The ever-increasing complexity of our securities laws has led to a great deal of confusion among investors over the differences between mutual funds and variable annuity sub-accounts. Are they the same thing or aren't they? And if they really are mutual funds, then why can't we just call them that? This article examines the similarities and differences between the two vehicles, and why a division exists between them.
Mutual Funds Overview
Regardless of whether they are open or closed end or trade on an exchange, mutual funds are by nature stand-alone entities. They are not offered in conjunction with any other security or investment, and each one has its own ticker symbol. Although some are managed for tax efficiency, they are not inherently tax-deferred vehicles.
In order to best understand the differences between funds and sub-accounts, it may help to understand how sub-accounts were created to begin with. In the past, life insurance companies had traditionally only offered fixed annuities and whole or universal life policies that guaranteed the holder's principal plus interest.
In the 1980s, they decided to start offering a new breed of policies and contracts, which allowed their customers to participate in the equity and fixed-income markets. Up until this time, a fixed annuity holder simply owned a single contract that paid a guaranteed rate of interest. But variable annuity policyholders would now have several different ways in which to invest the proceeds of their contracts. Therefore, mutual funds were introduced in the form of sub-accounts that allowed customers to choose between various types of investment alternatives.
So What Is It?
The selection of sub-accounts available in a particular contract is determined by agreement between insurers and fund companies. Insurance carriers will approach various mutual fund families and offer to place one or more of their funds inside their variable products. Most insurers will offer funds from at least a half-dozen different companies, usually including at least one of each family's flagship funds. Of course, the fund company benefits from having its Sub-account funds distributed—and marketed—by the insurance carrier.
Sub-Accounts vs. Mutual Funds
Characteristically speaking, variable sub-accounts are, for all practical purposes, mutual funds in disguise. In fact, some sub-accounts are virtual (if not exact) clones of their fund counterparts. They look and act like mutual funds, but there are a few differences that separate them from their independent cousins.
- Tax-Deferred Accounts: Variable sub-accounts will differ slightly in terms of daily price and performance, costs and fees and capital gains distributions. This last point becomes apparent on an annual basis, when all taxable mutual funds must declare and distribute their realized capital gains to shareholders on a pro rata basis. Variable sub-accounts will not do this, since they grow tax-deferred inside an annuity or insurance shell product. Because there is no need to do so, variable sub-account managers can manage these portfolios without regard to tax efficiency, which in turn affects the overall return realized by investors. Of course, in addition to the standard portfolio management expenses that come with any professionally managed investment vehicle, variable sub-accounts also present the standard range of fees and benefits that come with any variable annuity or life insurance contract, such as living and death benefits, mortality and expense fees, maintenance fees and other costs that are subtracted from the returns generated by the sub-accounts.
- Policy Changes: These differences eventually came to the attention of the Securities and Exchange Commission. Because of the strict laws pertaining to the characteristics of securities and how they are classified, regulators finally decided that the aforementioned differences necessitated the classification of sub-accounts as wholly separate securities. Therefore, they must be assigned different names and CUSIP numbers. Their historical performances must be listed separately as well, distinct from the track records posted by the original underlying funds. Of course, this can easily confuse investors when they attempt to evaluate the historical performance of a given sub-account. For example, if a certain mutual fund has performed solidly over the last 30 years, then an investor looking for that fund within a variable contract may not recognize its correlating sub-account name and symbol. Furthermore, if the historical performance of the sister sub-account only goes back a few years (which is the case with most sub-accounts since this rule has not been in effect all that long), then an uninformed investor may never even suspect that the sub-account really is a similar version of the fund that they are seeking. In this case, an investor that understands the correlation should probably pay more attention to the historical performance of the underlying fund than that posted by the sub-account, since both securities are ultimately managed by the same group of managers following the same philosophy, despite the differences in fees and tax management.
A Working Example
Allianz Life Insurance Co. has placed the Davis New York Venture Fund (NYVTX; CUSIP: 239080-104) inside its variable contracts and policies. It therefore created a corresponding sub-account known as the AZL Davis New York Venture Fund. It is managed by Allianz Investment Management LLC, a registered investment advisor and affiliate of Allianz Life Insurance Co. of North America, and sub-advised by Davis Advisors since March 2004. The CUSIP for this sub-account is 018821306. Since its inception, the sub-account has performed marginally worse than the original fund (A-shares) but can still be considered to be a replica of the original fund. Please note that the AZL Davis New York Venture Fund is now called the AZL T. Rowe Price Capital Appreciation Fund.
The Bottom Line
The differences between mutual funds and variable sub-accounts can be confusing, especially if the sub-account is an exact clone of its sister fund. Pay careful attention to the ticker symbols to ensure that you are getting the correct quote. If you own a variable contract of any kind, the insurance carrier will always be able to provide you with complete investment information on all of the sub-accounts within its contracts.