AAL VARIABLE PRODUCT SERIES FUND, INC.
March 1, 1998
AAL Variable Universal Life--Insuring and Investing for Your Future
The AAL Variable Product Series Fund, Inc. (the Fund) is an open-end
diversified investment company, commonly called a mutual fund. The Fund is made
up of seven separate Portfolios, each with its own specific investment
objective. Shares of the Fund are sold only to two separate accounts. The
separate accounts (the AAL Variable Annuity Account I and the AAL Variable Life
Account I) fund variable annuity and variable life insurance certificates (the
Certificates) offered by Aid Association for Lutherans (AAL). AAL also serves as
the Investment Adviser to the Fund. AAL will use its professional experience to
help the Portfolios to meet their individual objectives however, no assurance
can be made that these objectives will be met. This Fund Prospectus describes
the following Portfolios:
The AAL Variable Product Money Market Portfolio seeks to provide maximum
current income to the extent consistent with liquidity and a stable net asset
value of $1.00 per share by investing in a diversified portfolio of
high-quality, short-term money market instruments. An investment is neither
insured nor guaranteed by the U.S. government. There can be no assurance that
the Portfolio will be able to maintain a stable net asset value of $1.00 per
share.
The AAL Variable Product Bond Portfolio seeks to achieve investment
results that approximate the total return of the Lehman Brothers Aggregate Bond
Index by investing primarily in bonds and other debt securities included in the
index.
The AAL Variable Product Balanced Portfolio seeks to achieve investment
results that reflect investment in common stocks, bonds and money market
instruments, each of which will be selected consistent with the investment
policies of the AAL Variable Product Large Company Stock, Bond, and Money Market
Portfolios, respectively.
The AAL Variable Product Large Company Stock Portfolio seeks to achieve
investment results that approximate the performance of the Standard & Poor's 500
Composite Stock Price Index by investing primarily in common stocks included in
the index.
The AAL Variable Product Small Company Stock Portfolio seeks to achieve
investment results that approximate the performance of the Standard &Poor's
SmallCap 600 Index by investing primarily in common stocks included in the
index.
The AAL Variable Product International Stock Portfolio seeks to achieve
long-term capital growth by investing primarily in a diversified portfolio of
foreign stocks.
The AAL Variable Product High Yield Bond Portfolio seeks to achieve high
current income and secondarily capital growth by investing primarily in a
diversified portfolio of high risk, high yield bonds commonly referred to as
"junk bonds." The Portfolio actively seeks to achieve a secondary objective of
capital growth to the extent it is consistent with the primary objective of high
current income.
This Fund Prospectus provides information that buyers of the Certificates
ought to know before investing. Read this Fund Prospectus carefully along with
the accompanying Account Prospectus and keep them for future reference. The Fund
has filed a Statement of Additional Information, dated March 1, 1998 , with the
Securities and Exchange Commission. The information contained in the Statement
of Additional Information is incorporated by reference into this Prospectus. You
may obtain a copy of the Statement of Additional Information and/or the Annual
Report without charge by writing the Fund at the AAL Variable Products Service
Center, 4321 North Ballard Road, Appleton, Wisconsin, 54919-0001 or calling
800-225-5225 or 734-5721 locally. The Telecommunications Device for the Deaf
(TDD) number is 800-735-9644.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE COMMISSION HAVE
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO
THE CONTRARY IS A CRIMINAL OFFENSE.
<PAGE>
TABLE OF CONTENTS
Prospectus Summary
Organization of the Fund
The Fund and the Certificates
Reading the Prospectus
The Portfolios
Money Market Portfolio
Bond Portfolio
Balanced Portfolio
Large Company Stock Portfolio
Small Company Stock Portfolio
International Stock Portfolio
High Yield Bond Portfolio
Other Investment and Risk Factors Regarding the Portfolios
Investment Restrictions
Performance Information
Management of the Fund
Purchase and Redemption of Shares
Net Asset Value
Dividends, Distributions and Taxes
Additional Information
Fund Organization and Description of Shares
Voting Privileges
Indemnity and Limitation of Liability of Directors and Officers
Custodian, Transfer Agent and Independent Auditors
Shareholder Inquiries
Appendix: Security Ratings
Ratings in General
Corporate Bond Ratings
Commercial Paper Ratings
<PAGE>
PROSPECTUS SUMMARY
Organization of the Fund
The AAL Variable Product Series Fund, Inc. (the Fund) is registered with
the SEC as an open-end diversified management investment company. The Fund
currently consists of seven Portfolios, each of which represents a separate
series of shares of beneficial interest in the Fund. The Fund serves as a
funding vehicle for the AAL Variable Annuity Certificates and AAL Variable Life
Insurance Certificates (the Certificates). We issue the Certificates through one
of two separate accounts: AAL Variable Annuity Account I and AAL Variable Life
Account I (the Variable Accounts). The rights of the Variable Accounts as
shareholders of the Fund are distinguished from your rights as the Certificate
Owners; however certain voting privileges are passed down to you. See Voting
Privileges in this Fund Prospectus and the accompanying Account Prospectus for
more information concerning your rights as a Certificate Owner.
We include the Fund's financial statements and performance results in
the Statement of Additional Information for the AAL Variable Annuity. You can
obtain a Statement of Additional Information free of charge by calling
800-225-5225 or completing the order form at the end of the Account Prospectus.
We also give you performance information in this Prospectus for the Standard
&Poor's 500(R) Index, the Standard &Poor's SmallCap 600 Index and the Lehman
Brothers Aggregate Bond Index. Certain of the Portfolios seek to achieve
investment results that approximate the performance of these indexes. See
Performance Information for more information
The Fund and the Certificates
The Fund is the investment vehicle used by two separate accounts: the
AAL Variable Annuity Account I and the AAL Variable Life Account I. We
established both Variable Accounts under the laws of the State of Wisconsin. We
also registered them as unit investment trusts with the Securities and Exchange
Commission (the SEC) under the Investment Company Act of 1940 (the 1940 Act).
Each Variable Account meets the definition of a separate account under the
Federal securities laws. The SEC does not supervise the management or investment
practices or policies of the Variable Accounts.
The purpose of the Accounts is to fund either Annuity or Life Insurance
Certificates. Each Variable Account is divided into Subaccounts. A Premium
payment flows through the Certificate to either a Variable Account or a Fixed
Account according to your instructions. From the Variable Account, the premiums
flow to the Subaccounts in the amounts or percentages you allocate. In turn, the
Subaccounts invest in shares of one of the corresponding Portfolios of the Fund.
The Portfolios and their investment objectives are described below. We make no
assurance that the Portfolios will meet their investment objectives. You bear
all the investment risk for the performance of the Portfolios and their
corresponding Subaccount. The share price will vary with the performance of the
Portfolios.
Reading the Prospectus
References to "you" and "your" in this Fund Prospectus refer to you as
an indirect owner of the Fund through your ownership of either the AAL Variable
Annuity or the AAL Variable Life Insurance Certificates. References to "we,"
"us," or "our" refer to Aid Association for Lutherans, also known as AAL. We are
the Adviser of the Fund, the Transfer Agent for the Fund shares and the issuer
of the Certificates.
The Portfolios
In the Prospectus, we provide you with information on: the investment
objectives, policies and risks of investing in the Portfolios. We also include
the description of the management of the Fund and other services provided to the
Fund. In addition to each separate Portfolio description, we give more detailed
information on the risks of investing under Additional Investment Risks.
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Primary Primary Primary
Objective Investments Risks
AAL Variable Product Money Current Income Money Market Instruments Interest Rate and Credit
Market Portfolio
AAL Variable Product Bond Current Income with Total Investment Grade Bonds Interest Rate and Credit
Portfolio Return approximating the
Lehman Brothers Index
AAL Variable Product Balanced Income and Long-Term Large Company Stocks and Financial, Market, Interest
Portfolio Capital Growth Investment Grade Bonds Rate and Credit
AAL Variable Product Large Long-Term Capital Growth Large Company Stocks Financial and Market
Company Stock Portfolio with Total Return
approximating the S&P 500 (R)
Index
AAL Variable Product Small Long-Term Capital Growth Small Company Stocks Financial and Market
Company Stock Portfolio with Total Return
approximating the S&P
SmallCap 600 Index
AAL Variable Product Long-Term Capital Growth Foreign Stocks Financial, Market and
International Stock Portfolio Foreign Investment
AAL Variable Product High High Level of Current Below Investment Grade Bonds Interest Rate, Credit and
Yield Bond Portfolio Income and Capital Growth Market
</TABLE>
THE AAL VARIABLE PRODUCT MONEY MARKET PORTFOLIO
Investment Objective
The Money Market Portfolio seeks to provide maximum current income, to
the extent consistent with liquidity and a stable net asset value of $1.00 per
share, by investing in a diversified portfolio of high-quality, short-term money
market instruments.
Investment Policies
We invest in short-term money market instruments for the Portfolio, such as:
1. obligations issued or guaranteed by the U.S. government, its agencies or
instrumentalities, or shares of money market mutual funds that limit their
investments to the foregoing securities;
2. certificates of deposit, bankers acceptances and similar obligations of
U.S. banks, savings associations, foreign branches of U.S. banks, and
domestic branches of foreign banks. Issuing banks must have total assets at
the time of purchase in excess of $1 billion, and must be members of the
Federal Deposit Insurance Corporation;
3. commercial paper that at the time of purchase is defined as First Tier or
Second Tier by the Investment Company Act of 1940, as long as we do not
invest more than 5% of the Portfolio's total assets in Second Tier
commercial paper;
4. corporate obligations, including variable rate master notes, which at the
date of investment are rated in one of the two highest categories by a
nationally recognized statistical rating organization, or, if unrated,
issued by a corporation with outstanding short-term debt that has an
equivalent or better rating at the time of investment.
