Variable Annuities
MR. WATSON: We doubt that you will see the following information about units on the state exam, but it is still supposed to be covered in the course. This is technical, not difficult. Understand this and you will know more than the person who hired you. I know a lot of students just want the answers, but, we actually teach the material you will use once you are licensed, so, take your time. It will pay off in the long run.
MR. WATSON: Because of inflation, insurance companies came out with something called a variable annuity. We already said that a variable annuity is invested into mutual funds and that they are designed to offset inflation. The policy-owner chooses the investments.
MR. WATSON: So who regulates it?
ALL: State (Office of Insurance Regulation) and then the feds, (Securities & Exchange Commission).
MR. WATSON: Always say the word "state" first, then add the S.E.C., (the Federal government.) States regulate fixed annuities. The states and the Feds regulate Variable Annuities.
MR. WATSON: A Variable annuity is a bucket and inside this bucket you have funds (mutual funds or little buckets) - growth accounts, aggressive growth accounts, bond accounts, maybe a money market account. The owner gets to choose which fund to invest in and each bucket has investment risk different from the others. You can be as safe as you want, money markets, or as risky as you want, aggressive growth. Got it?
ALL: Yes.
A note: A mutual fund is an investment vehicle that is made up of a pool of funds for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors.
One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital. Each shareholder participates proportionally in the gain or loss of the fund.
MR. WATSON: So fixed annuities are expressed in terms of dollars. Variable annuities are expressed in terms of units. A minute ago you were getting $10,000 a year because we were talking about fixed annuities. Do you agree?
ALL: Yes.
MR. WATSON: Now we are talking about variable annuities, so you are going to get units. So there's two types of units. There are
- accumulation units , and
- annuity units .
So during the accumulation phase, you're buying accumulation units.
MR. WATSON: You're saying, "Of my $1,000 deposit, I want 50% to go into the aggressive growth account (this little bucket), and 50% of it to go into the money market account (that little bucket)."
MR. WATSON: If each unit costs $10, how many did you buy?
ALL: A hundred.
MR. WATSON: If each one of them costs $100, next month how many did you buy? 10. So after those two months you would have 110 accumulation units. You are buying more units when the price is low, fewer units when the price is high. Got it?
ALL: Yes.
MR. WATSON: Now, let's say I have 15,000 accumulation units. Each one of them is worth $10. How much is my variable annuity worth?
ALL: $150,000.
MR. WATSON: Now I am ready to annuitize my annuity. Do those words make sense to everybody? I am ready to take a stream of income.
ALL: Yes.
MR. WATSON: So, I have 15,000 units that are currently worth $150,000 and I am ready to annuitize my annuity.
MR. WATSON: Because variable annuities are expressed in terms of units, the company must convert the accumulation units into annuity units. I will just make up a number of units. Let's say the insurance company has converted this into 100 annuity units. You are now going to get 100 annuity units per month for the rest of your life. The number of units will never change.
MR. WATSON: When you annuitize your variable annuity, you lose all control over the investments. You now have a money manager who's managing that money-your money, my money, and the guy-down-the-street's money, all of this money is combined into the company's separate account. He's managing the separate account.
MR. WATSON: This month, for example, the annuity units are worth $8.00 How many units do I have? 100. Multiply by 8 bucks. My check is -
STUDENTS: $800.
MR. WATSON: Next month, the annuity units are worth $10.00 How many units do I have? 100.
MR. WATSON: Multiply it by $10, my check this month would be $1000. It went up.
MR. WATSON: The following month, each unit is now worth $1. How many units do I have? 100; multiplied by a dollar, my check is $100. So it went down.
MR. WATSON: The whole point to all of this is that the NUMBER of annuity units never changes, but the VALUE of those units change all the time.
MR. WATSON: There's risk because the amount you get each month depends on the value of those units, which is effected by overall market conditions and the investments the money manager makes. The policy-owner is taking the risk because you don’t know how much you’ll get each month.
MR. WATSON: Guys, the idea behind a variable annuity is it keeps pace with or out-performs inflation over time.
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