In this chapter we will discuss the different investment options of the variable annuity. This chapter will also discuss how to read a prospectus.

The Commitment

We could probably all agree that the easiest part of investing into a variable annuity is the actual step of choosing to invest in a variable annuity. Along with this choice an investor should understand their investment objectives, time horizons, risk tolerances, the basics of asset allocation and the investment objectives of the annuity's sub-accounts. The initial investment requires the investor to make two straightforward decisions:

1. How much money will be invested?

2. How will the purchase be made; as a lump sum or as a series of payments?

Once the investor has made the decision to purchase an annuity, they must then make a determination on where to invest annuity contributions. On the positive side, there are no absolute rules, although the variables remain the same: investment objective, time horizon and risk tolerance when selecting appropriate sub-accounts.

The investor does hold an ace in his back pocket in that they can rely on the expert money managers, not the individual securities, or sub-accounts. Sub-account managers select individual securities for the sub-accounts, thus the investor then selects the most appropriate sub-accounts for their portfolio.

This may sound exactly like a mutual fund investment. There is a good reason for that. It is exactly like a mutual fund investment. When an investor chooses a mutual fund, they can rely upon the professional money managers, convenience and economies of scale. Variable annuity sub-accounts are mutual funds within an insurance contract and are chosen as investment vehicles for the same reasons mutual funds are chosen. Although an added benefit of variable annuities is that of tax-deferred wealth accumulation. Mutual fund features and benefits remain the same, even when they are called sub-accounts.

Another common feature between variable annuities and mutual funds is that they are usually identified by their investment company and their primary investment objective and/or primary group of securities. An example of this would be Spectacular U.S. Government Bond Fund versus Spectacular Aggressive Growth Fund.

Variable annuity sub-accounts include the name of their primary investment objective (Aggressive Growth, Balanced or Specialty Portfolios) and/or primary group of securities. They can also include the name of the issuing insurer, the mutual fund company and/or the investment advisor managing the assets and the fund's investment objective. Variable annuity sub-accounts require a more descriptive name to understand its structure.

Insurers employ one or more of four distinct strategies

when managing sub-account assets.

Most investment companies employ in-house money managers to manage their family of mutual funds. Managing the assets of an insurer's variable annuity sub-accounts can be complex. Insurers employ one or more of four distinct strategies when managing sub-account assets:

1. Manage all sub-accounts internally. Assets are managed by money managers employed by the insurer.

2. Engage an independent investment advisor group as money manager for all sub-accounts. Assets are managed by independent money managers contracted by the insurer to do so.

3. Employ multiple independent advisors who specialize in a specific investment and who manage a specific sub-account. An insurer could contract a company to manage all equity sub-accounts and a different company to manage all fixed income sub-accounts.

4. Employ an independent investment advisor to manager a certain group of sub-accounts and manage some sub-accounts internally. An insurer could manage all fixed income sub-accounts internally, while contracting a company to manage all equity sub-accounts.

The long-term investment result and record of consistency demonstrated by the financial advisor are very important. The asset management structure for managing sub-accounts' assets is not as important.

It is important for the annuity investor that they understand:

What sub-account investment alternatives there are available,

The investment objectives of each sub-account,

The investment policies, and

Whether there are a sufficient number of investment alternatives available within a variable annuity sub-account structure to maintain an effective asset-allocation model.

Sub-Accounts

An investor needs to understand the relationship between the separate account and the sub-account to effectively select the appropriate investment option. A separate account (accumulation account) is a master investment account that acts as a channel to the established accounts. All funds invested flow through the separate account's channel into various sub-accounts. Each sub-account has a specific investment objective. Thus, combined with the other sub-accounts, this provides the investor the choice and the flexibility to select substantially different portfolios to meet asset-allocation and diversification demands.

Mutual fund investors purchase shares, whereas annuity sub-account investors purchase accumulation units. Accumulation units are to variable annuities as fund shares are to mutual funds. Accumulation units are purchased by the investor at net asset value (NAV), without commissions, in full and fractional units. No-load mutual funds are also purchased at net asset value (NAV). Load mutual funds that charge commissions are purchased from the net proceeds after deducting commissions. In rare circumstances, the investment company if requested by the investor can issue mutual fund share certificates. The request is not recommended by most experts. Sub-account accumulation unit certificates are never issued.

Accumulation units are to variable annuities

as fund shares are to mutual funds.

The net asset value (NAV) of each accumulation unit is determined at the close of trading of the New York Stock Exchange each day the Exchange is open. Accumulation unit values are determined each day by the insurer or the financial advisor. This is extremely vital and necessary because daily purchases and daily redemption prices are based on the net asset value (NAV), or closing price, by either calling the insurer or consulting various financial publications.

Sub-Account Options

Variable annuity sub-account choices and numbers depend on the contract, but normally sufficient flexibility exists with most variable annuities. Understanding the investment objectives of each sub-account is critical in choosing an asset-allocation mix that matches the financial objectives and investment risk tolerance of an individual investor. It is safe to say that most investors seek a consistent, competitive return and the preservation of their investment.

Most people probably understand the importance of financial planning and the security it provides. However, few investors understand the variation of financial planning and asset-allocation techniques. Thus, enter the agent and/or financial planner. Even fewer investors understand or appreciate risk tolerance and the management of risk.

Variable annuity sub-accounts can be divided into four broad categories:

1. Those seeking capital appreciation (stocks),

2. Those seeking fixed income (bonds),

3. Those combining stock and bonds (referred to as balanced), and

4. Those offering fixed income money market rates.

As discussed previously, a breakdown used to narrow the universe of sub-accounts should be based on performance, risk control, expense minimization, investment options, family rating and management. To fully understand the sub-accounts, we must understand how sub-accounts are ranked by various financial publications.

Performance

Normally, return figures and the subsequent ratings are based on the three calendar years ending on a certain date. For instance, it is common to use December 31 as an ending date. In the event that two or more sub-accounts are competing for the same category, a five year period will normally be used to compare and rate the sub-accounts. Performance figures represent total return figures: unit appreciation plus any dividends or interest payments are included.

When reading financial publications about variable annuity sub-accounts, you may notice that a three to five year period is used to rate their performance. This is because only a handful of variable accounts have been in existence for a ten year time horizon. On the other-hand, performance over one year is also not used because such figures could be the result of either luck or a one time event, thus not proving an accurate financial picture to go by.

Only a handful of variable annuity sub-accounts

have been in existence for a 10 year time horizon.

All performance figures should include a tabulation that shows how the sub-account has performed against a specific index. This kind of comparison to a specific index, such as the Russell 2000 for equity sub-accounts, will show how a particular sub-account has performed against its appropriate benchmark over each of the past several years.

Risk Control

Risk-adjusted return looks at how well a sub-account performed, based on the amount of risk it took. Everyone would like to get a great return on an investment without taking much risk. This, however, is not usually possible. More often than not, risk corresponds with return. Earning a 100 percent return on principal sounds very appealing, but if someone suggested this would require us to go to Reno and play Black-Jack, few people would sign up for the trip.

If an account receives high marks for risk control, it means that the fund took X amount of risk but received an X plus Y rate of return. A portfolio that is rated poorly in this area may still have good results but may take higher than normal risks compared to its peer group. This does not mean, however, that individuals should avoid variable annuities that are rated either fair or poor for risk control. A higher than normal risk can be counterbalanced by the addition of a low risk investment in the investor's portfolio. Again, an understanding of the individual sub-account's investment objectives will enable an investor to make important risk decisions.

Expense Minimization

The impact of expense minimization is often exaggerated by the media and by investors and advisors who focus on statistics. It is true that a 0.25% added expense will have an impact on an investor's total return in the long run. However, this is not nearly as important as selecting the right category to begin with, or even whether selecting a good portfolio manager who is conscious of risk-adjusted returns.

For the investors that would like to see a full picture, total expenses, including the annual contract charge, are rated in certain publications. This is the most straightforward and objective of the rated categories. On the other-hand, it is also, almost always, the least important.