We invest in securities maturing in 397 days or less and the Portfolio
maintains a dollar-weighted average portfolio maturity of not more than 90 days.
By limiting the maturity of the Portfolio's investment, we seek to lessen the
changes in asset values caused by fluctuations in short-term interest rates. To
the extent it is practical, we try to maintain a constant net asset value per
share of $1.00 for the Portfolio.
Do not consider the Portfolio as a deposit or other obligation of any
bank, credit union or any affiliated entity. The Federal Deposit Insurance
Corporation (FDIC) nor any other government agency insures nor protects your
investment. You bear all of the investment risk including the loss of principal.
Investment Risks
Interest Rate Risk
Changes in interest rate levels affect the yield of the money market
instruments in the Portfolio.
Credit Risk
The creditworthiness of the issuers of certain securities may decline
during the Portfolio's holding period.
Portfolio Manager
Alan D. Onstad, CFA, has managed the Money Market Portfolio since its
inception on June 14, 1995. Mr. Onstad is Assistant Vice President of Securities
and has been employed by us since 1973.
Annual Advisory Fee
We receive an investment advisory fee as compensation for its services
to the Fund. The fee is a daily charge equal to an annual rate of 0.35% of the
average daily net assets of each Portfolio up to $250,000,000 and 0.30% of the
average daily net assets of each Portfolio in excess of that amount.
Financial Highlights
The following Financial Highlights table covers the Money Market Portfolio
for the periods shown. This information was audited by Ernst & Young LLP, the
Fund's independent auditors. You should read the Financial Highlights together
with the Fund's audited financial statements and notes which, together with the
auditor's report thereon, are included in the December 31, 1997 Annual Report of
the AAL Variable Product Series Fund, Inc. You can obtain the Annual Report free
of charge. While this performance information should help you evaluate a
Portfolio and its investment objectives, past performance does not guarantee
future results of the Portfolios.
<TABLE>
Money Market
Portfolio Highlights
--------------------------------------------------
Period Ended Year Ended Year Ended
December 31, December 31, December 31,
1995 (1) 1996 1997
<CAPTION>
<S> <C> <C> <C>
Net asset value: beginning of period $1.00 $1.00 $1.00
Income from Investment Operations:
Net investment income 0.03 0.05 0.05
Net realized and unrealized gains (losses)
on investments - - -
Total from Investment Operations 0.03 0.05 0.05
Less Distributions:
From investment income (0.03) (0.05) (0.05)
From realized gains - - -
Total Distributions (0.03) (0.05) (0.05)
Net increase (decrease) in net asset value - - -
Net asset value: end of period $1.00 $1.00 $1.00
Total return (a) 3.02% 5.23% 5.33%
Net assets, end of period (in thousands) $7,045 $17,125 $25,460
Ratios and Supplemental Data:
Ratio of expenses to average net assets (b) 0.35% 0.35% 0.35%
Ratio of net investment income to average
net assets (b) (c) 5.71% 5.10% 5.24%
Portfolio turnover rate N/A N/A N/A
Average commission rate paid (d) N/A N/A N/A
(1) From commencement of operations on June 14, 1995.
(a) Total return does not reflect expenses that
apply at the Variable Account level. Inclusion of
these expenses would reduce the total return for
the periods shown.
(b) Calculated on an annualized basis.
(c) Without reimbursements the above ratios, on an
annualized basis, would have been:
Ratio of expenses to average net assets 1.40% 0.65% 0.46%
Ratio of net investment income to average
net assets 4.66% 4.80% 5.13%
(d) Amount shown reflects the average brokerage
commission paid on each share of stock traded by
the Portfolio during the period presented.
</TABLE>
THE AAL VARIABLE PRODUCT BOND PORTFOLIO
Objective
The Bond Portfolio seeks to achieve investment results that approximate
the total return of the Lehman Brothers Aggregate Bond Index (the Lehman Bond
Index) by investing primarily in bonds and other debt securities included in the
index.
Lehman Brothers reserves the right to make changes to the Lehman Bond
Index at any time, and eligible investments for the Bond Portfolio will include
any additional asset classes included in the Lehman Bond Index.
Policies
We invest only in a representative sample of fixed income and
mortgage-backed securities included in the Lehman Bond Index. We cannot invest
in all of the issues that make up the Lehman Bond Index because of the
prohibitive cost to acquire and maintain such a large number of issues. We
invest 80% or more of the Bond Portfolio's assets in securities that are
included in the Lehman Bond Index. Each security included must meet the
following criteria:
- have a maturity of no less than one year;
- have at least $100 million par amount outstanding;
- be rated as investment-grade quality;
- be fixed rate;
- be dollar-denominated and nonconvertible; and
- be publicly issued, no private placements.
We divide the Bond Portfolio into four classes of investment grade
fixed-income securities. As of December 31, 1997, these four classes represented
the following proportions of the Portfolio's total market value:
Percent of Total
U.S. Treasury & Government Agency 50.3%
Corporate 20.1
Mortgage-Backed 28.6
Asset-Backed 1.0
Total 100%
We may purchase mortgage-backed securities issued by the Government
National Mortgage Association (GNMA), the Federal Home Loan Mortgage
Corporation, the Federal National Mortgage Association, and the Federal Housing
Authority. GNMA securities are guaranteed by the U.S. government as to the
timely payment of principal and interest; securities from other
government-sponsored entities are generally not secured by an explicit pledge of
the U.S. government. We may also invest in conventional mortgage-backed
securities, which are packaged by private corporations and are not guaranteed by
the U.S. government. We will invest in the securities of a particular agency
only when the Portfolio Manager is satisfied that the credit risk is minimal.
Mortgage-backed securities that are guaranteed by the U.S. government are
guaranteed only as to the timely payment of principal and interest. The market
value of such securities is not guaranteed and may fluctuate.
We make every effort to ensure that the Portfolio will remain fully
invested. Our ability to match the performance of the Lehman Bond Index will be
affected to some extent by the size and timing of cash flows into and out of the
Portfolio. We will manage the Portfolio to reduce such effects. Portfolio
turnover is expected to be less than 50% per year. Although the Portfolio will
attempt to achieve a high correlation with the target Lehman Bond Index, it
cannot guarantee that such results will be achieved. Other factors that will
affect the Portfolio's ability to approximate the target index return are: the
size of the bid-ask spread associated with Portfolio investments and Portfolio
management expenses incurred. A portion of the assets, normally expected to be
less than 5% of the Portfolio's assets, may at times be invested in money market
investments. No securities, other than futures contracts, will be purchased on
margin.
Investment Risks
Interest Rate Risk
The direction of changes in interest rate levels generally have an
opposite directional affect on the value of the bonds in the Portfolio.
Credit Risk
There is a risk that the creditworthiness of an issuer of securities held
by the Portfolio could deteriorate as a result of developments unique to the
issuer, or which affect the issuer's industry or the economy generally. Such a
deterioration in creditworthiness indicates a higher risk of a default by the
issuer on interest and principal payments on its securities, and/or a higher
risk of bankruptcy. These increased risks likely would cause the value of the
issuer's securities to decline, which would cause a corresponding decline in the
net asset value of the Portfolio.
Portfolio Manager
R. Jerry Scheel has managed the Bond Portfolio since its inception on
June 14, 1995. Mr. Scheel is Second Vice President of Securities and has been
employed by us since 1972.
Annual Advisory Fee
We receive an investment advisory fee as compensation for providing
services to the Fund. The fee is a daily charge equal to an annual rate of 0.35%
of the average daily net assets of the Portfolio up to $250,000,000 and 0.30% of
the average daily net assets of the Portfolio in excess of that amount.
Financial Highlights
The following Financial Highlights table covers the Bond Portfolio for the
periods shown. This information was audited by Ernst & Young LLP, the Fund's
independent auditors. You should read the Financial Highlights together with the
Fund's audited financial statements and notes which, together with the auditor's
report thereon, are included in the December 31, 1997 Annual Report of the AAL
Variable Product Series Fund, Inc. You can obtain the Annual Report free of
charge. While this performance information should help you evaluate a Portfolio
and its investment objectives, past performance does not guarantee future
results of the Portfolios.
<TABLE>
Bond Portfolio Highlights
---------------------------------------------------
Period Ended Year Ended Year Ended
December 31, December 31, December 31,
1995 (1) 1996 1997
<CAPTION>
<S> <C> <C> <C>
Net asset value: beginning of period $10.00 $10.23 $9.90
Income from Investment Operations:
Net investment income 0.34 0.63 0.64
Net realized and unrealized gains (losses)
on investments 0.23 (0.33) 0.25
Total from Investment Operations 0.57 0.30 0.89
Less Distributions:
From investment income (0.34) (0.63) (0.64)
From realized gains - - -
Total Distributions (0.34) (0.63) (0.64)
Net increase (decrease) in net asset value 0.23 (0.33) 0.25
Net asset value: end of period $10.23 $9.90 $10.15
Total return (a) 5.80% 3.10% 9.37%
Net assets, end of period (in thousands) $9,363 $17,666 $26,710
Ratios and Supplemental Data:
Ratio of expenses to average net assets (b) 0.35% 0.35% 0.35%
Ratio of net investment income to average net
assets (b) (c) 6.54% 6.51% 6.55%
Portfolio turnover rate 6.51% 11.65% 18.41%
Average commission rate paid (d) N/A N/A N/A
(1) From commencement of operations on June 14, 1995.
