The fact that retail funds may be sold in variable annuity sub-accounts in the form of funds of funds, has prompted some insurers to seek to include retail funds in other annuities.

In 1981, the IRS prohibited the use of retail mutual funds in annuities. But an IRS private letter ruling on Sept. 22, 1998 allowed an annuity provider to create a sub-account in a fund-of-funds format, said Joseph McKeever and John Adney of Davis & Harman, a Washington, D.C. law firm.

The private letter ruling did not name the party that requested it and attempts to find out which firm or individual filed it were not successful.

There are likely to be more annuity providers trying the fund-of-funds approach, McKeever said.

"The only way we'll know if we've broken it [the prohibition] is when someone goes too far," he said.

The industry would also like to see individual retail mutual funds become available for use in annuities that are tailored to the 403(b) and 408(b) qualified markets, Adney said. Several insurance companies are seeking changes in the 1981 prohibition which would allow such use of retail funds, said Adney. He did not name any of the companies involved. Industry groups are not involved in the effort, he said.

Since 403(b)s are the 401(k) equivalent for tax-exempt organizations (usually for school teachers and state employees), and 408(b)s are annuity-based IRAs and 401(k)s and IRAs can invest in retail mutual funds, 403(b)s and 408(b)s should be able to do so as well, Adney said.

The IRS is expected to issue a response to requests for the changes later this year, Adney said.

Since variable annuity sub-accounts are very similar to their retail fund counterparts, the prohibition against the use of retail funds in sub-accounts is unfounded, some people in the industry argue.

"There is little or no practical difference in the annuity sub-accounts and retail mutual funds," said Shane Chalke, president of Annuity.Net of Leesburg, Va., a website that sells annuities online.

The IRS has allowed the fund-of-funds approach as long as customers do not choose which funds are in the fund-of-funds format, said Steve Roth, an attorney at Sutherland, Asbill & Brennan of Washington, D.C.

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