Investment Options

This category is the most complex to measure. Variable annuity sub-accounts should be rewarded with a favorable rating if they allow dollar-cost averaging (DCA) and/or allow a high number of transfers per year. This gives the investor the greatest amount of control over their investment. Most of the rating for this characteristic should be based on the number of sub-accounts available within the variable annuity "family" and the diversification of such choices or options.

Family Rating

This characteristic points out how many sub-accounts are available within the various variable annuity contracts and the caliber of these investment options. This is based on their respective risk-adjusted returns. A "family" is the number of choices offered to the investor. This family could be quite small, but still get the highest rating if most or all of the sub-accounts performed excellently when viewed on a risk-adjusted return basis.

Management

A sub-account must either possess an excellent risk-adjusted return or have had superior returns with very low levels of risk. It is assumed that most investors are equally concerned with risk and reward. Thus, when looking at various annuity contracts, the foundation of the text should be based on which variable annuity sub-accounts have the best risk-adjusted returns. The rating for this characteristic should be based on the sub-account's performance and risk control, both of which are usually heavily influenced by management.

Each of the following options will be categorized into one of the four broad categories listed on page 47. The sub-account breakdown used is as follows:

Aggressive Growth

Growth

Growth & Income

International Stocks

Balanced

Corporate Bonds

Government Bonds

High-Yield Bonds

Global & International Bonds (World Bonds)

Specialty Portfolios (Sector Portfolios)

Aggressive Growth Sub-Account

Seeking Capital Appreciation

This type of sub-account seeks to provide investors with maximum capital appreciation by investing in aggressive, less seasoned growth stocks. They focus strictly on appreciation, with no concern about generating income. Aggressive growth sub-accounts strive for maximum capital growth, frequently using such trading strategies as leveraging, purchasing restricted securities or buying stocks of emerging growth companies. Diversification is gained through a stock portfolio of aggressive growth, emerging growth and small capitalization company stocks. The portfolio composition is almost always completely comprised of U.S. stocks.

The Aggressive Growth objective is

maximum growth of the investment.

Aggressive growth sub-accounts can go up in value quite rapidly during times of strong market advances. These sub-accounts will often outperform other categories of U.S. stocks during bull markets (strong market advances), but experience worse than average losses during bear markets (market declines). Usually small company stocks are less volatile than the better known aggressive growth stocks. Small company refers to stocks whose market capitalization is less than $1 billion.

Aggressive growth portfolios can provide low income distributions. This is because they tend to be fully invested in common stocks that pay small or no cash dividends. A small or nonexistent dividend stream is unimportant for the annuity investor since tax liabilities are no immediate concern. A high turnover rate can result in a large capital gains liability for the mutual fund investor, whereas the annuity investor does not share this same liability because the annuity has tax-deferred growth.

Investing in this type of sub-account is not for the weak-hearted. It should be advised only for the sophisticated investor who maintains a well-diversified portfolio, who understands the importance of a long term investment strategy, who understands risk and volatility and who can sustain investment losses that are often substantially higher than those experienced in a more conservative portfolio. The investor who plans on participating for a long term and is not concerned with monthly or yearly variations, this aggressive growth portfolio can be very rewarding.

While aggressive growth sub-accounts present higher risks, the news is not at all a discouragement. The risks on these types of investments tend to dissolve over longer periods of time and aggressive growth sub-accounts normally produce a highly competitive long term result.

"Over the 15 years ending December 31, 1994, small stocks outperformed common stocks by 18%, as measured by the Standard & Poor's 500 Stock Index. From 1980 to 1977, small stocks averaged 17.0% (compounded per year) versus 15.7% for common stocks. A $10,000 investment in small stock grew to $105,600 over the 15-year period; a similar initial investment in the S&P 500 grew to $89,300." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

"During the 30 years ending December 31, 1994, there were eleven 20-year periods (e.g., 1964-1983, 1965-1984, and so on). The Small Stock Index, made up from the smallest 20% of companies listed on the New York Stock Exchange (NYSE), as measured by market capitalization, outperformed the S&P 500 in all of those 20-year periods.

"During the 20 years ending December 31, 1994, there were eleven 10-year periods (e.g., 1974-1983, 1975-1984, and so on). The Small Stock Index outperformed the S&P 500 in six of those eleven 10-year periods.

"Over the 50 years ending December 31, 994, there were forty-one 10-year periods (e.g., 1944-1953, 1945-1954, and so on). The Small Stock Index outperformed the S&P 500 in twenty-seven of those forty-one 10-year periods.

"A dollar invested in small stocks in 1945 grew to over $1,230 by the beginning of 1995. This translates into an average compound return of 15.3% per year. Over the 50-year period, the worst year for small stocks was 1973, when a loss of 31% was suffered. Two years later, these same stock posted a gain of almost 53% in one year. The best year was 1967, when small stock posted a gain of 84%."

The chart below shows that the variable annuity sub-accounts outperformed their mutual fund counterparts in 1994, 1992, 1991, 1989, 1987, and for the 3-, 5-, and 10-year periods ending December 31, 1994.

The table below shows statistics that may be useful when comparing variable annuity sub-accounts versus their mutual fund counterparts.

Average Annual Returns: Aggressive Growth

Annuity Sub-Accounts versus Aggressive Growth Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-1.0%	-1.3%
1993	17.0%	17.9%
1992	11.2%	8.6%
1991	55.6%	50.4%
1990	-8.4%	-7.9%
1989	31.3%	27.2%
1988	11.5%	15.7%
1987	-2.5%	-2.9%
3-year average	13.1%	8.3%
5-year average	12.1%	11.5%
10-year average	14.5%	13.3%

It should be noted or advised that aggressive growth sub-accounts should generally comprise only a small percentage of a total portfolio for even the most aggressive investor.

Growth Sub-Accounts

Seeking Capital Appreciation

This type of variable annuity sub-account's objective is to provide investors with steady capital appreciation by investing in a diversified portfolio of well-seasoned and financially sound companies. Current income is treated as a secondary concern. Growth sub-accounts typically invest in U.S. common stocks while avoiding speculative issues and aggressive trading techniques. Growth sub-accounts are invested into growth oriented firms that pay cash dividends and the concentration of assets is not as limited as the Aggressive Growth portfolios. The goal of most of these sub-accounts is long term growth. The approaches used to attain this appreciation can vary widely among these sub-accounts. The companies are normally include in the Standard & Poor's 500 and have demonstrated the ability to produce strong and consistent earnings, steady growth and regular dividend payments. Even though dividend payments are a secondary concern, these companies have generally paid dividends over a long period of time.

The goal of most Growth Sub-accounts is long-term growth.

Because the Growth sub-account is "safer" and less volatile, long term performance of these investments have a lower earnings ratio than Aggressive Growth sub-accounts. A tolerance for moderate risk is still necessary to invest in solid growth stocks, but over the long term, more than ten years, growth stocks have always outperformed other types of investments. This is especially true of bonds and certificates of deposit (CDs). This investment is suitable for investors seeking an above-average return from seasoned stocks and those who are willing to accept reasonable long term risk.

During prolonged market declines, Growth portfolios can sustain severe declines also. Since some portfolio managers of Growth sub-accounts attempt to time the market over a longer cycle, switching these funds often may be counterproductive. Although market timing is strongly discouraged, doing so with variable annuities will not trigger a tax liability that may occur with mutual fund market timing.

"Over the 15 years from 1979-1993, growth stocks outperformed government bonds by 74%. Common stocks averaged 15.7% compounded per year, versus 11.5% for government bonds. A $10,000 investment in stocks, as measured by the S&P 5000, grew to over $89,3000 over the 15-year period; a similar initial investment in government bonds grew to $51,3000." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

"Within a longer time frame, common stocks have also fared quite well. A dollar invested in stocks in 1945 grew to over $330 by the beginning of 1995. This translates into an average compound return of 12.3% per year. Over the 50 years ending December 31, 1994, the worst year for common stocks was 1974, when a loss of 26% was suffered. One year later, these same stocks posted a gain of 37%. The best year was 1954, when growth stock posted a gain of 53%.

"Over the past half-century, growth stocks have outperformed bonds in every single decade. If President George Washington has invested $1 in common stocks with an average return of 12%, his investment would be worth over $68.7 billion today. If he had enough luck to average 14% on his stock portfolio, his portfolio would be large enough to pay off our national debt four times over."

