Knowledge that Transforms

Variable Annuities are the subject of considerable discussion by individuals who identify themselves with life insurance companies and security dealers. The paper by Mr. Albert Linton published in the May, 1956, issue of the Journal of Finance is a case in point. This comment does not attempt to marshall arguments for or against variable annuities, but is concerned only with the major factors determining the size of the payments to be made from a variable annuity fund during the payment period. In Mr. Linton's Table 2, the assumption is made that the variable annuity payment would follow Standard and Poor's index of stock prices.1 The other major factor influencing the size of the annuity payment, the cash dividends that will be received by and added to the annuity fund during the period of the annuity payments, is omitted. This is comparable to omitting interest on the standard annuity contract. The purpose of Table 2 was evidently to display the magnitude of the fluctuations in variable annuity payments in contrast to the absolute dollar stability of the payments made under the terms of a traditional annuity contract. Mr. Linton emphasizes that “irate and disillusioned policyholders” might write letters to insurance commissioners and even congressmen when payments fall under variable annuity contracts. Such pressure might have been (or may be) the opportunity for federal regulation of those life insurance companies that issue variable annuity contracts. Column 1, Table 1, in this comment sets forth the fixed payment of $100 per month specified by Mr. Linton, Column 2 reproduces the assumed monthly payment made under a variable annuity contract as shown by Mr. Linton in his. Table 2, and Column 3 presents a revised statement of the monthly payment under a variable annuity contract taking cognizance of the dividends received by the annuity fund during each year of the life of the annuity. The period 1926 to 1954 is the period selected by Mr. Linton. According to Mr. Linton's presentation, the payments made under the variable annuity were less than those under the traditional contract in twelve of the twenty-nine years. The revised variable annuity payments fall below the fixed monthly payments of $100 in only three years. Furthermore, the lowest payment under the revised computation is $83 per month as compared with $49 per month shown by Mr. Linton. Certainly the intensity of the remarks in the policyholders' letters would be different if the variable annuity payments fell 17 per cent rather than 51 per cent below a norm established by the payment of a fixed number of dollars under a fixed annuity contract. Fixed annuity policyholders may well complain about the opportunities missed when they compare their $100 with the more than $200 monthly income in 1954 that might have been possible under a variable annuity contract. In the computation of Column 3, Table 1, the advantages accruing to the variable annuitant during the accumulation period have been foregone. Mr. Linton recognizes this advantage in suggesting that the rate of growth of funds during the accumulation period invested in a well-selected, properly diversified group of stocks has been larger than the rate of interest achieved by the investment portfolios that are the basis for traditional annuity contracts. We believe that such higher yields on equities are not dependent on inflation given the maintenance of our long-run rate of economic growth and that this relationship is very likely to continue. This position, however, must be left undefended since the space that may be alloted to a comment is very limited. Let the case of the conservative be admitted, however. The holder of a variable annuity contract, the annuitant, would take more risk with respect to the number of dollars he will eventually receive. Life insurance companies, other financial institutions, and even the structure of the capital markets will be affected by any considerable growth in the use of variable annuities. Such changes are certain to follow whether the life insurance companies themselves or some newly developed type of financial institution handles variable valued annuities.

S ummary A t the end of 1945 the corporate universe was characterized by a low level of capital assets relative to sales and a high degree of liquidity. The decade ending in 1955 was noteworthy for the high absolute level of investment in plant, equipment, and inventory. Corporations experienced no great financing difficulties in carrying out their expansion program; interest rates did not rise sharply during the period. The bulk of corporate investment was financed from internal sources of funds—retained profits and depreciation allowances—with internal sources more important in the first half of the ten‐year period. The relationship between internal and external financing was primarily dependent on cyclical variations in business activity. In periods of rising business activity short‐term borrowing and new security issues were utilized to supplement internal funds. In periods of declining economic activity long‐term financing through security issues was continued on a reduced scale and short‐term bank debt was reduced. Over the decade ending in 1955 there was an increasing trend toward long‐term securities issued to finance investment in plant, equipment, and inventories. All bonds outstanding for non‐financial corporations more than doubled from $23 billion at the end of 1945 to $54 billion at the end of 1955. There was some evidence to suggest that reduction in spreads between stock and bond yields encouraged stock financing in the latter years of the period. The most striking phenomenon in the long‐term debt market was the precipitous decline in the importance of individuals as holders of corporate bonds. In less than twenty years individuals' holdings of outstanding corporate bonds fell from two‐thirds to about one‐fifth. The largest holders of corporate bonds were life insurance companies who accounted for 50 per cent of all issues outstanding. Directly placed corporate securities—almost entirely bonds—accounted for about 40 per cent of gross security issues in the postwar decade. Life insurance companies held over 90 per cent of directly placed securities outstanding. In 1955 and particularly in 1956 growing tightness was evident in the capital market. The liquidity of corporations was worked down and the rate of increase in corporate internal sources of funds also fell. Capital outlays continued to rise. Accessibility to the capital market became critical to insure accomplishment of investment programs. Corporations entered the capital market on an enlarged scale at a time of continued high demands for funds from other sectors of the economy. The fall in liquidity of financial institutions plus the pursuit of a restrictive monetary policy by the central bank served to intensify the rise in yields and led to sharp increases in new financing costs and tightening of contract terms.