(a) Total return does not reflect expenses that
apply at the Variable Account level. Inclusion of
these expenses would reduce the total return for the
periods shown. (b) Calculated on an annualized basis.
(c) Without reimbursements the above ratios, on an
annualized basis, would have been:
Ratio of expenses to average net assets 1.25% 0.68% 0.52%
Ratio of net investment income to average
net assets 5.64% 6.18% 6.38%
(d) Amount shown reflects the average brokerage commission
paid on each share of stock traded by the Portfolio during
the period presented.
</TABLE>
THE AAL VARIABLE PRODUCT BALANCED PORTFOLIO
Objective
The Balanced Portfolio seeks to achieve investment results that reflect
investment in common stocks, bonds and money market instruments, each of which
will be selected consistent with the investment policies of the Large Company
Stock, Bond, and Money Market Portfolios, respectively.
Policies
We invest in the following three asset classes within the ranges given
for the Portfolio:
minimum maximum
- common stocks 35% 75%
- debt securities 25 50
- money market instruments 0 40
We select common stocks from the same pool of stocks that make up the
Large Company Stock Portfolio. The weighting of those stocks will be
proportionate to the weightings in the Large Company Stock Portfolio. For debt
securities, we will generally select securities from the same pool of securities
that make up the Bond Portfolio. At times, however, a debt security may be
selected that is not in the Bond Portfolio but will be selected in accordance
with that Portfolio's objectives. In similar fashion, we will select money
market instruments in keeping with the Money Market Portfolio, however, the
Balanced Portfolio will not always hold the same issues as the Money Market
Portfolio.
We periodically review and adjust the mix of investments among the three
security classes. In doing this, we strive to take advantage of changing
financial markets and economic conditions that could result in increased
returns. We strive to keep the annual turnover rate at below 50%. As of December
31, 1997, we weighted the investments in the classes as follows:
percent weighted
- common stocks 55%
- debt securities 35
- money market instruments 10
===
total 100%
Investment Risks
Financial Risk
There is the possibility that an individual company may not perform
well, and as a result, the value of that company's security may decline.
Market Risk
Over time, the stock market tends to move in cycles, with periods when
stock prices rise generally and periods when stock prices decline generally. The
value of the Portfolio's investments may increase and decrease more than the
stock market in general, as measured by the S&P 500(R). We do not employ any
temporary or defensive measures in times of generally declining market
conditions. You could lose money investing in the Portfolio.
Interest Rate Risk
The direction of changes in interest rate levels generally have an
opposite directional affect on the value of the bonds in the Portfolio.
Credit Risk
The creditworthiness of the issuers of certain securities may decline
during the Portfolio's holding period.
Portfolio Manager
John A. Larson, CFA, has managed the Balanced Portfolio since its inception
on June 14, 1995. Mr. Larson is Director of Securities and has been employed by
us since 1971.
Annual Advisory Fee
We receive an investment advisory fee as compensation for providing
services to the Fund. The fee is a daily charge equal to an annual rate of 0.35%
of the average daily net assets of the Portfolio up to $250,000,000 and 0.30% of
the average daily net assets of the Portfolio in excess of that amount.
Financial Highlights
The following Financial Highlights table covers the Balanced Portfolio for
the periods shown. This information was audited by Ernst & Young LLP, the Fund's
independent auditors. You should read the Financial Highlights together with the
Fund's audited financial statements and notes which, together with the auditor's
report thereon, are included in the December 31, 1997 Annual Report of the AAL
Variable Product Series Fund, Inc. You can obtain the Annual Report free of
charge. While this performance information should help you evaluate a Portfolio
and its investment objectives, past performance does not guarantee future
results of the Portfolios.
<TABLE>
Balanced Portfolio Highlights
---------------------------------------------------
Period Ended Year Ended Year Ended
December 31, December 31, December 31,
1995 (1) 1996 1997
<CAPTION>
<S> <C> <C> <C>
Net asset value: beginning of period $10.00 $10.92 $11.96
Income from Investment Operations:
Net investment income 0.22 0.41 0.46
Net realized and unrealized gains (losses)
on investments 0.92 1.05 2.09
Total from Investment Operations 1.14 1.46 2.55
Less Distributions:
From investment income (0.21) (0.41) (0.46)
From realized gains (0.01) (0.01) -
Total Distributions (0.22) (0.42) (0.46)
Net increase (decrease) in net asset value 0.92 1.04 2.09
Net asset value: end of period $10.92 $11.96 $14.05
Total return (a) 11.46% 13.65% 21.71%
Net assets, end of period (in thousands) $28,759 $126,518 $306,501
Ratios and Supplemental Data:
Ratio of expenses to average net assets (b) 0.35% 0.35% 0.35%
Ratio of net investment income to average net
assets (b) (c) 4.07% 3.89% 3.62%
Portfolio turnover rate 2.29% 5.43% 6.86%
Average commission rate paid (d) $0.0400 $0.0400 $0.0400
(1) From commencement of operations on June 14, 1995.
(a) Total return does not reflect expenses that
apply at the Variable Account level. Inclusion of
these expenses would reduce the total return for the
periods shown.
(b) Calculated on an annualized basis.
(c) Without reimbursements the above ratios,
on an annualized basis, would have been:
Ratio of expenses to average net assets 1.15% 0.60% 0.43%
Ratio of net investment income to
average net assets 3.27% 3.65% 3.53%
(d) Amount shown reflects the average brokerage
commission paid on each share of stock traded by
the Portfolio during the period presented.
</TABLE>
THE AAL VARIABLE PRODUCT LARGE COMPANY STOCK PORTFOLIO
Objective
The Large Company Stock Portfolio seeks to achieve investment results
that approximate the performance of the Standard & Poor's 500 Composite Stock
Price Index (the S&P 500(R) Index) by investing primarily in common stocks
included in the index.
Policies
We select stocks with the help of computer models instead of using
traditional analysis to emulate the S&P 500(R) Index. The Large Company Stock
Portfolio will strive to hold all of the stocks included in the S&P 500(R) Index
from time to time. The Portfolio will hold each stock in proportion to its
weighting in the S&P 500(R) Index. When periodic changes are made to the Index,
we will attempt to make similar changes to our Portfolio as soon as is
practicable. We expect Portfolio turnover no more than 50% per year.
To the extent possible, we try to remain fully invested. Our ability to
match the performance of the S&P 500(R) Index will be affected to some extent by
the size and timing of cash flows into and out of the Portfolio. We will try to
manage the Portfolio to reduce such effects. Other factors that will affect the
Portfolio's ability to approximate the target index return are: commission
expenses, other transaction fees, the size of the bid-ask spread associated with
stocks that are traded in the over-the-counter market, and Portfolio management
expenses incurred. We may also invest to some degree in money market
instruments. We do not expect them to exceed 3% of the Portfolio's assets. We
may invest up to 20% of the Portfolio's net assets, valued at the time of
purchase, in securities of foreign issuers, including American Depositary
Receipts (ADRs). The Portfolio may also invest in Standard & Poor's Depositary
Receipts (SPDRs). These are interests in a closed-end fund which generally
correspond to the price and yield performance of the S&P 500(R). In addition, we
may write (sell) covered call options in order to provide additional revenue and
to reduce the effect of price fluctuations in the Portfolio's securities. As the
writer of a covered call option, we may forego, during the option's life, the
opportunity to profit from increases in the market value of the security
covering the call option above the sum of the premium and the exercise price of
the call option. No securities, other than futures contracts, will be purchased
on margin. Although we will attempt to achieve a high correlation with the
target S&P 500 Index, we cannot guarantee that a high correlation will be
achieved.
Investment Risks
Financial Risk
There is the possibility that an individual company may not perform
well, and as a result, the value of that company's security may decline.
Market Risk
Over time, the stock market tends to move in cycles, with periods when
stock prices rise generally and periods when stock prices decline generally. The
value of the Portfolio's investments may increase and decrease more than the
stock market in general, as measured by the S&P 500(R). You could lose money
investing in the Portfolio. We do not employ any temporary or defensive measures
in times of generally declining market conditions. As a result, you have a
greater risk of losing your money invested in this Portfolio.
Portfolio Manager
David J. Schnarsky, CFA, has managed the Large Company Stock Portfolio
since its inception on June 14, 1995. Mr. Schnarsky is Assistant Vice President
and has been employed by us since 1991.
Annual Advisory Fee
We receive an investment advisory fee as compensation for providing
services to the Fund. The fee is a daily charge equal to an annual rate of 0.35%
of the average daily net assets of the Portfolio up to $250,000,000 and 0.30% of
the average daily net assets of the Portfolio in excess of that amount.
Financial Highlights
The following Financial Highlights table covers the Large Company Portfolio
for the periods shown. This information was audited by Ernst & Young LLP, the
Fund's independent auditors. You should read the Financial Highlights together
with the Fund's audited financial statements and notes which, together with the
auditor's report thereon, are included in the December 31, 1997 Annual Report of
the AAL Variable Product Series Fund, Inc. You can obtain the Annual Report free
of charge. While this performance information should help you evaluate a
Portfolio and its investment objectives, past performance does not guarantee
future results of the Portfolios.
