The conventional concept is that an annuity provides payments of a fixed amount over a specified period or throughout the lifetime of one or more persons. The persistent inflation over recent decades, however, has focused attention on the need for protecting the purchasing power of annuity benefits. This has given rise to a type of contract that attempts to achieve that objective by providing benefits that vary with changes in the insurer�s investment performance, which in turn often coincide approximately to changes in the purchasing power of the dollar. Such a contract has appropriately been named a variable annuity.

If a contract is to provide benefits with stable purchasing power, it must provide more dollars when prices rise and fewer dollars when prices decline. Theoretically this could be achieved by adjusting the benefits to changes in an appropriate price index, such as the Consumer Price Index published by the Bureau of Labor Statistics. This is not practical from the standpoint of the insurance companies, however, since there is no mechanism by which the value of the assets backing the annuity can be adjusted automatically, or otherwise, to changes in the dollar value of the annuity promises. As a practical solution, contracts have been developed that provide benefits adjusted to changes in the market value of the assets�typically, common stocks�in which the annuity reserves are invested. The theory is that over a long period of time, the market value of a representative group of common stocks tends to conform rather faithfully to changes in the consumer price level. Moreover, inasmuch as the insurance company�s liabilities to its annuitants are expressed in terms of the market value of the assets offsetting the liabilities, funds for the payment of annuity benefits will be available in the proper proportions at all times.

Supporters of the variable annuity feel that annuitants need some kind of protection against inflation, and they believe that a common stock investment program administered by a life insurance company is the best approach yet developed. Critics of the variable annuity approach question whether continuing inflation is inevitable, and even if it is, whether common stock investments provide an effective hedge against rising prices.

At present variable annuities are most often issued on a deferred basis. During the accumulation period, premium payments�or deposits, as they are frequently called�are applied to the purchase of accumulation units. The accumulation unit is assigned an arbitrary value, such as $10, at the inception of the plan, and the initial premiums purchase accumulation units at that price. Thereafter the units are revalued each month to reflect changes in the market value of the common stock that makes up the company�s variable annuity portfolio. On any valuation date, the value of each accumulation unit is determined by dividing the market value of the common stock underlying the accumulation units by the aggregate number of units. Dividends are usually allocated periodically to the participants and applied to the purchase of additional accumulation units, although they may simply be reinvested without allocation and permitted to increase the value of each existing accumulation unit. Capital appreciation or depreciation is always reflected in the value of the accumulation units, rather than in the number of units. (In other words, both realized and unrealized gains and losses are reflected for individual participants through an increase or decrease in the value of their accumulation units.) A portion of each premium payment is deducted for expenses, and the remainder is invested in accumulation units at their current market value.

A hypothetical accumulation is shown in table 6-2. In this example the initial purchase is made at age 35 with a gross consideration (premium) high enough to cover a $200 acquisition each month after paying insurer expenses. The assumptions behind the table 6-2 numbers are that the accumulation units change value once each year and that a full $200 is available each month to acquire more units. The units in this example grow at approximately 7.5 percent most years but fluctuate more or less than that in some years as stock prices are prone to do over short intervals. In this case there is an accumulation of $258,459.62 at the end of the 30th year (end of age 64 or beginning of age 65) consisting of 31,751.8 accumulation units.

At the beginning of the liquidation period, the accumulation units are exchanged for annuity units. The number of annuity units that will be acquired by the annuitant depends on the company�s assumptions as to mortality, dividend rates, and expenses, and upon the market value of the assets underlying the annuity units. In essence, the number of annuity units is determined by dividing the dollar value of the accumulation units ($258,459.62 in our example) by the present value of a life annuity at the participant�s attained age in an amount equal to the current value of one annuity unit (assumed to be $35 in this case). Although the number of accumulation units of a particular person increases with each premium payment and each allocation of dividends, the number of annuity units remains constant throughout the liquidation period (7,384.6 annuity units in this case). The units are revalued each year, however, reflecting the current market price of the common stock and the mortality, investment, and expense experience for the preceding year. The dollar income payable to the annuitant each month is determined by multiplying the number of annuity units by the current value of each unit. During the annuity�or liquidation�period, the higher the market price of the stock and the greater the dividends, the greater the dollar income of the annuitant will be. During the accumulation stage, however, it is to the annuitant�s advantage for stock prices to be relatively low since he or she will thus be able to acquire a larger number of accumulation units for each premium payment.

Some of the more recent variable annuity contracts differ from the above by using only one unit rather than two, by discounting for mortality before as well as after retirement, and by limiting variations in the unit value to investment experience only.

A participant in a variable annuity plan should not normally be permitted to surrender his or her accumulation units for cash or to take other action that might involve temptations to play the stock market. When the variable annuity is used as part of a pension plan, surrender values are not generally made available. When the variable annuity is sold as an individual contract, surrender privileges are made available but on a much more restricted basis than in connection with ordinary annuities. Under all plans the current value of the accumulation units is payable to a designated beneficiary (if any) or the estate, usually as a continuing income but a lump sum settlement is possible upon the death of the participant during the accumulation period.

In a landmark decision, the United States Supreme Court held that an individual variable annuity contract is a security within the meaning of the Securities Act of 1933 and that any organization that offers such a contract is an investment company and subject to the Investment Company Act of 1940. Hence any company that offers individual variable annuity contracts is subject to dual supervision by the Securities and Exchange Commission and the various state insurance departments. Persons selling variable annuities must pass the series 6 licensing exam of the National Association of Securities Dealers (NASD).