Looking for funds: variable-annuity writers consider their subaccounts to be the all-star team of the mutual-fund world, and they look carefully at performance, management and consistency to keep only the top players.

At the end of last year, about 8,300 mutual funds were based in the United States, and they held some $7.4 trillion in assets, according to The Investment Company Institute. For investors seeking the kind of professional money management that funds offer, those numbers and the choices they represent can be bewildering.

Variable annuities, with nearly $1 trillion in assets, offer the same kind of professional money management within a tax-deferred package. Given the higher costs of variable annuities, the tax deferral is a big part of their appeal. But variable-annuity writers also strive to add value for their policyholders by offering a full range of investment options within a smaller, easier-to-manage universe of funds. Whether overt or implicit, part of the value proposition of a variable annuity is that the product manufacturer has carefully chosen and monitored funds to help investors reach their retirement goals and avoid making bad investment mistakes along the way.

Many manufacturers of variable annuities, in fact, consider the subaccounts they offer to be the all-star team of the mutual-fund world. Their produce offerings include the best-known fund-management companies and the most famous of fund names, even though those investment options are separate entities from the mutual funds after which they are named. Other subaccounts are funds the variable-annuity company has created, but they are often run by some of the top managerial talent available, and insurers have more control over these proprietary funds. Many variable-annuity companies offer both outside funds and their own funds.

This extra layer of management provides "tremendous value," said Bill Goslee, vice president for investment and advisory services for Nationwide Financial. "We pioneered the multimanager annuity over 20 years ago," he said. "We created the Best of America brand, which was really all about bringing together the best of the best ... The ability to leverage our team of analysts and the relationships we have with these mutual funds is something most people and their advisers could not replicate on their own. A lot of advisers and representatives may not have the time, expertise, resources or inclination to do the fund research."

The trend of the past decade or so has been for variable-annuity companies to offer lots of investment choices--often 50, 60 of more funds--and funds managed by several outside companies with the same objectives, said Nancy Kenneally, senior consultant with Tillinghast Towers-Perrin in New York. "When variable annuities were first introduced, companies offered very few funds, maybe five to eight," she said. "The trend then was for the insurers to build the funds themselves and to be the money manager."

Goslee said Nationwide's objective in Best of America, "at a high level," is to help advisers and financial representatives provide appropriate investments to meet their clients' goals. The company seeks to meet that objective in four main ways, he said:

* To provide breadth and depth in significant asset classes, and to provide choice and style diversification within those classes (investment style considers company size, earnings potential and stock price);

* To offer "world-class" money managers, investment quality and name-brand funds;

* To provide long-term above-average returns; and

* To provide tools to help financial advisers work with their clients. These tools include an asset-allocation planner from Chicago-based Ibbotson Associates and technology to help investors sort data. Nationwide has also created fund alerts, which notify a financial representative when a fund hits a certain price target or return target.

Prudent use of tax-sheltered transfers can enhance the returns of the overall product. Most variable-annuity writers intend that their fund options be deployed under asset-allocation programs with the help of a financial adviser, and they provide tools for advisers and clients to set appropriate allocations and then to stick with them through such services as periodic asset rebalancing. Rick Carey, founder of the Variable Annuity Research and Data Service, now a part of the Finetre Corp., sees the variable annuity as an investment vehicle capable of providing performance equal or superior to any other investment vehicle, in part because of asset-allocation advantages. "When you buy one of these contracts, you have tax deferral on any transfers and switches between funds," he said. "You're really buying a fund of funds." Supporters of asset rebalancing say it can boost returns by taking profits and lowering risk, and variable annuities offer a convenient way to do it without triggering taxable events.

Due to the bear market, contract performance "has gotten lost" in the past few years, Carey said, as product manufacturers and advisers have shifted the spotlight to protection features. "But we're trying to retire here," he said. "The basic question is, 'Where can I go to get the greatest performance with the least amount of risk?'"

Finding Good Funds

Nationwide has assembled a team of analysts, currently with eight members, dedicated to fund selection and monitoring. "Some companies outsource this work, but we think it's a core strength," Goslee said. "Under all of Nationwide, this group oversees not only variable-annuity options, but also options in variable life insurance, 401(k)s and 457 plans. If you add it all up, we oversee more than $50 billion of assets."

To select funds for inclusion inside a variable annuity, Goslee said the team first uses a quantitative review process that evaluates performance for one, three, five and sometimes 10, years. The evaluation team considers performance in individual years and compares it with appropriate peer-group and index benchmarks. To measure volatility, the team checks on standard deviation. It also uses the metric beta, which tracks how much more volatile the fund is than the index it uses as its benchmark. To help with style consistency, the team uses the r-squared metric, which measures how correlated a fund is to an equity benchmark. Goslee said good style consistency helps to position and evaluate a fund within an asset-allocation model. Finally, the team considers expenses. "You try to minimize them, but you certainly take into account the quality of the product and the reasonableness of the expenses," he said.