<TABLE>
Large Company
Stock Portfolio Highlights
--------------------------------------------------
Period Ended Year Ended Year Ended
December 31, December 31, December 31,
1995 (1) 1996 1997
<CAPTION>
<S> <C> <C> <C>
Net asset value: beginning of period $10.00 $11.51 $13.83
Income from Investment Operations:
Net investment income 0.11 0.23 0.23
Net realized and unrealized gains (losses)
on investments 1.52 2.34 4.25
Total from Investment Operations 1.63 2.57 4.48
Less Distributions:
From investment income (0.11) (0.23) (0.23)
From realized gains (0.01) (0.02) (0.02)
Total Distributions (0.12) (0.25) (0.25)
Net increase (decrease) in net asset value 1.51 2.32 4.23
Net asset value: end of period $11.51 $13.83 $18.06
Total return (a) 16.39% 22.47% 32.59%
Net assets, end of period (in thousands) $23,138 $120,089 $318,475
Ratios and Supplemental Data:
Ratio of expenses to average net assets (b) 0.35% 0.35% 0.35%
Ratio of net investment income to average net
assets (b) (c) 2.27% 1.97% 1.48%
Portfolio turnover rate 0.47% 1.77% 1.00%
Average commission rate paid (d) $0.0400 $0.0400 $0.0400
(1) From commencement of operations on June 14, 1995.
(a) Total return does not reflect expenses that
apply at the Variable Account level. Inclusion of
these expenses would reduce the total return for the
periods shown.
(b) Calculated on an annualized basis.
(c) Without reimbursements the above ratios, on an
annualized basis, would have been:
Ratio of expenses to average net assets 1.26% 0.63% 0.43%
Ratio of net investment income to average
net assets 1.37% 1.69% 1.39%
(d) Amount shown reflects the average brokerage
commission paid on each share of stock traded by the
Portfolio during the period presented.
</TABLE>
THE AAL VARIABLE PRODUCT SMALL COMPANY STOCK PORTFOLIO
Objective
The Small Company Stock Portfolio seeks to achieve investment results
that approximate the performance of the S&P SmallCap 600 Index by investing
primarily in common stocks included in the index.
Policies
We select stocks with the help of computer models instead of using
traditional analysis to emulate the S&P SmallCap 600 Index. The Small Company
Stock Portfolio will hold each stock in similar proportions as in the S&P
SmallCap 600 Index. The Portfolio will try to hold as many of the 600 issues in
the index as is practicable. When periodic changes are made to the Index, we
will attempt to make similar changes to our Portfolio as soon as is practicable.
We expect Portfolio turnover of no more than 50% per year, althogh the turnover
for 1998 may be greater because of the one-time change in holdings to reflect
the S&P SmallCap 600 Index.
To the extent possible, we try to remain fully invested. Our ability to
match the performance of the S&P SmallCap 600 Index will be affected to some
extent by the size and timing of cash flows into and out of the Portfolio. We
try to manage the Portfolio to reduce such effects. Other factors that affect
the Portfolio's ability to approximate the target index return are: commission
expenses, other transaction fees, the size of the bid-ask spread associated with
stocks that are traded in the over-the-counter market, and Portfolio management
expenses incurred. We may also invest to some degree in money market
instruments. We do not expect them to exceed 3% of the Portfolio's assets. We
may invest up to 20% of the Portfolio's net assets, valued at the time of
purchase, in securities of foreign issuers, including American Depositary
Receipts (ADRs). In addition, we may write (sell) covered call options in order
to provide additional revenue and to reduce the effect of price fluctuations in
the Portfolio's securities. As the writer of a covered call option, we may
forego, during the option's life, the opportunity to profit from increases in
the market value of the security covering the call option above the sum of the
premium and the exercise price of the call option. No securities, other than
futures contracts, will be purchased on margin. Although we attempt to achieve a
high correlation with the target S&P SmallCap 600 Index, we cannot guarantee
that a high correlation will be achieved.
Prior to March 1, 1998, the Portfolio's objective was to approximate the
performance of Wilshire Small Cap Index.
Investment Risks
Financial Risk
Small, less-established companies may have relatively lower revenues, limited
product lines, lack of management depth and a lower share of the market for
their products or services than larger companies. Stocks of these companies
present a greater risk of losing value than stocks of larger, more established
companies.
Market Risk
Over time, the stock market tends to move in cycles, with periods when stock
prices rise generally and periods when stock prices decline generally.
Historically, small capitalization stocks have experienced more price volatility
than mid-size and large capitalization stocks. Some of the reasons they have
greater volatility include:
less certain growth prospects of small firms;
lower degree of liquidity in the markets for such stocks; and
greater sensitivity of small companies to changing economic conditions.
As a result, the value of the Portfolio's investments tends to increase and
decrease substantially more than the stock market in general, as measured by the
S&P 500(R). We do not employ any temporary or defensive measures in times of
generally declining market conditions. As a result, you have a greater risk of
losing your money invested in this Portfolio.
Portfolio Manager
Brian J. Flanagan, CFA, has managed the Small Company Stock Portfolio
since March 1, 1997. Mr. Flanagan is Investment Manager and has been employed by
us since 1994. From 1992 to 1994 he was an investment assistant with Valley
Trust Company, Madison, Wisconsin and an investment analyst for Northwestern
National Insurance Group, Brookfield, Wisconsin.
Annual Advisory Fee
We receive an investment advisory fee as compensation for providing
services to the Fund. The fee is a daily charge equal to an annual rate of 0.35%
of the average daily net assets of the Portfolio up to $250,000,000 and 0.30% of
the average daily net assets of the Portfolio in excess of that amount.
Financial Highlights
The following Financial Highlights table covers the Small Company Portfolio
for the periods shown. This information was audited by Ernst & Young LLP, the
Fund's independent auditors. You should read the Financial Highlights together
with the Fund's audited financial statements and notes which, together with the
auditor's report thereon, are included in the December 31, 1997 Annual Report of
the AAL Variable Product Series Fund, Inc. You can obtain the Annual Report free
of charge. While this performance information should help you evaluate a
Portfolio and its investment objectives, past performance does not guarantee
future results of the Portfolios.
<TABLE>
Small Company
Stock Portfolio Highlights
--------------------------------------------------
Period Ended Year Ended Year Ended
December 31, December 31, December 31,
1995 (1) 1996 1997
<CAPTION>
<S> <C> <C> <C>
Net asset value: beginning of period $10.00 $10.99 $12.54
Income from Investment Operations:
Net investment income 0.08 0.12 0.11
Net realized and unrealized gains (losses)
on investments 0.99 1.86 3.05
Total from Investment Operations 1.07 1.98 3.16
Less Distributions:
From investment income (0.07) (0.12) (0.11)
From realized gains (0.01) (0.31) (0.71)
Total Distributions (0.08) (0.43) (0.82)
Net increase (decrease) in net asset value 0.99 1.55 2.34
Net asset value: end of period $10.99 $12.54 $14.88
Total return (a) 10.70% 18.19% 25.37%
Net assets, end of period (in thousands) $15,666 $70,209 $152,928
Ratios and Supplemental Data:
Ratio of expenses to average net assets (b) 0.35% 0.35% 0.35%
Ratio of net investment income to average
net assets (b) (c) 1.43% 1.14% 0.81%
Portfolio turnover rate 2.85% 20.14% 29.65%
Average commission rate paid (d) $0.0400 $0.0400 $0.0400
(1) From commencement of operations on June 14, 1995.
(a) Total return does not reflect expenses that
apply at the Variable Account level. Inclusion of
these expenses would reduce the total return for the
periods shown.
(b) Calculated on an annualized basis.
(c) Without reimbursements the above ratios, on an
annualized basis, would have been:
Ratio of expenses to average net assets 1.37% 0.75% 0.45%
Ratio of net investment income to average
net assets 0.41% 0.74% 0.71%
(d) Amount shown reflects the average brokerage
commission paid on each share of stock traded by
the Portfolio during the period presented.
</TABLE>
THE AAL VARIABLE PRODUCT INTERNATIONAL STOCK PORTFOLIO
Investment Objectives
The Portfolio seeks long-term capital growth by investing primarily in a
diversified portfolio of foreign stocks.
Investment Policies
Under ordinary circumstances, we invest in at least 65% of the
Portfolio's total assets in foreign stocks, and securities convertible into
foreign stocks of companies domiciled in at least three different countries not
including the United States: We invest in a variety of different regions and
countries including but not limited to Argentina, Australia, Austria, Belgium,
Brazil, Canada, Chile, Denmark, Finland, France, Germany, Greece, Hong Kong,
India, Indonesia, Ireland, Italy, Japan, Luxembourg, Malaysia, Mexico, The
Netherlands, New Zealand, Norway, Peru, Philippines, Portugal, Singapore, South
Africa, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, and the
United Kingdom.
Typically, we consider a stock to be a "foreign stock" if it is issued
by a company that is domiciled in a particular country if it:
(1) is organized under the laws of that country; or
(2) has at least 50% of the value of its assets located in that country; or
(3) derives at least 50% of its income from operations or sales in that country.
For stocks that do not meet the above domicile criteria, we make a
good-faith determination based on such factors as the location of issuer's
assets, personnel, sales and earnings.
We may invest the remaining 35% of the Portfolio's total assets in:
additional foreign stocks; U.S. stocks; structured notes and/or preferred
stocks; and up to 20% of the Portfolio's total assets in U.S. and foreign bonds
and other debt obligations, including lower-rated debt, commonly referred to as
"junk bonds" (i.e., securities rated BB or lower by Standard & Poor's
Corporation(R) or Ba or lower by Moody's Investor Services, Inc.) and unrated
securities.
