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How to Allocate Funds Inside a Variable Annuity

Variable annuities combine some of the key features of mutual funds with those of deferred annuities to produce a unique investment vehicle that is ideal for long term retirement planning. Like mutual funds, variable annuities include a family of funds, called separate managed accounts that invest in various portfolios of stocks, bonds, real estate, and fixed yield investments affording investors the opportunity to achieve market-based returns. The primary difference is that the earnings from variable annuity managed accounts are allowed to accumulate tax deferred. Optimizing both the returns and the tax advantages of variable annuities requires a sound asset allocation strategy tailored for each investor.

Variable Annuity Investment Characteristics

A variable annuity is a form of a deferred annuity in which investors are allowed to choose from among a family of professionally managed accounts to invest their funds. Typically, the family of accounts is comprised of a variety of stock and bond accounts with varying investment objectives. For instance, the stock accounts might include a growth stock account, an aggressive growth account, and an international stock account.

The bond accounts might include a corporate bond account, a high yield bond account and a government bond account. You might also find a balanced account that combines stock and bond investments, and accounts that invest in real estate investment trusts are also common. Finally, the family might have a cash account or a fixed yield investment.

Each of these accounts fall within a specific part of the risk/reward spectrum, with some offering potentially high returns with a commensurate level of risk. On the other end are accounts that focus on minimizing risk with lower or more stable returns. As with type of investing, no one single account is going to meet the overall investment objectives of an investor, nor will it likely satisfy his or her risk requirements. Therefore, the best investment approach is to allocate investment funds among several different asset classes, and diversify within those classes in order to create a more stable portfolio with the potential for consistent long term returns.

What is Asset Allocation?

Asset allocation is an investment strategy that considers a combination of asset classes for investors’ portfolios that best match their objectives, preferences and risk tolerance. Since asset classes tend to perform differently, within their own investment cycles, owning several asset classes will have the effect of stabilizing the overall portfolio. For example, when stock prices increase, bond prices tend to decline. Because no one can accurately project the movements of either, the best strategy is to allocate a portion of funds to each.

The more a portfolio consists of assets that don’t necessarily correlate with one another, (in other words, the price movements of one are independent of another), the less volatile the overall portfolio will be. For example, real estate is an asset that doesn’t necessarily correlate with stocks. The prices of real estate tend to move independent of other markets.

Modifying Risk

Additionally, each asset class has a corresponding amount of risk, whether it’s market risk, inflation risk, taxation risk, interest rate risk or liquidity risk. An effective allocation strategy accounts for all forms of risk by using one type of asset to offset the risk associated with another. For instance, an investment in fixed annuities is vulnerable to the long term effects of inflation. By combining that investment with an investment in a precious metals fund or a real estate fund, the potential risk of inflation is countered. Conversely, the fixed yield account can have a modifying effect on any volatility associated with the other funds.

Creating an Individual Asset Allocation Strategy

Using a combination of asset classes, investors can create a total investment portfolio that more closely matches their specific objective, priorities, preferences and risk tolerance. The asset mix of any one investor is going to be different than the next, so there is no one perfect portfolio allocation. Rather, investors need to consider their own allocation in light of their individual financial circumstances:

Goals and Priorities

: Without a clear target, it is difficult to know where to aim. And, because most investors have a limited amount of funds to invest, priorities must be set.

Risk Tolerance

: It’s important to understand your ability to withstand market fluctuations. More importantly, all types of risks need to be considered.

Investment Preferences

: Some investors have an aversion or a preference towards certain types of investments. For instance, some will only invest in the stock socially responsible companies.

Time Frame

: Understanding your investment time frame is important for determining the proper balance of conservative and more growth oriented investments. That balance will change over time as your time frame shortens.

Asset Allocation in Motion

Once you have determined the best allocation for your portfolio, it is vitally important to review it regularly. Your financial circumstances, including your outlook and risk tolerance will evolve over time, and you can count on the fact that the financial markets and the economy will change as well.

A big mistake investors make is to let the gains in any one asset class to run, which will throw their allocation out of balance. For instance, they may have allocated just 40% of their funds to stock accounts. Yet, after a long stock market rally, the gains achieved push that allocation up to 60% of their portfolio. Their portfolio is now exposed to more market risk than, perhaps, they were willing to assume initially.

An asset allocation strategy is definitely not a set-it-and-forget-it strategy. It is important to make sure your portfolio is correctly balanced and properly diversified to match your current financial profile. With variable annuity investors are allowed to transfer funds between accounts as many as four to six times a year, which is plenty to make any necessary adjustments.