Next, Nationwide assesses a fund manager's ability to continue a fund's excellence as part of the qualitative review. "We look at a manager's tenure, experience and education," Goslee said. "Then we look at how consistently the portfolio-management process is applied, at how well and consistently a fund manager can articulate it from team member to member. Then we consider the ownership of the fund and the owner's philosophy and culture. Typically, we will perform on-site due diligence."

After selecting a fund, Nationwide monitors performance through quarterly reports from the fund manager. Depending on circumstances, the team may hold conference calls or receive other updates. Sometimes a fund manager may visit Nationwide, or the team visits the manager.

Goslee said Nationwide has achieved "outstanding success" in its variable-annuity portfolios. For example, the company reported that at the end of last year, 21 out of 72 funds available within its America's Future Annuity II, a newer product in its Best of America series, had Morningstar ratings of four or five stars. Five stars from the fund-rating organization mean a fund's performance places in the top 10% of its broad investment class, while four stars mean it places in the next 22.5%.

On the surface, that data may indicate that the annuity's performance is merely random, given that about 29% of its subaccounts rated in the top 32.5% of their Morningstar-rated peer groups. But those are current ratings--only a snapshot of the moment. Over longer periods, the funds in the Nationwide product fared much better. Goslee said its subaccount lineup averaged the 49th percentile over the past year, the 45th percentile over the past three years, and the 39th percentile over the past five years. Only two funds in the Nationwide lineup were currently rated one star, and 10 were rated two stars. About half of them are slated to be removed in May.

If management is dissatisfied with a fund, Nationwide can make changes to its investment menus. Goslee said the team considers changes annually. If the underperformer were an outside fund, the company would remove it from its lineup prospectively so that it would no longer be offered to new clients. If it were a proprietary fund, the company could replace the subadviser. A more dramatic change would be to actually move assets to a diffcrent fund, which Goslee said is a "rare and complicated process."

Working With Financial Planners

Like Nationwide, Minnesota Life Insurance Co. chooses to populate its portfolios with mostly outside funds, also known as variable insurance trusts. Choosing outside funds provides a quick way to provide depth and choice inside the variable-annuity product, said Marshall Urbanz, manager of variable investment marketing. "At a high level, we look first at performance, then brand," he said. "We try to add multiple funds per asset manager to make sure we have a partnership relationship and some scale with the fund company. And we don't necessarily look for top-performing funds from the previous year. We want good historical performance, we consider cost and fund lees, and we perform risk-and-return measurements by asset class."

As of early February, Minnesota Life had $2 billion of variable-annuity assets and $1.3 billion of variable-life assets under management. The company works with 13 outside fund managers and offers proprietary funds through its subsidiary, Advantus Capital Management. Distribution is through 1,800 registered representatives nationwide who belong to the Securian Financial Network. The company also wholesales to individual broker dealers, and it plans this year to offer a customized individual annuity through the Waddell & Reed mutualfund and financial-planning company.

Minnesota Life builds a product portfolio in accordance with fund flows it anticipates. For example, its MultiOption Advisor annuity, which comes in three versions priced to reflect different commission schedules, offers more than 50 funds, with a high percentage of large-cap funds. Eight of them are in large-cap value, eight in large-cap growth and three in large-cap core. The real estate category, by contrast, contains only one fund option; it is a proprietary fund managed by subsidiary Advantus Capital Management, and it ranks first among peers for recent one-year and three-year periods, said Urbanz. It also ranks high over the five-year period.

The company surveys financial advisers to learn what they want to see in products and in portfolio management tools. The company deals primarily with the financial-planning channel and has no distribution through wirehouses and banks. Many advisers have sold Oppenheimer and Fidelity products, so Minnesota Life included a number of funds from those mutual-fund companies, Urbanz said.

Minnesota Life works with Ibbotson to construct model portfolios its clients can use and relies on Ibbotson to classify funds according to objective and style. The insurer recommends automatic rebalancing as a way to take profits from asset classes performing well and to maintain original risk profiles, Urbanz said. "Part of the value proposition that Minnesota Life brings is through the financial advisers we work with," he said. "They provide an important service and take clients in the right direction.

"We provide a select universe," he added. "And inside the contract, clients avoid tax consequences and transaction costs with each trade."

The insurer uses the Lipper fundrating company to monitor the performance of funds. "If we have some funds not performing the way we want over the long term--and it may be in performance or in cash flow--we don't add the funds to our new products," Urbanz said. The company has about 10 older contracts into which it is not accepting new money.

Expanding Fund Lineup

In the early 1990s, Guardian Insurance & Annuity Co. had only about 12 fund options in its variable annuities. Today, the subsidiary of the Guardian Life Insurance Company of America offers three annuities with an average of 44 subaccounts, and it adds funds when it sees a need to fill an asset-allocation gap, said Peggy Coppola, vice president of business development.