We do not place any restrictions on the debt ratings of securities
acquired or, the portion of the Portfolio's assets we may invest, in a
particular rating category. We may also invest up to 100% of total assets in
emerging countries.
Investment Risks
Foreign Investment Risk
Foreign investment risks include currency, liquidity, political,
economic and market risks, as well as risks associated with governmental
regulation and nonuniform corporate disclosure standards. We may invest from 0%
to 100% of the Portfolio's total assets in emerging growth countries, which may
entail more risk than investing in mature countries. The greater the percentage
of net assets the Portfolio invests in emerging countries, the greater the
investment risks.
There are other specific investment risks to certain of the securities
that make up the International Stock Portfolio. See Additional Investment Risks
for more information.
Sub-Adviser
We hired Oechsle International Advisors, L.P. (Oechsle), a Delaware limited
partnership, with principal offices at One International Place, Boston,
Massachusetts, 02110, as the Sub-adviser to the Portfolio. The general partner
of Oechsle is Oechsle Group, L.P., and the managing general partner of Oechsle
Group, L.P. is Walter Oechsle. Oechsle is an independently owned money
management organization primarily focused on the management of international
securities. The organization is a partnership, formed and registered as an
investment adviser with the Securities and Exchange Commission in 1986 by a
group of investment professionals who previously worked as a team at Putnam
International Advisors. The founding partners of Oechsle have worked together
for an average of 15 years. As of September 30, 1997, Oechsle has managed $10
billion in assets. Oechsle began serving as sub-adviser to the Portfolio at its
inception on March 1, 1998.
Oechsle makes the day-to-day investment decisions for the Portfolio
under our direction and control. Oechsle determines which securities to purchase
and sell, arranges the purchases and sales, and gives other help in formulating
and implementing the investment program for the Portfolio.
Portfolio Manager
Kathleen Harris and Sean Roche have managed the Portfolio since its
inception on March 1, 1998. Both Ms. Harris and Mr. Roche are employees of
Oechsle, the sub-adviser. Ms. Harris has been a Portfolio Manager at Oechsle
since January 1995. Prior to this, she was portfolio manager and Investment
Director for the State of Wisconsin Investment Board and a Fund Manager and
Equity Analyst for Northern Trust Company. Mr. Roche has been a general partner
and portfolio manager with Oechsle since 1986.
Annual Advisory Fee
We receive an investment advisory fee as compensation for providing
services to the Fund. The fee is a daily charge equal to an annual rate of .80%
of the average daily net assets of the Portfolio. From this amount we pay the
Sub-adviser the following fee based on assets under management:
Total Assets Annual Fee
First $20 million .54%
Next $30 million .45%
Over $50 million .36%
THE AAL VARIABLE PRODUCT HIGH YIELD BOND PORTFOLIO
Investment Objective
The High Yield Bond Portfolio seeks high current income and secondarily
capital growth by investing primarily in a diversified portfolio of high risk,
high yield bonds commonly referred to as "junk bonds." The Portfolio actively
seeks to achieve a secondary objective of capital growth to the extent it is
consistent with the primary objective of high current income.
Investment Policies
Usually, we invest at least 65% of the Portfolio's total assets in high
yield bonds. By high yield bonds, we mean debt securities rated below
investment grade by a nationally recognized statistical rating organization,
such as a Ba rating or lower by Moody's Investors Services, Inc. or BB or lower
by Standard & Poor's Ratings Group, or, if unrated, of comparable quality as we
determine. See the Appendix for information on credit ratings. We define high
yield bonds to include:
- fixed; - floating rate interest debt obligations;
- variable; - deferred interest debt obligations;
- convertible bonds; - structured debt obligations;
- zero coupon bonds; - asset-backed debt obligations; and
- pay-in-kind bonds; - mortgage-backed debt obligations.
We may invest the remaining 35% of the Portfolio's total assets in any
combination of: additional high yield bonds; common and preferred stocks;
investment grade bonds; and government obligations. We may invest up to 20% of
the Portfolio's net assets in bonds of foreign issuers.
In evaluating the quality of a particular high yield bond for investment
in the Portfolio, we do not rely exclusively on credit ratings. In appropriate
circumstances, we perform our own credit analysis. We consider the issuer's:
- financial resources; - debt maturity schedules;
- operating history; - borrowing requirements; and
- sensitivity to economic - management's abilities.
conditions and trends;
- relative values based on anticipated
cash flow, interest and asset coverages
and earning prospects
We attempt to identify those issuers of high yield bonds whose financial
condition is adequate to meet future obligations, has improved or is expected to
improve in the future. However, we do not have restrictions on the rating level
of the securities in the Portfolio and may purchase and hold securities in
default.
Investment Risks
Interest Rate Risk
The direction of changes in interest rate levels generally have an
opposite directional affect on the value of the bonds in the Portfolio.
Credit Risk
The primary risk of investing in the high yield sector is the credit
risk. Bonds rated below investment grade have greater risks of default than
investment grade bonds. In fact, some may already be in default.
Market Risk
Frequently, high yield bonds have a less liquid resale market than the
market for investment grade bonds. In some cases, these bonds have no resale
market at all. As a result, we may have difficulty valuing portfolio securities,
choosing the securities to sell in order to meet redemption requests, and/or
selling or disposing of portfolio securities on favorable terms. The high yield
market has in the past, and may in the future, experience market risk due to
adverse publicity and investor perceptions, whether or not based on fundamental
analysis, decreasing market sales and liquidity, especially on the lesser traded
issues.
There are other specific investment risks to certain of the securities
that make up the High Yield Bond Portfolio. See Additional Investment Risks for
more information.
Sub-Adviser
We have hired AAL Capital Management Corporation (AALCMC) to provide
portfolio management services for the High Yield Bond Portfolio. AALCMC is a
registered investment adviser and is an affiliate of ours. In addition to being
the sub-adviser, AALCMC is also the distributor of the AAL Variable Annuity and
AAL Variable Life Insurance Certificates. Under our Sub-Advisory Agreement,
AALCMC determines which securities to purchase and sell, arranges the purchases
and sales, and gives other help in formulating and implementing the investment
program for the Portfolio.
Portfolio Manager
Dave Carroll, CFA, has managed the High Yield Bond Portfolio since the
Portfolio's inception on March 1, 1998. Currently, Mr. Carroll is also managing
the AAL High Yield Bond Fund, which is one of The AAL Mutual Funds. Prior to
this, he served as an analyst and trader for Cargill Financial Services from
January through September 1996. From 1986 to August 1995, he was a second vice
president and portfolio manager for Fortis Advisers, Inc.
Annual Advisory Fee
We receive an investment advisory fee as compensation for providing
services to the Fund. The fee is a daily charge equal to an annual rate of 0.40%
of the average daily net assets of the Portfolio. We pay the sub-adviser an
annual fee of 0.25% of average daily net assets from our advisory fee as
compensation for its services.
OTHER INVESTMENT AND RISK FACTORS REGARDING THE PORTFOLIOS
Temporary Defensive Purposes
For the International Stock and High Yield Bond Portfolios we have a
temporary defensive position policy that allows us to invest up to 100% of a
Portfolio's total assets in cash and short-term money market obligations,
including tax-exempt money market funds and investment grade fixed-income
securities when significant adverse market, economic, political or other
circumstances require immediate action to avoid losses. Primarily, we may
purchase the following types of securities for temporary defensive purposes:
securities issued or guaranteed by the U.S. government or its agencies or
instrumentalities; commercial paper rated at the time of purchase in the highest
rating category by NRSROs; and bank obligations, including repurchase
agreements, of banks having total assets in excess of $1 billion.
We may invest up to 100% of the International Stock Portfolio's total
assets in U.S. securities or in securities primarily traded in one or more
foreign countries, or up to 100% in debt securities.
Interest Rate Risk
For the Bond, Balanced, High Yield Bond and Money Market Portfolios, you
can expect that interest rate changes will significantly impact upon the value
of your Portfolio investments. Interest rates are influenced by supply and
demand as well as economic monetary policies. In general, a decline in
prevailing interest rate levels generally will increase the value of the
securities, particularly the bonds, held as assets in a portfolio and vice
versa. As a result, interest rate fluctuations will affect a Portfolio's net
asset values but not the income received from its existing investments. However,
changes in the prevailing interest rate level will affect the yield on
subsequently purchased securities. Because yields on the securities available
for purchase by the Portfolios will vary over time, we cannot assure a specific
yield on a Portfolio's shares.
Longer-term bonds are more sensitive to interest rate changes than
shorter-term bonds, reflecting the greater risk of holding these bonds for a
longer period of time. Longer-term bond prices increase more dramatically when
interest rates fall and decrease more dramatically when interest rates rise.
Prices of short-term debt, such as money market instruments, are less price
sensitive to interest rate changes because of their short durations.
Income-producing equity securities generally pay higher than average
dividends. Due to the regular payment of higher dividends, these securities,
like bonds, are more sensitive to interest rate levels than other equity
securities.
Investing in Bonds Versus Investing in a Portfolio
Investing in a Portfolio that owns bonds is not the same as buying an
individual bond. Both bonds and portfolios owning bonds offer regular income.
While individual bonds can offer a fixed amount of regular income until
maturity, a Portfolio may include a constantly changing pool of bonds with
differing interest rates and maturity prices. Both share prices and dividends
may fluctuate in a Portfolio owning bonds.