The chart below shows that the variable annuity sub-accounts outperformed their mutual fund counterparts in 1991, 1989, and 1987.

"The variable annuity subaccounts outperformed

their mutual fund counterparts for 1991, 1989, and 1987."

Gordon K. Williamson goes on to relate: "Growth subaccounts should be part of everyone's holdings. They should comprise no more than 25% in a diversified, conservative portfolio, 50% for the moderate risk-taker, and 75% for the aggressive investor. I recommend a 10% commitment to this category for the moderate and aggressive portfolio. Notice that other stock categories (international, growth and income and aggressive growth) are also recommended. As with any category of variable annuities, whenever larger dollar amounts are involved, more than one subaccount per category should be used."

If the investor's goal is to meet the challenges of inflation, conservative and seasoned stocks are the most appropriate long term investments.

"Growth stocks should always be a larger portion of a variable annuity's long term asset-allocation model." - All About Variable Annuities by Bruce F. Wells

The chart below shows a year by year, as well as a three, five and ten year average for the Growth investment category. As with this table, the variable annuity sub-account is compared with the similar mutual fund category. The performance figures are average figures, representing all funds and sub-accounts that fall within this investment goal.

Average Annual Returns: Growth

Annuity Sub-Accounts versus Growth Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-2.9%	-2.1%
1993	11.3%	11.6%
1992	6.7%	8.4%
1991	36.9%	36.7%
1990	-6.2%	-5.1%
1989	27.9%	26.8%
1988	11.2%	14.9%
1987	3.1%	2.6%
3-year average	4.9%	5.9%
5-year average	8.3%	8.9%
10-year average	12.0%	12.8%

Growth & Income Sub-Accounts

Combining Stock and Bonds

This type of variable annuity sub-account's objective is to provide investors with a competitive, long term total return by investing in a portfolio that combines both growth stock (equities) and bonds (fixed income). These sub-accounts seek to produce both capital appreciation and current income, with a priority given to appreciation potential in the stock purchased. This kind investment strategy attempts to reduce risk and produce a more consistent and competitive return through the diversification of asset classes. The goal of these sub-accounts is to provide long term growth without excessive risk in share price.

The goal of these sub-accounts is to provide long term growth without excessive risk in share price.

An equity income portfolio is conservative by its design, places a high emphasis on the preservation of the sub-account's assets and is almost exclusively comprised of U.S. stocks with a majority invested on utility, computer, energy, retail, and financial common stocks. The sub-accounts also provide higher income distributions, fewer variations in return and greater diversification than Growth and Aggressive Growth sub-accounts. The growth stocks in the portfolio will usually be weighed toward well-seasoned stocks that pay above-average dividends. The sub-account also contains high-grade convertible bonds and fixed-income securities. An equity income portfolio that produces consistent performance over the long term, is judged successful. Equity income, income and total return are sub-accounts that are characteristic of Growth and Income portfolios.

The attractive quality of this sub-account is its consistent performance. Using this sub-account as an investor's approach to asset allocation is great if they want to lower their risk and receive consistent returns. By selecting securities that have comparatively high returns, the investor's overall risk is reduced. Dividends will help "hike-up" the overall return of growth and income sub-accounts during negative market conditions.

While the investor may be offered a number of growth stock sub-account alternatives, the primary choices are Aggressive Growth, Growth and Growth and Income. Within the three equity sub-account classes, there are multiple choices that include:

• Foreign sub-accounts,
• Global sub-accounts,
• Sector sub-accounts,
• Precious metals sub-accounts,
• Small capitalization sub-accounts,
• Emerging global sub-accounts, and
• Utility sub-accounts.

Most variable annuity sub-account investment options will be discussed in this manual. However, it should be noted that it is impossible for any variable annuity contract to offer an infinite array of investment choices, nor would it even be necessary. A good variable annuity contract should offer sufficient investment choices, not an infinite number of investment choices. In this case, more is not better.

"The appropriate initial investment decision is

asset class (stock and/or bonds);

the subsequent choice is sub-accounts, not vice versa."

- All About Variable Annuities by Bruce F. Wells

"Over the 50 years ending December 31, 1994, common stocks outperformed inflation, on average: 70% of the time over 1-year periods; 82% of the time over 5-year intervals; 83% of the time over 10-year periods; and 100% of the time over any given 20-year period of time. Over the same 50-year period, high-quality, long-term corporate bonds outperformed inflation, on average: 60% of the time over 1-year periods; 50% of the time over 5-year intervals; 46% of the time over 10-year periods; and 48% over any given 20-year period." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

Gordon K. Williamson goes on to relate: "I recommend a 10% commitment to this category for the conservative investor, 15% for the moderate, and 10% for the aggressive portfolio. This is one of the few categories of subaccounts that is recommended for all types of portfolios. As with any category of variable annuities, whenever larger dollar amounts are involved, more than one sub-account per category should be used."

The chart below shows that the variable annuity sub-accounts outperformed their mutual fund counterparts only in 1994, 1988, and for the 3-year period.

Average Annual Returns: Growth and Income

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-0.3%	-1.5%
1993	10.6%	10.8%
1992	7.7%	8.3%
1991	26.7%	28.8%
1990	-6.3%	-4.7%
1989	21.3%	23.3%
1988	16.9%	14.8%
1987	0.1%	2.1%
3-year average	6.6%	5.8%
5-year average	7.6%	7.8%
10-year average	12.2%	13.3%

International Stocks

This type of variable annuity sub-account invests for capital appreciation through portfolio invested in foreign equity securities of companies whose primary operations are outside the United States. International stocks invest in securities of foreign companies; they do not invest in U.S. stock at all. Global sub-accounts invest in both foreign and U.S. stocks.

Normally an international stock sub-account will diversify with securities from a number of foreign countries. Foreign markets have grown to represent over two-thirds of the world's capitalization and annualized returns during the past ten years. Funds are available for specific countries or specific regions. The areas that dominate the world stock funds are the United States, Japan, Europe and the Pacific Rim. Investing in foreign securities requires sophisticated and specialized knowledge. Returns are affected not only by a foreign company's earnings but also by currency transactions and the local political environment.

International stocks invest in securities of foreign companies; they do not invest in U.S. stock at all.

This type of sub-account should only be invested in by sophisticated investors who are willing to assume a greater degree of risk. The opportunities for above-average returns are greater, but are also counterbalanced by the additional market and currency risks. Even with the greater risks, it should still be considered. By investing abroad, an investor is investing in different economies that experience prosperity and recession at different times. During the 1980s, foreign stocks were the number-one performing investment, averaging a compound return of over 22 percent per year, versus the 17 percent for U.S. stock and the nine percent for residential real estate. The bottom-line is that international funds provide an investor with added diversification. In fact, the more independent these foreign markets become in relation to the U.S. market, the greater the diversification potential for the investor, thus lowering the total risk to the investor.

If an investor invested in the foreign markets directly, they would have to know and understand thoroughly the foreign brokerage process, international taxes, and the various marketplaces and their economics. They would have to be aware of currency fluctuation trends as well as have access to reliable financial information so a proper investment decision could be made. This is nearly impossible for the individual investor. Expert money managers allow the average investor to take advantage of the foreign markets.

The economic outlook of foreign countries is the major factor in the professional money managers decision regarding international investing. A secondary concern may the value of the U.S. dollar relative to the foreign currencies.

• A strong dollar will lower the foreign portfolio's return.
• A weak dollar will enhance international performance.

Trying to determine the direction of any currency is as difficult as trying to figure out what the U.S. stock market will do on any given day.

Investors who do not wish to be subjected to the currency swings may opt to use a variable annuity subaccount that practices currency hedging. Currency hedging is basically an insurance policy to protect one's investment if the dollar is making a killing in currency futures contracts. It only pays off if the dollar becomes strong, increasing in value against the currencies represented by the portfolio. The cost of this type of insurance becomes part of the cost of doing business. In the case of currency contracts, the contract expires and a new one is purchased, covering another period of time. When properly handled, the gains in the futures contracts (the insurance policy) can offset most or all of the security losses attributed to a strong U.S. dollar. An investor may believe that buying currency contracts is a risky business for the sub-account, but if done properly it is not.