All but 13 of Guardian's subaccounts are outside funds. In choosing them, the company considers fund performance over one- to 10-year periods, style consistency, reputation of the outside company, and any sales support the fund company would give. Coppola said Guardian receives good feedback from the field as to what kinds of funds distributors and their clients want and how well the funds fit into asset-allocation programs the distributors use. "We also have a lot of our own information that shows us what our representatives are selling," she said. "We look at flows into various funds, and if one is not selling, we might not want to keep it."

Coppola said that with its 13 proprietary funds, for which the insurer hires the managers, Guardian is tied more into the everyday management. "You don't have a track record with subadvised funds," she said. "Net asset value starts from day one. But you have more flexibility in the management of the fund, and you probably have a stronger working relationship with the manager. When you're not connected in that way, you don't know if you're really that connected to the way portfolios are managed."

A drawback to outside funds is that when they aren't performing as well as the company would like, making changes is more complicated, Coppola noted.

Meetings of outside fund managers and Guardian's distributors have been a "real plus," according to Coppola, but fewer managers these days attend sales meetings in the field. Some managers participate in sales meetings at Guardian's home office, but more often, a member of the fund company's wholesaling team attends these meetings, she said.

Coppola made the case that the Guardian adds value to its variable annuities by virtue of its selection and monitoring of subaccounts. "We spend time on it, we're careful about it, and we're careful about expenses," she said. "It's all part of our product management."

According to Richard Reilly, former president of Allmerica Financial Services, some evidence indicates that variable-annuity subaccounts have the potential to outperform their mutual-fund peers because the subaccount can stay more fully invested. "You have a much higher redemption rate in mutual funds," said Reilly, who remains active in retirement with the National Association for Variable Annuities. "It's about 20% in a regular mutual fund, so it has to have a higher cash position to pay the redemptions. Of course, that may help performance in a down market."

Variable-Annuity Fund
Performance vs.
S&P 500 Index

This graph shows the five-year
weighted average return for
growth funds in variable
annuities. VA fund performance is
net of investment advisory fees
and fund expenses but gross of
other product-related fees. The
S&P 500 Index has no expenses.

             Net Fund Performance

             5-Year VA    5-Year
             Net Return   S&P 500

1998            19.6%      24.1%
1999            27.3%      28.6%
2000            17.2%      18.4%
2001             9.3%      10.7%
2002            -0.6%       1.2%
9/30, 2003       1.9%       1.0%

Source: Tillinghast's VALUE Survey

Note: Table made from line graph.

Performance of Variable-Annuity Subaccounts

(Through Jan. 30, 2004, annualized)

These annualized investment returns represent how variable-annuity
investment options tracked by VARDS performed, by category, based on
the funds' accumulation unit values. That means the performance numbers
include the basic insurance charges and fund expenses, but do not
include annual maintenance fees, which average $25 per contract.

Category                                YTD %   1 Yr %   2 Yr %

Small Company Funds                      3.32    47.07     5.00
Aggressive Growth Funds                  3.00    37.40    -0.90
Specialty Funds                          2.78    42.36     3.53
All Equity Funds                         2.22    37.78     2.64
International Stock Funds                2.06    42.27     7.53
Growth Funds                             2.02    34.51     0.34
Growth and Income-Funds                  1.58    32.25     1.45
All Balanced Funds                       1.37    22.81     3.92
Equity-Income Funds                      1.24    31.27     3.02
Corporate Bond High Yield Funds          1.24    20.76     9.96
All Fixed-Income/Bond Funds              0.73     9.83     7.55
Government Bond General Funds            0.68     2.46     4.92
Corporate Bond High Quality Funds        0.67     4.07     5.31
Corporate Bond General Funds             0.61     6.86     6.45
Government Bond Mortgage-Backed Funds    0.47     1.32     3.78
International Bond Funds                 0.30    14.34    14.39
All Money Market Funds                  -0.07    -0.64    -0.37
Government Bond-Treasury Funds          -0.44    -0.29     1.24

Category                                3 Yr %   4 Yr %   5 Yr %

Small Company Funds                      -1.29    -0.49     6.01
Aggressive Growth Funds                 -11.36   -10.88    -2.06
Specialty Funds                          -5.75    -3.47     1.01
All Equity Funds                         -5.46    -4.38     0.75
International Stock Funds                -4.40    -6.56     1.64
Growth Funds                             -7.35    -5.70    -1.02
Growth and Income-Funds                  -3.77    -1.59    -0.30
All Balanced Funds                       -0.51     0.73     1.72
Equity-Income Funds                      -0.66     2.48     2.11
Corporate Bond High Yield Funds           4.06     2.25     1.85
All Fixed-Income/Bond Funds               5.16     5.30     3.86
Government Bond General Funds             4.92     6.46     4.45
Corporate Bond High Quality Funds         5.32     6.51     4.46
Corporate Bond General Funds              5.67     6.48     4.62
Government Bond Mortgage-Backed Funds     4.20     5.92     4.56
International Bond Funds                  9.39     8.74     6.89
All Money Market Funds                    0.43     1.48     1.88
Government Bond-Treasury Funds            2.68     6.01     2.53

Source: Variable Annuity Research and Data Service, a part of the
Finetre Corp.