Perhaps the most significant challenge facing established retail bank brokerage operations is how to broaden the relationships and revenue stream from a finite deposit base.

One response is to reduce dependence on transaction-based commissions and move toward more asset-based investment products. To this end, trail payments on mutual funds and even wrap account fee structures are getting increased interest in the bank environment. (The latter is slightly ironic, since the great-grandparent of all wrap accounts is the bank trust department relationship.)

Another approach, however, is for the brokerage group to bring its existing mutual fund investor base slightly further up the sophistication ladder through variable annuities.

Our research shows that mutual funds account for approximately 32% of bank brokerage sales activity industrywide, while annuities (both fixed and variable) represent around 7%. The annuity sales component further divides into roughly two-thirds fixed annuities and one-third variable annuities.

This 2-to-1 mix of fixed to variable annuities sales is similar to the profile in many of the more traditional life insurance sales forces. However, other distribution channels have a radically different mix to their annuity activity. independent representative financial planning firms, for example, often have variable annuity sales levels that outweigh fixed annuities sales.

A Growth Spurt

Variable annuities are in a phase of tremendous growth and change, much like mutual funds in the early 1980s. Currently, there are some $90 billion in variable annuities, and we expect this number to double in the next few years.

Variable annuities are attractive to a bank brokerage group not only for their commission potential, but because they provide an opportunity for an additional product relationship with existing fund investors.

Attractive Features

From a bank investor's perspective, a variable annuity is attractive for the following reasons:

* Variable annuities provide the potential for tax-deferred asset growth unavailable in retail mutual funds.

* Variable annuities have increasingly diverse money management alternatives, with relatively flexible tax-free switching capabilities.

* Asset management fees in variable annuities subaccounts are slightly lower than similar portfolios of mutual funds. (Realistically, this lower asset charge is more than offset by higher contract-level charges that provide the insurance component of a variable annuity.)

* Most variable annuities carry no front-end load or commission charge to the customer.

Profit Potential

From the bank registered representative's perspective, the product is attractive for these reasons:

* The potential payout is significant. Gross commissions on variable annuities average over 5%, while mutual funds average 4% or less.

* The product lends itself to asset retention. As retirement planning vehicles, these are inherently long-term investments.

* Once an initial investment is made, subsequent additions are likely.

* Compensation structures are attractive. Registered representatives often receive a combination of an up-front payout and a trail on assets. These trails can create substantial long-term revenue for a high-producing sales rep.

* Selling variable annuities is as much an educational process as a sales process.

Once a client understands the product, the sale is often a matter of suitability. This is a strong fit with the traditional bank/client relationship.

No two bank brokerages are alike. but there are a few common characteristics in those successfully selling variable annuities. Virtually all are full service, not discount brokerages. The representatives actively pursue relationship selling, often acting as a financial planner to their clients. Their focus is similar to low-end trust services: capital preservation, retirement planning, college planning, rudimentary real estate planning.

In many ways, this is the easiest environment in which to convince a client of the value of paying a commission. It is precisely this relationship that has resulted in the impressive sales of load mutual funds through banks.

We have observed a pattern in more aggressive bank brokerage operations. Initially, fixed annuities predominate, gradually giving way to a more even balance, and finally shifting to favor the variable version. Boatmen's Bancshares in St. Louis is a classic example of this evolution, which is perhaps one reason for Boatmen's Investment Services' having an average annual commission revenue per registered representative of nearly double the industry average.

With intense press attention and increased coverage from data houses such as Morningstar and VARDS, customers are becoming more sophisticated. Our work with bank customers, as well as bank brokers, suggests that the following product features are crucial for a competitive variable annuity offering:

* Manager Recognition. The investment manager is often the primary indicator of quality in variable annuities. Name recognition has allowed companies such as Putnam to expand rapidly, and leverage off the awareness of well-known mutual funds.

* Stepped-Up Death Benefits. Varying levels of guaranteed death benefit exists in the market. Cutting-edge products that offer some form of market-based fallback are achieving good results. Variations available in some products include guaranteed market percentages, or index-tied minimum increases. The estate planning feature seems particularly appropriate in bank sales.

* Fixed Account Guarantees. In the last 18 months, this provision has become an important sales point. With money market rates at or below 3%, and the S&P always volatile, investors view these guaranteed rates of 3% to 4% for the life of the contract as more attractive.

Fleet Financial's joint venture with American Skandia Life Assurance Co. established it as the first bank to offer a proprietary variable annuity. The Galaxy variable annuity uses four no-load portfolios mirroring their Galaxy mutual funds.

Beyond the novelty of being bank sold, the structure of the annuity bears mention. The mortality and expense charges (which cover the cost of the insurance rather than the investment components of the product) are only .55%.

This is less than half the typical M&E" charge. However, this savings is offset mostly by the relatively high investment management fees charged by Fleet (greater than 100 bps on average). At this level of M&E expenses, Skandia is obviously taking a long-term position in the profitability of its participation in the venture.

The most noteworthy feature of the Fleet annuity is that it has no surrender charges. Most variable annuities contracts have no front-end loads. but rather substantial surrender charges on amounts withdrawn. Starting as high as 8% in the first year, these charges often decrease over time and eventually disappear after the eighth year or so. Also, many variable annuities allow for some modest amount, say 10%, to be withdrawn without incurring the surrender charge. Fleet's Galaxy has none of these surrender tolls, allowing the investor to "try on" the product and transfer out early if dissatisfied.

While Fleet does not yet disclose sales levels. and the product is too new to appear in the traditional tracking sources, industry estimates are that approximately $20 million had been raised as of the end of May. The initial roll-out to a partial distribution channel makes it much too early to assess market response, but it is reasonable to expect that the full ongoing introduction to Fleet's retail customer base will increase substantially the asset base of this variable annuity.

Staying Tuned

The entrance of banks into variable annuities is a development worth watching. Great Western recently announced that it will follow Fleet's lead, and is rolling out a proprietary variable annuity in conjunction with American General Life of Houston. Like Fleet, it hopes to leverage off the success of its proprietary mutual fund group, Sierra Trust. Signet Bank and First of America Bank have also announced plans to roll out a proprietary product, although little additional detail has emerged.

In our opinion, efforts to increase the profitability and diversity of a bank brokerage operation without careful consideration of a variable annuity program would be woefully deficient.

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