As with any type of insurance it only pays off if there is an "accident". Currency hedging pays off if the U.S. dollar increases in value against the currencies represented by the portfolio's securities. However, if the dollar remains level or even decreases in value, the insurance policy does not pay because the investment is not loosing. The foreign securities increase in value and the currency contracts become worthless when the U.S. dollar remains level or decreases in value.

Is currency hedging important on a risk-adjusted basis? Consider this: how do a foreign and U.S. stock portfolio fare against each other? Answer: over the last ten years from 1983 to 1993, U.S. stocks had a risk level 16, versus just over 17 for foreign equities. When currency hedging is added to the portfolio, the international risk level falls to 13 and the U.S. level stay at 16.

An integrated world economy has evolved over the decade from 1983 to 1993 from many distinct national economies of the past. Many investment opportunities once thought to be uniquely American have gradually shifted to other areas around the world. Today, there is over 60 percent of stock market capitalization represented by non-U.S. companies. The case for internationally diversifying portfolios has never been stronger. Especially with the recent trade agreements, such as NAFTA and GATT, the case for international portfolios is even stronger. For an investor to earn competitive returns, U.S. investors can no longer afford to ignore foreign opportunities - or be afraid of them.

It has already been stated that all investors want to increase their investment returns and reduce their portfolio risk. These are two compelling reasons to invest in the international market. Global investing allows an investor to maximize their returns by investing in some of the world's best-managed and most profitable companies. The most potential for growth is in countries that are industrializing, having the cheapest labor and the richest natural resources while remaining undervalued.

Diversification is commonly known to reduce risk.

The Pacific Basin which includes Japan, Hong Kong, Korea, Taiwan, Thailand, Singapore, Malaysia and Australia, has experienced phenomenal growth and represents 34 percent of today's world stock market capital. This is nearly double what is was ten years ago. Japan is the most economically mature country in the Pacific Basin. It has become a dominant force behind the development of the newly industrialized countries (NICs) of Hong Kong, Korea, Thailand, Singapore, Malaysia and Taiwan. As the demand for Japanese products increases, costs in Japan have also increased, so the need to find affordable production of goods has caused Japanese investment to flow into neighboring countries, thus fostering their development as economically independent and prosperous countries.

The newly industrialized nations (NICs) possess some of the world's cheapest labor and richest untapped natural resources. Because of this, they have recently experienced a phenomenal influx of international investment capital.

Experienced investors have known the names of many of Europe's major producers such as Nestle', Volkswagen or Perrier. Europe's impressive manufacturing capacity with its diverse industrial base and quality labor pools can make it an environment for growth and accessible to U.S. investors through variable annuities that have foreign and global sub-accounts.

"European markets have proven time and again that they represent tremendous investment potential. From 1983 to 1993, European markets have consistently produced greater total returns than the U.S. stock market, which averaged 14.8% over this same period." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

Gordon K. Williamson goes on to relate: "With economic deregulation and the elimination of internal trade barriers, many European companies, for the first time in their history, are investing in and competing for exposure to the whole European market. Companies currently restricted to manufacturing and distributing within their national boundaries will soon be able to locate facilities anywhere in Europe, maximizing the efficient employment of labor, capital and, raw materials.

"Like any other subaccount category, this one should not be looked at in a vacuum. The real beauty of foreign subaccounts shines through when they are combined with other categories of U.S. equities."

As the following table will show, variable annuity sub-accounts outperformed their mutual fund counterparts for 1994, 1993, and 1990.

One of the important things to remember is that international investing reduces overall risk of an investor's portfolio. Besides reducing risk, they can also provide excellent returns. According to a Standford University study, overall risk is cut in half when a global portfolio of stock is used instead of one based on U.S. issued stock alone. Another study showed that the least volatile investment portfolio would be composed of 60 percent U.S. stocks and 40 percent foreign stocks. These studies reflect the importances of balancing a portfolio between U.S. and foreign equities.

Average Annual Returns: International Stocks

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-1.1%	-2.9%
1993	33.0%	31.3%
1992	-6.9%	-0.8%
1991	-10.5%	18.4%
1990	7.7%	-10.8%
1989	20.8%	21.65%
1988	8.5%	14.2%
1987	-7.0%	5.0%
3-year average	7.2%	9.1%
5-year average	4.1%	5.5%
10-year average	1.1%	15.7%

Balanced Sub-Accounts

Combining Stock & Bonds

The Balanced sub-accounts, also referred to as Total Return sub-accounts, mix investments in common stocks, bonds and convertible securities to decrease volatility and stabilize market swings. The goal of Balanced sub-accounts is to provide for both growth and income. The Total Return basis (current yield plus or minus principal appreciation) is the net amount earned during a given period, normally measured annually. The reason for asset allocation and diversification is not only to reduce risk, but also to receive competitive returns from the best performing investments.

The goal of Balanced sub-accounts is to provide

for both growth and income.

Balanced portfolios, like the growth and income accounts, provide a high dividend yield that is sheltered from taxation within a variable annuity. The goal or main objective of the Balanced sub-account is accomplished by taking advantage of market rises through stock holdings and providing income with bond holdings. The portfolio composition is almost always comprised of U.S. securities. Balanced portfolios provide neither the best not the worst of both investment worlds. They often outperform the different categories of bond funds when things are good, although, they suffer greater percentage losses during stock market declines. When interest rates are on the rise, Balanced sub-accounts will typically decline less than bonds. When rates are falling, Balanced sub-accounts will also outperform a bond portfolio if stocks are doing well.

Balanced sub-account investing is important to wealth accumulation and is a perfect choice for the investor who cannot decide between stocks and bonds. This hybrid security is ideal for an investor who wants a sub-account manager to determine the portfolio's weighting of stocks, bonds and convertibles.

As the following table shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1990, 1987 and very slightly in 1993.

"Conservative investors should have no more than 40% of their portfolios committed to this category. Moderate investors could place up to 80% of their holdings in balanced subaccounts. These high levels assume that a portfolio's diversification is largely dependent on using only a few categories of variable annuity subaccounts. I recommend a 20% commitment to this category for the conservative investor and only 10% for the moderate portfolio. As is true with any category of variable annuities, whenever larger dollar amounts are involved, more than one subaccount per category should be used." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

Average Annual Returns: Balanced or Total Return

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-3.9%	-2.8%
1993	11.3%	11.2%
1992	6.8%	7.1%
1991	22.8%	26.4%
1990	0.1%	-0.6%
1989	18.5%	19.6%
1988	11.0%	12.2%
1987	2.1%	1.8%
3-year average	4.3%	5.1%
5-year average	7.0%	7.8%
10-year average	10.4%	11.5%

Corporate Bond Sub-Accounts

Fixed Income

Corporate Bond sub-accounts invest in debt instruments issued by corporations for building expansion, capital improvements, equipment purchases or any number of other reasons corporations borrow money. As the name implies, Corporate bond sub-accounts are primarily comprised of bonds issued by corporations. Portfolios are almost always comprised of U.S. issues.

Bonds are the second most common fixed-income asset group that also offer fixed rates of return and return of principal. All bonds introduce the element of market and/or credit risk into the decision making process. The hazard of credit risk is that the issuer will default on the interest and/or principal payments. The perils of market risk involve the possibility that the market value of the bond could decrease as interest rates increase and/or credit risk concerns could arise.

The only bonds considered to be without credit risk are those backed by the U.S. government and certain government agency securities. However, all fixed-income securities, including U.S. government bonds, are subject to market risk.

To be specific, there are three major classifications of fixed-income securities:

1. Corporate,

2. Government, and

3. Municipal bonds.

Each offers a predictable and reliable income stream and bonds tend to experience less market volatility than equities. The rate of return on a fixed-income security depends on three factors:

1. The general interest rate environment,

2. The creditworthiness of the bonds, and

3. The maturity of the bond.

No municipal bond sub-accounts are offered in variable annuity contracts because municipal bond interest is exempt from federal taxes.

The major influence on bond prices, which effects the value of the underlying sub-account, is interest rates. There is an inverse relationship between interest rates and the value of the bond - when one goes up, the other goes down. Bonds often include other features such as conversion privileges, but are primarily purchased for their income stream.

