annuity credits an investor with a certain percentage, such as 3, 4, or 5%, depending on the amount invested. This design is significant in providing immediate enhanced values to the annuity owner. The equity index annuity is designed for more conservative investors who wish to enjoy the benefits of investing in the stock market with a protective investment floor on the downside. This annuity typically provides the contract owner an investment return that is at least a prescribed percentage of the return of the S&P 500 Index, for example, while guaranteeing no less than a stated fixed return on the investment. These new product designs not only keep the variable annuity industry dynamic, but they respond to the needs and desires of investors in meeting their retirement planning objectives. In discussing the annuity of tomorrow, I would like to address four topics-technology, annuitization, menu design, and legislative enhancements. With the advances of technology, more people are using their computer to accomplish tasks they would have done in person or over the telephone. People visit Web sites to do bank transactions and place stock orders on-line instead of with a stockbroker. It certainly won't be long before younger investors, who are familiar with existing technology, take their retirement planning on-line. Fortunately, this issue has been addressed by the SEC, and guidelines for providing annuity information electronically have been established. Not only will dissemination of information become easier, NAVA and other organizations are working to make this somewhat complicated product easier to understand with the simplified prospectus and the prospectus profile. These advances would increase the "user friendliness" of annuities, and appeal to those investors who are now hesitant to invest in something that they don't completely understand. Another NAVA initiative is the work being done with NSCC as that firm develops a centralized annuity processing system. Not only will technology increase the availability and understanding of variable annuities, but it will reduce operating costs significantly, which can be passed on to benefit the contract owner. Future advances must also be made on the annuitization side of the contract. Payouts will be designed to offer a guarantee of principal, a cash value and a death benefit. As we have seen in the past, the concerns of our clients will drive the options that we offer in the future. Forward thinking companies that offer annuitization payments on a variable basis to permit a client's investment to keep pace with inflation will design ways in which these payments can be stopped for a lump sum distribution in case of an emergency, or can be made to a beneficiary in a variety of forms and at different points in time. We must look for ways in which the flexibility of the accumulation phase of the annuity contract may be extended to the annuitization phase. As the annuity increases in popularity and understanding, we will need to design contracts that make available the features wanted and needed by the investor. Several companies have developed contracts that give options or a type of "menu" approach. This gives the client the advantage of getting and paying for exactly the feature desired. To encourage greater utilization of the variable annuity in retirement planning, Congress should provide for the tax free step up in basis for annuity assets upon death of the owner. It is available for mutual funds today and it was available for variable annuities until the fall of 1979. Individuals should not be disadvantaged if their circumstances change and they find they do not need to live on all of the annuity assets in their lifetime. If total step up in basis were viewed as "too much of a benefit" because of the favorable tax-deferral treatment during the life of the contract, then at least a partial step up on capital growth should be enacted, with dividend and interest accumulations remaining subject to federal income taxation. The non taxable exchange provisions of Section 1035 of the IRC should be extended to permit an annuity to be exchanged for a life insurance policy. Right now, one can exchange an annuity for an annuity, or a life insurance policy for an annuity, on a non taxable basis. I am sure there are some challenges in designing this, but again, to provide maximum incentives for individuals to save for their own retirement in a tax efficient manner, the ability to move unneeded annuity assets to a better purpose would be a positive influence. We know that annuity savings are doing the job for many Americans. Congress should make these positive changes to encourage retirement savings, thus relieving pressure on Social Security entitlements in the future. In closing, it is clear that the 76 million Americans we call the Baby Boom generation will continue to impact our economy and markets. There is no question that the needs and demands of working Americans can and must be well-served by the variable annuity. As an industry, we must move forward, taking utmost advantage of technology to provide quality investment programs and annuity features at reasonable costs. This is what Americans want; it is what they need, and best of all, we can provide it!