Investment grade and Medium grade Bond Investments
We may purchase investment grade bonds for the Bond, Balanced,
International and High Yield Bond Portfolios. A debt or other fixed-income
security is considered investment grade if it is rated investment grade by a
NRSRO, such as BBB or better by Duff and Phelps Credit Rating Co. (Duff &
Phelps) and Standard & Poor's Corporation (Standard & Poor's) or Baa or better
by Moody's Investors Services, Inc. (Moody's). Securities rated in the fourth
highest category, such as BBB by Duff & Phelps or Standard & Poor's or Baa by
Moody's, are considered medium grade bonds and are more sensitive to economic
changes and have speculative characteristics. If a bond in a Portfolio has lost
its rating or has its rating reduced, we do not have to sell the security, but
we will consider the lost or reduced rating in determining whether that
Portfolio should continue to hold the bond.
Mortgage-Backed Securities
For the Bond, Balanced, and High Yield Bond Portfolios, we may invest in
mortgage-backed securities with amortizing payments consisting of both interest
and principal and prepayment privileges (the ability to prepay the principal or
a portion of it without penalty). Mortgaged-backed securities represent interest
in pools of mortgage loans made by lenders such as savings and loan
institutions, mortgage bankers, commercial banks and others. Various government,
government-related and private organizations combine these mortgages for sale to
investors (such as the Government National Mortgage Association (GNMA) that
guarantees and issues mortgage-backed securities). Mortgage-backed securities
generally provide for a "pass through" of monthly payments made by individual
borrowers on their residential mortgage loans, net of any fees paid to the
issuer or guarantor of the securities. The yield on these securities applies
only to the unpaid principal balance.
We reinvest the periodic payments of principal and interest and
prepayments, if any, in securities at the prevailing market interest rates. The
prevailing rates may be higher or lower than the rate on the original
investment. During periods of declining interest rates, prepayment of mortgages
underlying mortgage-backed securities tend to accelerate. Accordingly, any
prepayments on mortgage-backed securities that we hold for a Portfolio reduce
our ability to maintain positions in high-yielding, mortgage-backed securities
and reinvest the principal at comparable yields for the Portfolio. If we buy any
mortgage-backed securities for a Portfolio at a premium, the Portfolio receives
prepayments, if any, at par or stated value, which lowers the return on the
Portfolio. Finally, the risk of prepayment tends to cause the value of a
Portfolio's investments in mortgage-backed securities to increase less in times
of decreasing interest rates and decline more in times of increasing interest
rates. On the other hand, these securities tend to have a higher yield than do
securities with no prepayment feature.
High Yield Bond Investments
We may invest in high yield bonds for the International Stock and High
Yield Bond Portfolios.
Credit Risk
The primary risk of investing in the high yield sector is the credit
risk. Bonds rated below investment grade have greater risks of default than
investment grade bonds (including medium-grade bonds) and, may in fact, be in
default. Issuers of high yield bonds usually do not have strong historical
financial conditions, requiring them to offer higher yields to compensate for
the greater risk of default on the payment of interest and principal. These
bonds have speculative characteristics or are speculative. As a result, their
market values are less sensitive to interest rate changes on a short-term basis,
but more sensitive to adverse economic developments or individual corporate
developments because of their lower credit quality. During an economic downturn
or period of rising interest rates, issuers of lower-rated bonds may have more
difficulty meeting their principal and interest payment obligations or obtaining
additional financing to make the interest payments on their debt. When issuers
have difficulty meeting projected goals or obtaining additional financing, the
default rate on high yield bonds will likely rise.
Market Risk
Frequently, high yield bonds are less liquid than investment-grade
bonds. In some cases, these bonds have no resale market at all. As a result,
these bonds are more difficult to price accurately and are subject to price
volatility. We may experience difficulty in valuing the high yield securities in
these portfolios or purchasing or disposing of them on favorable terms,
particularly during adverse market or economic conditions. In the event of an
illiquid market or in the absence of readily available market quotations for
certain high yield bonds in the Portfolios' portfolios, our judgment will play a
greater role in valuing the securities.
Portfolio Turnover
We expect the High Yield Bond Portfolio to have portfolio turnover
greater than 100% and the other Portfolios to have a portfolio turnover of less
than 100%. We do not calculate a portfolio turnover rate for The Money Market
Portfolio because of the short maturities of its investments. Due to the high
volume of buying and selling activity in a Portfolio with turnover in excess of
100%, we may pay more commissions for a Portfolio and may realize more taxable
gains than in portfolios with less turnover, which may result in an increase in
a Portfolio's expenses and lower returns for shareholders. We may trade for a
Portfolio at a portfolio turnover rate significantly exceeding 100%, when we
believe the benefits of short-term investments outweigh any increase in
transactions costs or capital gains. For more information on transaction
expenses and taxes, please refer to sections entitled Portfolio Transactions,
Dividends, Distributions, and Taxes, and Performance Information.
Financial Futures Contracts and Options
Except for the Money Market Portfolio, we may engage in options, futures
and options on futures transactions for the Portfolios, but only for bona fide
hedging or other permissible risk management purposes. Specifically, each
Portfolio may enter into futures contracts provided that not more than 5% of its
assets are required as a futures contract margin deposit; in addition, a
Portfolio may enter into futures contracts and options transactions only to the
extent that obligations under such contracts or transactions represent no more
than 33% of the Portfolio's assets. We may use these strategies for several
reasons:
- to maintain cash reserves while simulating full investment,
- to facilitate trading,
- to reduce transaction costs or
- to hedge against price movements.
Our ability to use futures and options transactions successfully
depends upon our skill for predicting the level and direction of the securities,
options and futures markets, interest rates and other factors. An incorrect
prediction may make the implementation of the hedging strategy in furtherance of
a Portfolio's investment objectives difficult. For example, significant
differences may exist between the securities and the options and futures markets
that could result in an imperfect correlation between them. Also, an incorrect
prediction on the changes in the level and direction of interest rates could
cause us to have a lower return for the Portfolio than it would have had if we
had not attempted the hedging transaction. In the absence of the ability to
hedge, however, we might make other Portfolio decisions in anticipation of the
same market movements with similar investment results, but, most likely, at
greater transaction costs.
When-Issued and Delayed Delivery Securities
To ensure the availability of suitable securities, we may buy
when-issued or delayed delivery securities for the International Stock, Bond,
Balanced, High Yield Bond and Money Market Portfolios. Generally, we will not
pay for when-issued securities or start earning interest until we have received
the underlying securities for the Portfolios. We do not speculate in when-issued
securities for the Portfolios. We purchase the securities with the expectation
of acquiring the underlying securities when delivered. However, we sell
when-issued securities before the settlement date when we believe it is in the
best interest of a Portfolio.
Illiquid and Restricted Securities
Except for the Balanced (money market instruments portion) and Money
Market Portfolios, we may hold up to 15% of a Portfolio's net assets in illiquid
securities. We may hold up to 10% of the Money Market Portfolio's net assets in
restricted and illiquid securities. Illiquid securities are securities we
believe cannot be sold within seven days in the normal course of business at
approximately the amount at which we have valued or priced the securities for a
Portfolio, including securities we acquired in private placements that have
restrictions on their resale (restricted securities). We deem time deposits and
repurchase agreements maturing in more than seven days illiquid. Because an
active market may not exist for illiquid securities, we may experience delays
and additional cost when trying to sell illiquid securities. For more
information on restricted and other illiquid securities regarding the Money
Market Portfolio, please refer to the Statement of Additional Information,
Privately Issued Securities: The Money Market Portfolio. The Board of Directors
has established procedures for determining the liquidity of Portfolio securities
and has delegated the day-to-day liquidity determinations to the Adviser.
Subject to the limitations for illiquid investments stated above, we may
purchase liquid restricted securities eligible for resale under Rule 144A under
the Securities Act of 1933 (the Act), without regard to the 15% or 10%
limitation. Rule 144A permits certain qualified institutional buyers, such as
the Portfolios, to trade in privately placed securities not registered under the
Act. Institutional markets for restricted securities have developed as a result
of Rule 144A, providing both readily ascertainable market values for 144A
securities and the ability to liquidate these investments to satisfy redemption
orders. However, an insufficient number of qualified institutional buyers
interested in purchasing certain Rule 144A securities held by a Portfolio could
adversely affect their marketability, causing us to sell the securities at
unfavorable prices.
Variable Rate Demand Notes
All of the Portfolios may purchase variable rate securities. The Money
Market Portfolio may purchase variable rate securities (the yields will vary in
relation to changes in specific money market rates, such as the prime rate) with
actual maturities of 397 days or more, but only under conditions established by
the Securities and Exchange Commission rules that permit such securities to be
considered as having maturities of less than 397 days. We intend to invest in
these longer-term variable rate securities only when, in our view, we may be
able to take advantage of the higher yield that is usually paid on these
securities over other short-term securities, and it appears to us that the
variable rates on these securities may reduce the fluctuations in market value
typical of longer-term securities. We also may purchase variable rate securities
with a put option, which may further reduce the risk of fluctuations in market
value.
Structured Securities
The International Stock Portfolio may invest in structured notes and/or
preferred stocks. These securities have a value (i.e., principal amount at
maturity and/or coupons or dividend amounts) linked to currencies, interest
rates, commodities, indices or other financial indicators. Typically, these
securities are debt securities or deposits whose value at maturity (i.e.,
principal value) or coupon rate is determined by reference to a specific
instrument or statistic. For example, gold structured securities may provide for
maturity values that depend on the price of gold, resulting in securities whose
prices tend to rise and fall together with gold prices. These securities involve
additional risk, including structures that may reduce the coupons and/or
dividend amounts to zero or the redemption amounts payable at maturity as a
result of a decline in the value of the underlying instrument. Structured
securities may have more volatility than the price of the underlying instrument
Foreign Securities
The Portfolios may invest in foreign securities domestically through
American Depository Receipts (ADRs) and securities of foreign issuers traded on
a U.S. national securities exchange or the NASDAQ National Market System The
International Stock Portfolio may invest in foreign securities other than ADRs,
and may invest in ADRs without limit. Foreign securities may present a greater
degree of risk (including risks related to tax provisions or appropriation of
assets) than do securities of domestic issuers.