"There is a direct correlation between a

bond's price volatility and its maturity date."

- All About Variable Annuities by Bruce F. Wells

Like most debt investments, corporate bonds have a stated maturity date and pay a fixed rate of interest. The amount of appreciation or loss of a corporate bond sub-account primarily depends on the average maturity of the bonds in the portfolio and the yield of the bonds in the sub-account's portfolio. These sub-accounts have a wide range of maturities. The name of the portfolio will often indicate if it is composed of short term or medium term obligations. Short term bond sub-accounts are comprised of debt instruments with an average maturity of five years or less and subject to very little interest rate risk or reward. Medium term bond sub-accounts are comprised with maturities averaging between 6 and 15 years and subject to one-third to one-half the risk level of long term accounts. Long term bond sub-accounts are comprised of maturities ranging from 16 to 30 years and will average eight percent increase or decrease in share price for every cumulative one percent change in interest rates. The greater the maturity, the more the portfolio's unit price can change.

Usually purchased because of its reinvested income stream, an investor's principal in a bond sub-account can fluctuate. Thus, the issuer's creditworthiness should be a major consideration when purchasing corporate bonds. For instance, blue-chip corporations rarely default on either interest or principal payments, thus they are able to borrow capital at the most favorable prevailing rate. For emerging companies and corporations with weaker balance sheets and shorter track records, lenders extract higher rates and impose stricter borrowing conditions.

Corporate bonds issued to foreign companies are subject to the same credit risk conditions as are the domestic corporations. As with the domestic corporations, major foreign corporations borrow at a more favorable rate, while emerging and less financially stable foreign corporations pay higher rates to borrow capital. A major consideration before investing in foreign corporations are the currency exchange risks. Unless payment is required in U.S. dollars, currency fluctuations can increase leverage and exposure dramatically. Many sub-account managers handle this additional risk by extensive country diversification and/or currency hedging.

Within this same category, we will also consider Investment-Grade Corporate Sub-accounts. These seek current income, safety and preservation of capital by investing in a portfolio of high-quality corporate bonds. Investment-grade securities are defined as securities that are rated investment grade by the various bond rating services. Chapter six will cover the different rating agencies available. Bonds with the highest credit rating will pay the least interest on their fixed-income debt. As the quality of bonds decrease, interest rates increase. When the economy is thriving, fixed-income money managers often lower their average portfolio rating to receive additional yield. During less prosperous times, money managers have a tendency toward raising their portfolio's quality rating.

Sub-account money managers have a vast array of choices when purchasing investment-grade corporate bonds. All major U.S. and foreign corporations issue debt securities. Creditworthiness is the money manager's primary consideration when choosing. The second is the maturity date. Investment-grade Bonds are also issued with varying maturity dates but are categorized as short, intermediate and long term. The importance of maturity cannot be overemphasized. Except in unusual market circumstances, bonds with longer maturities pay higher interest rates and carry more market risk. To lower this risk, fixed-income sub-account managers diversify their portfolios by purchasing bonds with varying maturity dates.

"Over the 15-year period from 1979 to 1993, individual corporate bonds underperformed common stock by more than 40%. Long-term corporate bonds averaged 11.6% compounded per year, versus 15.7% for common stock and 17.0% for small stocks. A $10,000 investment in corporate bonds grew to $51,700 over that same 15-year period; a similar initial investment in common stocks grew to $89,000. For small stocks, the investment grew to $105,600." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

Gordon K. Williamson goes on to relate: "Within a longer time frame, corporate bonds have only outpaced inflation on a pretax basis. A dollar invested in corporate bonds in 1945 grew to $15.01 by the beginning of 1995. This translates into an average compound return of 5.6% per year. During this same period, $1 inflated to $8.37, which translates into an average annual inflation rate of 4.3%. Over the 50 years ending December 31, 1994, the worst year for long-term corporate bonds, on a total return basis (yield plus or minus principal appreciation or loss), was 1969, when a loss of 8% was suffered. The best year was 1982, when corporate bonds posted a gain of 44%."

As the following table shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1993, 1991 and the three-year period ending December 31, 1994.

Average Annual Returns: Corporate Bonds

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-5.0%	-3.6%
1993	9.8%	8.6%
1992	6.1%	6.4%
1991	15.2%	14.3%
1990	5.7%	7.7%
1989	10.7%	11.7%
1988	6.6%	7.3%
1987	0.5%	2.5%
3-year average	3.4%	4.6%
5-year average	6.0%	7.3%
10-year average	8.1%	9.5%

Government Bond Sub-Accounts

Fixed Income

This type of sub-account invests only in direct and indirect U.S. government obligations. The goal of this sub-account is to provide current income and safety of capital. The investments can include one or more of the following:

Treasury bills (T-Bills): Short term government obligations that mature in three months, six months or one year. At maturity, the investor is paid the face value. The profit is the difference between the face value of the Treasury bill and the lower auction price paid for the treasury bill. The minimum denomination is $10,000, plus $5,000 increments.

Treasury Notes (T-Notes): Intermediate term government obligations with maturities ranging from two to ten years. They are issued at par and bear a specific rate of interest, which is paid every six months. The minimum denomination is $5,000 for two and three year notes, plus $5,000 increments or they are sold in increments of $1,000, plus $1,000 increments.

Treasury Bonds (T-Bonds): Long term government obligations with maturities ranging from 10 to 30 years. They are issued at par and bear a specific interest rate, which is paid every six months. They are normally issued in increments of $5,000, with a minimum investment of $1,000, with $1,000 increments.

Zero Coupon Bonds (STRIPSs): Normally long term government obligations for which interest payments are not distributed to the bondholder until maturity. The standard zero coupon bonds are sold at a discount that reflects the yield and mature at par.

The coupon portion is the interest rate. So a zero coupon means that no interest is paid currently on these bonds. Instead, an investor buys at a discount from the bond's face value. Every year the interest builds up within the bond itself, until it reaches face value at maturity.

The above comprise the entire marketable debt of the U.S. government.

Government National Mortgage Association bonds (GNMAs): Pools of mortgage securities insured by the Federal Housing Administration or guaranteed by the Department of Veterans Affairs. It then passes through each of the homeowners' interest and principal payments to investors who then receive a pro rata share. GNMA guarantees the performance of the mortgages. This is considered an indirect obligation of the government, but is still backed by the full faith and credit of the United States. GNMA is also referred to as a Ginnie Mae. GNMAs are the highest yielding government-backed security that an investor can get.

Federal National Mortgage Association bonds (FNMAs): Not issued by the government but are considered virtually identical in safety to GNMAs.

Many government bond sub-accounts include adjustable-rate instruments to reduce price volatility as the rates are periodically reset to reflect current market conditions. Government bonds are without credit risk but are subject to market risk, especially in the longer maturities.

The average maturity of securities found in government bond sub-accounts ranges widely. It is dependent upon the type of sub-account and management's perceptions of risk and the future directions of interest rates. As stated before, the major influence on bond prices is interest rates. There is an inverse relationship between interest rates and the value of the bond - when one goes up, the other goes down.

The major influence on bond prices is interest rates.

These portfolios can be attractive to bond investors because they provide diversification and marketability that are not as readily available in direct bond investments. The investor should remember that government and corporate bonds are generally not a good investment, once inflation and taxes are factored in. An investor who appreciates the cumulative effects of even low levels of inflation should probably avoid government and corporate bonds except during retirement.

"Over the 15 years ending December 31, 1994, government bonds underperformed long-term corporate bonds only slightly - 11.5% versus 11.6% for corporates. A $10,000 investment in U.S. government bonds grew to $51,300 over the 15-year period; a similar initial investment in corporate bonds grew to $51,7000." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

Gordon K. Williamson goes on to relate: "Within a longer time frame, government bonds have only slightly outperformed inflation. A dollar invested in governments in 1945 grew to $12.42 by the beginning of 1995. This translates into an average compound return of 5.2% per year. Over the 50 years ending December 31, 1994, the worst year for government bonds was 1967, when a loss of 9% was suffered. The best year was 1982, when government bonds posted a gain of 40%. All of these figures are based on total return (current yield plus or minus any appreciation or loss of principal).

