During the 1930s, when the U.S. economy was experiencing only moderate inflation rates, many people purchased annuities for retirement in the belief that they insured a comfortable, guaranteed income for life. A successful insurance company advertisement of the late 1930s enthusiastically proclaimed, Retire for life on 300 dollars a month!

Then rising inflation rates began to affect the average persons standard of living. Beginning in the 1960s, people became aware that they had to plan for more retirement dollars just to keep pace with anticipated increases in living costs. Savers sought financial instruments that could more readily keep up with inflation. Individuals of even average means were turning to the stock market for an increasing portion of their investments. Like savings institutions, insurance companies looked for ways to improve their traditional products. In an attempt to combine traditional annuity guarantees with the growth potential of a securities investment, the variable annuity was developed.

These include four mutual funds with differing objectives, plus a fixed account

Variable annuities generally are divided into two basic types. The difference between them lies in who has control over investing the money deposited into the annuity. With the first type, the company-managed variable annuity, the insurance company determines how the annuity funds are invested. With the second type, which could be referred to as a self-directed variable annuity, the annuity owner has substantial control over the investment of funds.

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The original variable annuities which were introduced in the 1950s were company-managed types. In this type of annuity, premiums paid in by contract owners are pooled and placed in a separate account designated by the insurance company. This method serves to distinguish these investments from the companys other invested funds. (One advantage of a variable annuity is if the insurance company runs into financial problems, the funds in the separate account are beyond the reach of the companys creditors. This is also true for the portfolios in self-directed plans.) The account is organized like a mutual fund in that it is made up of various investments usually stocks, bonds and government securities. The insurance companies investment managers buy and sell these investments on a continuing basis.

Like mutual fund managers, the insurance company tries to invest the money wisely and profitably so that it will generate a competitive return for its investors. In addition, the insurance company must meet both state and federal regulations regarding investment practices for these products. (Variable annuities are subject to regulation by the Securities and Exchange Commission, Internal Revenue Service, and state regulatory bodies.)

One of the better known company-managed annuities is the College Retirement and Equities Fund, or CREF. Designed by the Teachers Annuity and Insurance Association, it was the first variable annuity, appearing on the market in 1952. Because of CREFs relatively long history, it has been the subject of many detailed studies.

With the self-directed annuity, the contract owner can choose from several investments, each with different objectives. The selection of investments may be made during both the accumulation and distribution periods. The owner selects investments based on his or her investment objectives in much the same way that a mutual fund investor does.

In effect, the contract owner may construct a personal investment portfolio within the annuity

The annuity application form lists the selection of investments that the insurance company offers. For an example of a hypothetical self-directed variable annuity, consider there are five selections available. The fixed account offers guaranteed safety of principal and specifies a fixed interest rate. (Interest rates on the fixed account may be guaranteed for periods ranging from one calendar quarter to one or two years or even longer.) Customers choose from among these options according to their investment objectives.