Foreign Investing Expenses
Investing in foreign securities costs more than investing in U.S.
securities due generally to higher transaction costs, such as the commissions
paid per share. As a result, Portfolios that invest in foreign securities tend
to have higher expenses, particularly funds that invest primarily in foreign
securities. In addition to higher commissions, they generally have higher
advisory and custodial fees. However, you may find investing in a fund that
purchases foreign securities a more efficient way to invest in foreign
securities than investing in individual foreign securities. Higher expenses
attributable to a Portfolio that invests in foreign securities does not mean
that the Portfolio has higher expenses than others with similar investment
policies and percentages of assets invested in foreign securities.
Foreign Currency Transactions
Foreign securities have currency risk, meaning the risk that changes in
foreign currency exchange rates and exchange control regulations will affect
favorably or unfavorably the U.S. dollar value of these securities (and any
income generated from them). To manage this risk and facilitate the purchase and
sale of foreign securities for a Portfolio, we may engage in foreign currency
transactions involving:
- the purchase and sale of forward foreign currency exchange
contracts (agreements to exchange one currency for another at a
future date);
- options on foreign currencies;
- currency futures contracts; or
- options on currency futures contracts.
Although we use foreign currency transactions to protect against adverse
currency movements, they involve the risk that we may not accurately predict the
currency movements, which could adversely affect a Portfolio's total return. We
set forth further information on foreign securities and currency transactions in
the Statement of Additional Information.
Risks of Investing in Foreign Securities
Currency Risk
Even though a Portfolio may hold securities denominated or traded in
foreign securities, we measure a Portfolio's performance in terms of U.S.
dollars, which may subject the Portfolio to foreign currency risk. Foreign
currency risk is the possibility that the U.S. dollar value of foreign
securities (and any income generated therefrom) held by a Portfolio may be
affected favorably or unfavorably by changes in foreign currency exchange rates
and exchange control regulations. Therefore, the net asset value of a Portfolio
may go up or down as the value of the dollar rises or falls compared to a
foreign currency.
Liquidity Risk
Foreign markets or exchanges tend to have less trading volume than the
New York Stock Exchange or other domestic stock exchanges or markets, meaning
the foreign market may have less liquidity. The lower liquidity in a foreign
market can affect our ability to purchase or sell blocks of securities and
obtain the best price in the foreign market for a security. Foreign markets tend
to have greater spreads between bid and asked prices, trading interruptions or
suspensions and brokerage and other transaction costs. Settlement practices vary
from country to country and many foreign markets have longer settlement periods
for their securities in comparison to domestic securities. These differing
practices may cause us to lose opportunities for favorable purchases elsewhere
and interest income. Also, foreign markets may trade on days when the Portfolios
do not value their portfolios. This means that a Portfolio's Net Asset Value can
change on days when you cannot access your account. We may incur extra costs for
a Portfolio when involved in currency hedging. For example, restrictions on
converting a foreign currency into U.S. dollars may adversely affect the value
of a Portfolio.
Political, Economic and Market Risks
The degree of political and economic stability varies from country to
country. If a country seizes money from foreigners or nationalizes an industry,
a Portfolio may lose some or all of any particular investment in that country.
Individual foreign economies may vary favorably or unfavorably from the U.S.
economy in such areas as growth of gross national product, inflation rate,
savings, balance of payments and capital investment, which may affect the value
of a Portfolio's investment in any foreign country.
Governmental Regulation
Many foreign countries do not subject their markets to the same degree
and type of laws and regulations that cover the U.S. markets. Also, many foreign
governments impose restrictions on investments in their capital markets as well
as taxes or other restrictions on repatriation of investment income. The
regulatory differences in some foreign countries make investing or trading in
their markets more difficult and risky.
Nonuniform Corporate Disclosure Standards
Many countries have laws making information on publicly-traded
companies, banks and governments unavailable, more difficult to obtain or
incomplete. The lack of uniform accounting standards and practices among
countries impairs the ability of investors to compare common valuation measures,
such as price/earnings ratios, as applied to securities of different countries.
INVESTMENT RESTRICTIONS
In addition to those policies noted above with respect to specific
investments, the Portfolios are subject to certain investment restrictions which
are set forth in the Statement of Additional Information under the caption
"Investment Restrictions." Among other restrictions, a Portfolio may not:
(a) invest more than 25% of its total assets in securities of issuers
whose principal business activities are in the same industry,
excluding securities issued or guaranteed by the United States
government or any of its agencies or instrumentalities; or
(b) invest more than 5% of its total assets in a single issuer or purchase
more than 10% of the outstanding voting securities of a single issuer,
except that up to 25% of the Portfolio's total assets may be invested
without regard to this limitation and except that this limitation does
not apply to securities issued or guaranteed by the United States
government or its agencies or instrumentalities.
The foregoing investment restrictions and the additional investment
restrictions set forth in the Statement of Additional Information, and the
investment policies of any Portfolio with respect to specific investments, may
be changed by the Fund's Board of Directors without shareholder approval.
However, each Portfolio's investment objective is fundamental, meaning it cannot
by changed unless the shareholders of the Portfolio approve the change.
PERFORMANCE INFORMATION
From time to time, we calculate and advertise performance information
for different historical periods of time by quoting yields or total returns
designed to inform you of the performance of a Portfolio. We show yields and
total returns based on historical performance but these yields and returns do
not reflect charges or deductions against the relevant Variable Account or the
relevant Certificates. We expect each indexed Portfolio to track its respective
index as closely as possible. However, a Portfolio has operating expenses that
an index does not, so a Portfolio will not be able to match the performance of
its index exactly. Historical performance does not indicate future performance.
Expense and performance information for the Portfolios may be compared
in advertising, sales literature, and other communications to that of other
variable products tracked by Lipper Analytical Services, Inc. (Lipper), Variable
Annuity Research Data Service (VARDS), Morningstar, Inc. (Morningstar),and other
services. In addition, the performance of the Portfolios is compared to the S&P
500 Index, the S&P SmallCap 600 Index, the Wilshire Small Cap Index, the Lehman
Bond Index, the Dow Jones Industrial Average, and other widely recognized
indexes. Unmanaged indexes assume the reinvestment of dividends, if any, but do
not reflect any deduction for fund expenses. We periodically report performance
ratings in financial publications such as Forbes, Barron's, Fortune, Money
Magazine, Business Week, Financial Planning, The New York Times, and The Wall
Street Journal.
Keep in mind, yield and total return quotations reflect the performance
of a hypothetical investment during a specified period. They are based on
historical performance and do not in any way indicate future performance.
Quotations of a Portfolio's yield and total return do not reflect charges or
deductions against the Certificates or the Variable Account. Since you can only
purchase shares of the Portfolios through a Variable Annuity or Variable Life
Insurance Certificate, you should carefully review the Account Prospectus for
information on additional charges and expenses. Excluding these charges from
quotations of the Portfolio's performances has the effect of increasing the
performance quoted. You should keep in mind the effect of these charges when
comparing the Portfolios' performances to those of other mutual funds. Please
review carefully the yield and total return figures for the relevant Subaccounts
which accompany the yields and total returns quoted for the Portfolios.
Yields and Total Returns
The yield of a Portfolio refers to the income generated by an investment
in the Portfolio over a specified thirty-day period (seven-day for the Money
Market Portfolio) expressed as a percentage rate of return for that period. We
calculate the yield by dividing the net investment income per share for the
period by the price per share on the last day of that period. This yield is
annualized and shown as a percentage. This means that the income is assumed to
be earned for each 30-day period for twelve periods and is expressed as a
percentage of the investments. The effective yield for the Money Market
Portfolio is calculated similarly, but for a seven-day period. The effective
yield will be slightly higher than the yield quotation because of the
compounding effect of the assumed weekly reinvestment.
The total return of a Portfolio refers to the percentage change in value
of an investment in the Portfolio. For this calculation, we assume all income
and capital gains distributions are reinvested and a proportional share of Fund
expenses is deducted during a specified period of time. We calculate total
returns for one-, five-, ten-year periods or for the life of the Portfolio.
Average annual total return is the constant rate of return over a specified
period that is compounded annually.
Whenever we advertise performance, we include standardized yield and
total return information calculated in accordance with methods established by
the SEC. We may also include other total return calculations (known as a
nonstandardized calculation) such as cumulative rates of return or returns
calculated for periods other than those prescribed by the SEC. For more
information about the Portfolios' performance, see the Statement of Additional
Information and the Fund's annual report.
Index Information
From time to time, we may compare the performance of the Portfolios with
that of their benchmark index. Four Portfolios are considered to be indexed
Portfolios: Bond, Balanced, Large Company Stock, and Small Company Stock. These
Portfolios are passively managed; securities that comprise the Portfolio are the
same securities in their respective index or a representative sample of
securities of their index. The other Portfolios (Money Market, International,
and High Yield Bond) are actively managed; the Portfolio Manager uses his own
discretion to determine whether to include a security in the Portfolio. We may
compare some of these actively managed Portfolios to benchmark indexes to give
you a perspective on the Portfolios' performance.