"Over the 50 years ending December 31, 1994, there were forty-one 10-year periods (1944-1953, 1945-1954, and so on). On a pretax basis, government bonds outperformed inflation during only fifteen of the forty-one 10-year periods. Over the same 50-year period, there have been thirty-one 20-year periods (1944-1963, 1945-1964, and so on). On a pretax basis, government bonds have outperformed inflation during only eight of these thirty-one periods. All eight of those 20-year periods ended between 1986 and 1994."

Since variable annuities charge a mortality charge of normally one percent, it may be best to minimize bond sub-account holdings. Expenses can eat away at the returns. For bond sub-accounts to be most effective, they would need to be held for an average of at least ten years to make them more worthwhile than mutual funds or direct ownership.

As the following table shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1993, 1991, and 1989.

Average Annual Returns: Government Bonds

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-4.6%	-3.6%
1993	8.3%	8.0%
1992	5.5%	6.0%
1991	14.7%	14.1%
1990	6.0%	8.4%
1989	12.8%	12.0%
1988	6.3%	6.7%
1987	-0.6%	1.5%
3-year average	3.0%	3.4%
5-year average	5.9%	6.4%
10-year average	7.9%	8.3%

High-Yield Bond Sub-Accounts

Fixed-Income

High-Yield Bond sub-accounts invest in lower-rated debt instruments. Bonds can be classified as either

• Bank Quality Bonds (also known as Investment Grade Bonds), which are rated very highly by a rating company, such as A.M. Best or Standard & Poor, or
• High-Yield Bonds (also known as Junk Bonds), which are rated very low to moderate.

High-yield bonds are classified as junk bonds because of their lower ratings and additional risk of default. As with any risk or reward picture, the opportunity for highly competitive yields is counterbalanced by an exposure to higher credit risks and higher default rates compared to investment grade bonds. Certain institutions and fiduciaries are forbidden to invest their clients' monies in anything less than investment grade. You might say that everything less than bank quality is considered junk.

High-yield bonds can be subject to substantial price erosion during slow economic times or when questions arise about a bond issuer's creditworthiness. High-yield sub-accounts perform best during good economic times. Such issues should be avoided by traditional investors during recessionary times because the underlying corporations may experience difficulty making interest and principal payments when business slows down. Do not overlook the fact that, like common stocks, these bonds can perform very well during the second half of a recession. Their volatility is normally substantially higher than that of investment grade bonds.

"An individual investor is best served by not

purchasing individual high-yield bonds, EVER."

- All About Variable Annuities by Bruce F. Wells

When an investor is interested in this type of sub-account, it should not be overly stated that this is not for the idle investor. The high-yield bond market is too sophisticated and should be left to professionals. As with aggressive growth stocks, high-yield bonds can have a positive effect and reduce risk through diversification. The question is not return, but risk exposure. The majority of investors are comfortable with a moderate percentage of high-yield bonds in their sub-accounts asset-allocation model.

Although high-yield bonds may exhibit greater volatility than their bank quality peers, they are safer when it comes to interest rate risk. This is because junk issues have high-yielding coupons and shorter maturities than quality corporate bond sub-accounts. They fluctuate less in value when interest rates change. So, during expansionary times in the economy when interest rates are rising, high-yield sub-accounts will generally drop less in value than investment grade corporate or government bond sub-accounts. When interest rates are falling, corporate and government bonds will often appreciate more in value than high-yeild sub-accounts.

In terms of economic cycles and important technical factors, high-yield bonds resemble equities at least as much as they do traditional bonds.

"Studies show that only 19% of the average junk subaccount's total return is explained by the up- or down-movement of the Lehman Brothers Gov't/Corp. Bond Index. To give an idea of how low this number is: 94% of a typical high-quality corporate bond subaccount's performance is explainable by movement in the same index. Indeed, even international bond subaccounts have a higher correlation coefficient than junk: 25% of their performance can be explained by the index." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

"The high end of the junk bond market, those debentures rated BBB and BB, have been able to withstand the general beating the junk bond market incurred during the late 1980s and early 1990s. Moderate and conservative investors who want high-yield bonds as part of their portfolio should focus on subaccounts that have a high percentage of their assets in higher-rated bonds - BB or better.

Well over 90% of the junk bonds in existence at the end of 1989 had been issued since 1982. Not surprisingly, the mutual fund and variable annuity industries helped finance this growth. According to Salomon Brothers, junk bond defaults averaged only 0.84% from 1980 to 1984. This rate almost tripled from 1985 to 1989, when defaults averaged 2.2% per year. In 1990, defaults surged to 4.6%. Analysis based on historical data did not predict this huge increase in defaults. The default rate dropped to 1% in 1994. Junk bonds rated BB are going to perform closer to high-quality bonds than will lower-rated junk. For example, during 1990, BB-rated bonds declined only slightly in price and actually delivered positive total returns. Bonds rated CCC declined over 36% in price.

"The table shows year-by-year, as well as 3-, 5-, and 10-year averages for this investment category. The variable annuity subaccount category is compared against the similar mutual fund category. These performance figures are average figures, representing all funds and subaccounts that fall within this investment objective.

The following table shows that the variable annuity sub-accounts outperformed their mutual fund counterparts for 1990 and for the last five year period. The difference between these two investment vehicles was very close for all other periods.

Average Annual Returns: Government Bonds

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-4.0%	-3.9%
1993	18.1%	18.9%
1992	16.6%	17.5%
1991	35.7%	37.3%
1990	-7.7%	-10.3%
1989	-1.4%	-0.2%
1988	11.7%	13.0%
1987	0.5%	1.6%
3-year average	9.9%	10.6%
5-year average	10.6%	10.5%
10-year average	9.0%	9.9%

Global & International Bond Sub-Accounts

Fixed-Income

International bond sub-accounts, also referred to as foreign sub-accounts are the fixed-income equivalent of their foreign equity companions previously discussed. Global sub-accounts, also referred to as World Bond sub-accounts, invest in securities all over the world (which includes U.S. fixed-income securities) whereas international sub-accounts invest in foreign fixed-income securities. This type of sub-account's objective is high current income, safety and preservation of capital by investing in a portfolio of foreign fixed-income securities. International sub-accounts purchase securities issued in various foreign currencies such as Frances, pounds, yen and deutsche marks. The fixed-income markets do involve some risks that can be reduced through global diversification.

Global bond sub-accounts seek higher interest rates -

no matter where the search may take them.

International bond sub-accounts generally offer higher yields because of their real or perceived higher risk. Like their foreign equity companions, these sub-accounts are subject to market risk, currency exchange risk and varying degrees of credit risk depending on the portfolio mix. Prospective investors need to be aware of the potential changes in the value of the foreign currency relative to the U.S. dollar.

Global bond sub-accounts normally invest in bonds issued by stable governments in a handful of countries. These sub-accounts try to avoid purchasing foreign government debt instruments from politically or economically unstable countries. The objective of the Global bond sub-accounts is higher interest rates, no matter where the search may take them. Inclusion into the portfolio is dependent upon the money manger's perception of the interest rates, the country's projected currency strength against the U.S. dollar and the predicted political and economic stability.

Since countries move in different economic cycles, so do the capital gain prospects of the bonds issued in those countries. At any one time, a certain country may offer the highest returns. As global economic cycles shift, a different country may then hold out the greatest opportunities. Because foreign markets do not necessarily move in tandem with U.S. markets, each country represents varying investment opportunities at different times. International bond portfolios have out performed their U.S. counterparts for the past 25 years. Using global accounts diversifies an investor's portfolio thus reducing the investor's risk level. There are not many variable annuities that have international or global bond sub-accounts.

To evaluate the effect on interest rates and bond values in the economic environment requires an understanding of two important factors:

1. Inflation: During inflationary periods, when too much money is chasing too few goods, government tightening of money supply helps create a blanket between an economy's cash resources and its available goods.

2. Money Supply: This refers to the amount of cash made available for spending, borrowing or investing. This money supply is controlled by the central banks of each nation. Money supply is a primary tool for managing inflation, interest rate and economic growth. A nation can tighten the money supply thus helping to bring on disinflation, which is a decelerated loan demand, reduced durable goods orders and falling prices. Disinflationary times the underlying value of existing bonds is strengthened because interest rates also fall. During disinflationary times also means lower yields for government bond investors even though such factors contribute to a healthier economy.

The true enemy of bond investors is inflation,

which drives interest rates higher.

When nations put into effect policies to reduce inflation, thus reducing interest rates, this can be quite disquieting to individuals who specifically invest for a high monthly income. In reality, falling interest rates mean higher bond values for investors seeking long term growth or a high total return. The true enemy of bond investors is inflation, which drives interest rates higher. Inflation diminishes bond values and erodes the buying power of the interest income that investors receive. Investors seeking income need to find economies where inflation is coming under control with interest rates high enough to provide favorable bond yields. Not all bond markets will peak at the same level, although they do tend to follow patterns. Investors should target those countries where interest rates are at peak levels and inflation is falling. This not only results in higher income but also creates significant potential for capital appreciation when rates are ultimately declining.

A proven technique for controlling market risk: Diversification.

Even if investors have a primary goal of high income, they must consider credit and market risk. By investing primarily in variable annuity sub-accounts that purchase government guaranteed bonds from the world's most creditworthy nations, one can get an extra measure of credit safety for payment of interest and repayment of principal. Sub-account money managers can diversify across multiple markets thus significantly reducing market risk as well. Diversification is a proven technique for controlling market risk.

"Over the 25 years ending December 31, 1994, international bonds outperformed U.S. bonds and inflation. They have come close to matching the return of U.S. common stocks. From 1964 through 1994, there were twenty-one 10-year periods (e.g., 1964 - 1973, 1965 - 1974, and so on). The Non-U.S. Bond Index outperformed the U.S. Bond Index in eighteen of the past twenty-one 10-year periods from 1964 to 1994." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

"Each year, from 1984 through 1994, at least three government bond markets have provided yields higher than those available in the United States (Salomon Brothers, Inc.). With almost 50% of the world's bonds found outside the United States, investors must look beyond U.S. borders to find bonds offering yields and total returns that meet their investment objectives."

A facet of investing in global bonds that escapes many investors is that they offer more than just yield or income. They can actually offer, with successful money management of these global bond portfolios, three different important components:

1. Capital appreciation,

2. Yield, and

3. Currency management.

While most investors understand the concept of investing in global sub-accounts for the income, investors may lose out on the capital appreciation opportunities if they strictly search for just high yields. On the other hand, those investors looking solely for capital appreciation may often give up current income. Investors who do not apply the principles of currency management may see their investment erode when exchange rates change adversely in global bonds.

As stated before, there is an inverse relationship between bond values and interest rates. Investing in global bonds provides for the potential for capital appreciation during periods of declining interest rates. When interest rates fall, existing bond values climb. When interest rates rise, existing bond values decline.

When interest rates fall, existing bond values climb.

When interest rates rise, existing bond values decline.

Gordon K. Williamson goes on to relate: "If you are limiting your bond portfolio to U.S. investments, you are missing out on over half of the world's bond market opportunities. Currently, over half of the world's government bonds are issued in countries other than the United States. Investing in global bonds can help position U.S investors' portfolios to benefit from capital growth opportunities in world bond markets, while capturing income from those bonds. Each year, from 1985 through 1994, at least three government bond markets have provided yields higher than those available in the United States.

"Inflation has historically been a key factor in driving worldwide interest rates higher. Inflation diminishes bond returns and erodes the buying power of the interest income that investors receive. In the 1990s, a worldwide trend toward disinflation is developing. Our own Federal Reserve has been actively battling inflation, and as a result has been able to keep rates relatively low in an effort to strengthen the U.S. economy. This trend should spread to other nations, such as Germany and Japan, over the next few years. Targeting those countries where interest rates are at peak levels and inflation is falling not only results in higher income but also creates significant potential for capital appreciation.

"World bond subaccounts, particularly those that have a high concentration in foreign issues, are an excellent risk-reduction tool that should be utilized by the vast majority of investors. Conservative portfolios should have no more than 50% of their diversified holdings in world bonds, moderates should have no more than 30% and, aggressive investors should have no more than 20%."

As the following table shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1987 and for the ten year period.

Average Annual Returns: World Bonds

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-6.5%	-5.8%
1993	11.7%	16.0%
1992	0.1%	2.5%
1991	10.1%	13.5%
1990	11.9%	12.7%
1989	6.2%	6.2%
1988	3.0%	4.5%
1987	23.1%	18.0%
3-year average	1.4%	3.8%
5-year average	6.0%	7.5%
10-year average	12.0%	9.5%

Specialty Portfolios

Specialty sub-accounts, also referred to as Sector sub-accounts, allow a variable annuity investor an opportunity to invest in a particular segment of the economy, such as timber, mining, airline, chemical, automotive, paper, real estate or banking industries. Some sources include metals and utilities as specialty portfolios, while other sources do not. Most, if not all, of the companies represented in these sub-accounts are domestic.

Specialty sub-accounts are the most volatile portfolio to invest in. This microinvestment approach adversely affects the risk-reward investment scenario significantly because of the lack of diversification. The whole point of hiring expert money managers and diversifying investment assets is to increase the opportunity for more consistent and competitive long term investment results. With this in mind, specialty sub-accounts are basically counterproductive to that investment objective. If an investor wishes to invest in a specialty sub-account, only a small portion should be devoted to it. There are two reasons why this limitation may be recommended:

1. When the investor chooses a specialty/sector sub-account, they are tying investment management hands; their ability to find worthy stocks is limited by prospectus to a certain industry. If this industry or sector is not performing well, the sub-account will not do either - no matter how experienced the management team is. Again, this hinders the goal of diversification.

2. Specialty Sector portfolios are considered very risky. The entire sub-account is prone to the fortune or misfortune of a particular industry, so an investor could have a combined substandard performance and above-average risk.

So why would anybody want to invest in specialty portfolios? These portfolios allow a person to invest in real estate, for example, without going through the trouble of buying and managing their own properties. Also, this category can actually reduce the overall risk of an investor's portfolio because it has a random or negative correlation meaning it may go up when other parts of the portfolio are moving sideways or even going down.

An investor needs to determine their time horizon when considering whether or not to invest in a specialty portfolio. The longer the holding period, the greater the chance that a specialty/sector sub-account will turn out to be rewarding. It is not unusual for a specialty sub-account to increase from 40% to 100% during the first year of ownership only to drop 25% to 50% the following year. The specialty portfolio often has no consistency or predictability.

As the following table shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1990 and 1988.

Average Annual Returns: Specialty

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-3.7%	-2.3%
1993	17.9%	29.4%
1992	2.9%	4.6%
1991	15.2%	25.0%
1990	-8.7%	-9.2%
1989	16.1%	26.8%
1988	10.6%	7.1%
1987	6.6%	6.6%
3-year average	5.6%	8.0%
5-year average	4.1%	8.5%
10-year average	n/a	11.5%

Metals Sub-Accounts

Specialty Portfolios

The precious metals sub-accounts can also be referred to as gold sub-accounts, though they often own minor positions in other precious metals such as silver and platinum. The objective of the precious metals sub-accounts is aggressive capital appreciation by investing in precious metals and mining stocks throughout the world. These portfolios are the most speculative sub-accounts available in most variable annuity contracts. They are considered highly specialized and are usually considered specialty or sector sub-accounts. These types of sub-accounts experience diminishing support during periods of relatively low inflation rates and stable commodity prices and they offer investment alternatives.

The proportion and type of metal held by a sub-account can have a great impact on its performance and volatility. Outright ownership of gold bullion is almost always less volatile than ownership of stock of a gold mining company itself. Until the late 1970s many investment advisors recommended a percentage allocation to gold funds to offset inflation. The concept has been expanded to include other precious metals stocks and the actual commodity. Silver has nearly twice the volatility of gold and yet has not had any greater return over the long term.

"Metals subaccounts should be avoided by anyone who cannot tolerate wide price swings in any single part of a portfolio."

- The 100 Best Annuities You Can But by Gordon K. Williamson

Metal sub-accounts are suitable investments during times of high inflation and troubling world events. It may be surprising to most readers that historically both metals have outperformed inflation by less than one percent annually. The inclusion of this type of sub-account in an asset-allocation model can reduce a portfolio's risk and volatility, despite the potential of its own volatility.

"Metal subaccounts are the riskiest category of variable annuities. This is true regardless of the composition of the gold subaccount. Although this is a high-risk investment when viewed alone, ownership of a metals subaccount can actually reduce a portfolio's overall risk level and often enhance its total return because gold usually has a negative correlation to other investments. That is, when one investment goes down in value, gold will often go up. Thus, a portfolio comprised strictly of government bonds will actually exhibit more risk and less return than one comprised of 90% governments and 10% in a metals subaccount." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

As the following table shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1994, 1992, 1991, 1990, and the three year and five year periods.

Average Annual Returns: Metals

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-4.7%	-11.7%
1993	60.6%	83.8%
1992	-6.4%	-15.0%
1991	-3.0%	-4.4%
1990	-17.2%	-23.9%
1989	18.2%	25.6%
1988	-21.9%	-17.8%
1987	33.2%	36.8%
3-year average	11.4%	10.5%
5-year average	3.0%	-0.5%
10-year average	n/a	5.5%

Utility Stock Sub-Accounts

Specialty Portfolios

Utility sub-accounts are similar to fixed-income sub-accounts although it is technically an equity investment. Their goal is to provide a competitive dividend yield through the purchase of the stocks of major utilities, preserve capital assets and experience modest capital appreciation. Another aspect of most of these sub-accounts is their goal of long term growth. Even though utility portfolios offer this modest capital appreciation, they can still offer attractive total returns and can be particularly attractive investments during times of market uncertainty and declining interest rates. Like metal sub-accounts, the financial standing for this category can change in a matter of months, and should also not be omitted from serious consideration. Particularly regarding utilities, a strong case can be made for purchasing this industry group at depressed times.

Utility sub-account's objective is for both long term growth and income. They invest in common stocks of utility companies across the country. Somewhere between one-third and one-half of these sub-accounts' total return comes from common stock dividends. Generally utility sub-accounts stay away from speculative issues. Instead they focus on well-establised companies that have a solid history of paying good dividends. Utility sub-accounts may sound safe, and that is because they are considered safe. Stocks of any category that rely on a high level of reinvested dividends has a built-in safety cushion in that a comparatively high dividend income means that an investor can count on the appreciation of the underlying issues.

Metal and Utility sub-accounts only represent a couple specialty sub-account categories mentioned in this chapter. Sub-accounts that invest in only one industry should be avoided by most investors for two reasons:

1. As with metal sub-accounts, the utility sub-account's money manager is limited to choose only securities from one particular geographic area or industry.

2. Again, as with metal sub-accounts, the track record of specialty sub-accounts as a whole is not good. In fact, as a general category, these specialty sub-accounts represent the worst of both financial worlds: above average risk and substandard returns.

Utility sub-accounts are the one exception to the aforementioned description. Generally there are four things that determine the profitability of a utility company:

1. How much the utility pays for energy: While the price of oil and gas is directly passed on to the consumer, the utility companies are sensitive to this issue. This is because higher fuel prices mean that the utility industry has less latitude to increase its profit share margins. Thus investors that have invested in utility sub-accounts can expect smaller profits and/or dividends when higher prices present themselves.
2. The general level of interest rates: After the energy costs are evaluated, interest is the industry's greatest expense. Utility companies are heavily in debt. Their interest costs directly affect their profitability. When interest rates go down, a utility company can refinance their debt and in turn the savings can be enormous. Take for example a hundred million dollar loan at 11 percent interest. If the interest rate falls to seven percent, the utility company saves thousands of dollars. Lower interest rates translate into more money left over for shareholders.
3. The company's expected use of nuclear power: Nuclear power has been a hot-bed of opinions for the United States for the last few decades. Other countries have come to grips or ignored the matter, but the United States is still quite divided. There have been no new nuclear power plants successfully proposed in the last several years. We still do not know what the future will hold. The venturing into nuclear energy has not been successful. It always seems more expensive than anticipated by the utility companies and the independent experts they rely on for advice. Because of these reasons, sub-account money managers have veered away from utility companies that are involved with nuclear energy and seek out utility companies that have no foreseeable plans to develop any nuclear power facilities. Avoidance of such utilities keeps share prices more stable and predictable.
4. The political climate: The Public Utilities Commission (PUC) is very politically involved and can directly reflect the opinions of a state's government. We are all concerned about our utility bills and the state officials elected to their positions want to keep their constituents happy. Thus they are more likely to be reelected if they are able to keep rate increases to a minimum. Modest or minimum increases can be healthy for the utility companies, although freezing rates for a couple of years is a bad sign.

Utility stock prices follow very closely the long term bond market. If the economy is doing well and long term interest rates go up, utility stock prices are likely to go down. Utility stock are also at risk to a general stock market decline, although they are considered less risky than other types of common stocks because of their dividends and the monopoly position of most utilities.

If the economy is doing well and long term interest rates go up,

utility stock prices are likely to go down.

"Worldwide, there is a tremendous opportunity for growth in this industry. The average per-capita production of electricity in many developing countries (2,500 kilowatt hours) is only one-fifth of the level in the United States (12,000 kilowatt hours). All over the world, previously underdeveloped countries are making economic strides as they move toward free market systems. When emerging countries become developed economically, their citizens demand higher standards of living. As a result, their requirements for electricity, water, and telephones should rise dramatically. Also many countries are selling their utility companies to public owners, opening a new arena for investors." - The Hundred Best Annuities You Can Buy by Gordon K. Williamson

"The net result of all of this for investors is that variable annuities are beginning to offer global utilities subaccounts. Increased diversification (allowing a subaccount to invest in utility companies all over the world instead of just in the United States), coupled with tremendous long-term growth potential, should make this a dynamic industry group for the next few decades."

As the table below shows, the variable annuity sub-accounts outperformed their mutual fund counterparts for 1990 and 1987.

Average Annual Returns: Utility

Annuity Sub-Accounts versus Mutual Funds

Year	Sub-Account	Mutual Fund
1994	-9.9%	-8.3%
1993	9.4%	14.7%
1992	7.2%	9.4%
1991	15.9%	20.2%
1990	4.0%	-2.4%
1989	8.5%	29.5%
1988	6.7%	13.3%
1987	6.0%	-4.2%
3-year average	2.5%	5.2%
5-year average	4.7%	6.8%
10-year average	n/a	11.0%

In Summary

• An investor needs to understand the relationship between the separate account and the sub-account. A separate account is a master investment account that acts as a channel to the established accounts. All funds invested flow through the separate account's channel into various sub-accounts.
• Sub-account diversification is essential for competitive and consistent long term asset growth.
• Variable annuity sub-accounts are mutual funds within an insurance contract and are chosen as investment vehicles for the same reasons mutual funds are chosen.
• Accumulation units are to variable annuities as fund shares are to mutual funds. Accumulation units are purchased by the investor at net asset value (NAV), without commissions, in full and fractional units.
• The breakdown used to narrow down the universe of sub-accounts should be based on performance, risk control, expense minimization, investment options, family rating and management.
• A "family" is the number of choices offered to the investor. This family could be quite small, but still get the highest rating if most or all of the sub-accounts performed excellently when viewed on a risk-adjusted return basis.
• Aggressive Growth Sub-Accounts focus strictly on appreciation, with no concern about generating income and strive for maximum capital growth.
• Growth & Income Sub-Account's objective is to provide investors with a competitive, long term total return by investing in a portfolio that combines both growth stock (equities) and bonds (fixed income).
• International stocks invest in securities of foreign companies. They do not invest in U.S. stock at all. Global sub-accounts invest in both foreign and U.S. stocks.
• The Balanced sub-accounts mix investments in common stocks, bonds and convertible securities to decrease volatility and stabilize market swings.
• Global sub-accounts invest in securities all over the world. This includes which includes the United State's fixed-income securities, whereas international sub-accounts invest in foreign fixed-income securities.