The table below presents a comparison of average annual total returns for
certain of the Fund's Portfolios, as compared with their respective benchmark
indexes for the period shown. The total return information for each of the
Portfolios reflects the reinvestment of all dividends and capital gains
distributions, and the deduction of the Portfolio's operating expenses net of
expense reimbursements by us. Without these reimbursements, the total return
figures for each of the Portfolios would have been lower. It is presently
anticipated that we will continue making reimbursements at the present rate
through the current fiscal year.
<TABLE>
Average Annual Total Returns
For Periods Ended December 31, 1997
<CAPTION>
<S> <C> <C> <C> <C> <C>
1 Year 5 Years 10 Years Best Year for Index Worst Year for Index
Bond++ 9.37% n/a n/a
Lehman Bond Index* 9.65 7.48% 9.18% 32.62% (2.92)%
Large Company Stock++ 32.59 n/a n/a
S&P 500 Index** 33.36 20.26 18.02 53.99 (10.80)
Small Company Stock++ 25.37 n/a n/a
S&P SmallCap 600 Index*** 25.58 n/a n/a 29.96 (4.77)
Wilshire Small Cap 26.83 17.09 n/a 26.83 (3.13)
Index+
- -----------------------------------
*Lehman Bond Index began 12/31/75.
**S&P 500 Index began 3/4/57.
***S&P SmallCap 600 Index began 10/31/94.
+Wilshire Small Cap Index began 9/28/92.
++Total return does not reflect the expenses that apply at the Variable Life
Account level. Inclusion of these expenses would reduce the total return for the
period shown.
</TABLE>
It is important for you to note the extraordinary performance of
equities in recent years and put these short-term returns into the context of
historical norms. Along with sharp up-swings, we can expect some down-swings in
the short-term. But over the long-term, history causes us to expect more
conservative and stable growth.
Lehman Bond Index
The Lehman Brothers Aggregate Bond Index (Lehman Bond Index) invests
primarily in bonds and other debt securities. This index is a broad-based bond
index that encompasses four major classes of investment-grade fixed income
securities in the United States: U.S. Treasury and U.S. government agency
securities, corporate debt obligations, mortgage-backed securities and
asset-backed securities. As of December 31, 1997, these four classes represented
the following proportions of the index's total market value:
[SHOW AS PIE CHART]
Lehman Bond Index
December 31, 1997
Percent of Total
U.S. Treasury & Government Agency 49.5%
Corporate 19.3
Mortgage-Backed 30.2
Asset-Backed 1.0
Total 100%
The effective average weighted maturity of the index was 8.7 years as of
December 31, 1997.
Lehman Brothers can change asset classes and the weightings in the index at any
time.
S&P 500(R) and S&P SmallCap 600 Indexes
Standard & Poor's Corporation (R) (Standard & Poor's or S&P) compiles
several broad-based indexes used as benchmarks for tracking certain market
sectors. The most widely known is the S&P 500(R) Composite Stock Price Index
(S&P 500(R) Index). The S&P 500(R) index is a market-value weighted index of 500
common stocks representing more than 70% of the total market value of all
publicly traded common stocks. The weightings make each company's influence on
the index performance directly proportional to that company's market value. This
characteristic has made the S&P 500(R) Index the investment industry standard
for measuring the performance of portfolios comprised of large-capitalization
stocks. The companies whose stocks are included in this index tend to be the
leading companies in leading industries within the U.S. economy.
This index is a standard used to measure the performance of larger
capitalization stocks. The index is constructed by Standard & Poor's, which
chooses stocks on the basis of market values and industry diversification. Most
of the largest 500 companies listed on U.S. stock exchanges are included in the
index. Additional stocks that are not among the 500 largest stocks, by market
value, are included in the S&P 500 Index for diversification purposes. The index
is capitalization weighted--that is, stocks with a larger capitalization (shares
outstanding times current price) have a greater weight in the index
Another index from Standard & Poor's(R) we use as a benchmark is the S&P
SmallCap 600 Index. The S&P SmallCap 600 Index is a benchmark index for tracking
small-capitalization stocks ranging in value from approximately $29 million to
$2.9 billion. While this index is relatively new, the industry recognizes it as
a good benchmark for tracking small-cap stocks. The 600 stocks that make up the
index are listed on either the New York Stock Exchange, the American Stock
Exchange or the NASDAQ quotation system. In addition, the stocks that make up
the index are liquid, meaning they are easily traded. These characteristics of
the S&P SmallCap 600 Index make it relatively easy to emulate. The easier it is
to track an index, the more likely that a Portfolio is to tracking the index'
performance. As of March 1, 1998, we began investing in the stocks that make up
the S&P SmallCap 600 Index and use the index for comparison purposes for our
Small Company Stock Portfolio.
Both the 500 and the 600 indexes are comprised of U.S. equity stocks.
S&P(R) periodically makes additions and deletions of stock to its indexes.
Selection of a stock for inclusion in either S&P(R) index in no way implies an
opinion by S&P(R) as to its attractiveness as an investment. Standard &
Poor's(R) only relationship to the Fund is the licensing of the Standard &
Poor's(R) marks, the S&P 500(R) Index, and the S&P SmallCap 600 Index. These
indexes are determined, composed and calculated by Standard & Poor's(R) without
regard to any particular Portfolio of the Fund. "Standard & Poor's(R),"
"S&P(R)," "Standard & Poor's 500," "S&P 500(R)," "500," "Standard &Poor's
SmallCap 600 Index," and "S&P SmallCap 600 Index" are trademarks of The
McGraw-Hill Companies, Inc. and have been licensed for use by AAL and the Fund.
The Fund and the Certificates are not sponsored, endorsed, sold or promoted by
Standard & Poor's(R). Standard & Poor's(R) makes no representation regarding the
advisability of investing in the Fund. See the Statement of Additional
Information for additional disclaimers and limitations of liabilities on behalf
of S&P.
Wilshire Small Cap Index
This index is also known as the Wilshire 250. The index is a creation of
Wilshire Associates Incorporated, the Pacific Stock Exchange and the Chicago
Board of Trade. The index is comprised of 250 small-capitalization stocks.
Component stocks are U.S. equity stocks selected according to liquidity,
industry sector and market capitalization parameters. The index is
custom-designed to represent the performance attributes of the
small-capitalization segment of the U.S. equity markets.
Before March 1, 1998, the objective of the Small Company Stock Portfolio
was to seek investment results that approximate the Wilshire 250. Due to a
change in investment objective, the Small Company Stock Portfolio now seeks to
approximate the investment results of the S&P SmallCap 600.
MANAGEMENT OF THE FUND
Fund officers and officers of AAL are responsible for the day-to-day
operations of the Fund. The Fund's Board of Directors decides matters of general
policy and reviews the activities of the Fund's Adviser and the Fund's officers.
The Adviser
Aid Association for Lutherans (AAL) is the Adviser to the Fund. AAL has
extensive investment management experience. Currently, AAL manages almost $18
billion in assets for its insurance portfolios in addition to the $831 million
of assets for the Fund. AAL's principal business is selling insurance and other
financial products to its members including: life, disability income, long-term
care and Medicare supplement insurance and annuities to its members. Through its
affiliates, AAL Capital Management offers mutual funds and the AAL Member Credit
Union offers credit union services. Membership is open to Lutherans and their
families.
AAL was organized on November 24, 1902 as a fraternal benefit society
under Internal Revenue Code section 501(c)(8) and incorporated under the laws of
the state of Wisconsin as a non-stock, non-profit corporation. As of December
31, 1997, AAL has approximately 1.7 million members and is the world's largest
fraternal benefit society in terms of statutory assets (almost $18 billion). The
principal address of the Adviser is 4321 North Ballard Road, Appleton, Wisconsin
54919-0001.
AAL has entered into an Investment Advisory Agreement with the Fund.
According to the agreement, AAL manages the investment and reinvestment of the
Fund's assets and supervises the Fund's daily business affairs subject to the
supervision of the Fund's Board of Directors. AAL provides the Fund with the
personnel and facilities necessary to manage the Fund. AAL formulates and
implements a continuous investment program for the Portfolios consistent with
each Portfolio's investment objectives, policies and restrictions.
Generally, AAL will reimburse the Fund for substantially all of its
operating expenses other than investment advisory fees, brokerage commissions,
and any extraordinary items such as litigation expenses or income tax
liabilities. Notwithstanding the reimbursement, each Portfolio will bear all of
its operating expenses that are not specifically assumed by AAL, including:
interest and taxes; brokerage commissions; insurance premiums; compensation and
expenses for those Directors who are not affiliated with AAL; independent legal
and audit expenses; fees and expenses of the Fund's custodian, shareholder
servicing or transfer agent and accounting services agent; expenses incident to
the issuance of its shares, including stock certificates and issuance of shares
on the payment of, or reinvestment of dividends; fees and expenses incident to
the registration under Federal or state securities laws of the Fund or its
shares; Fund or Portfolio organizational expenses; expenses of preparing,
printing and mailing Fund reports, notices, proxy material and prospectuses to
shareholders of the Fund; all other expenses incidental to holding meetings of
the Fund's shareholders; dues of, or assessments of, or contributions to, the
Investment Company Institute or any successor or other industry association;
such non-recurring expenses as may arise, including litigation affecting the
Fund and the legal obligations which the Fund may have to indemnify its officers
and Directors with respect thereto; and cost of daily valuation of each of the
Portfolio's securities and net asset value per share. AAL may withdraw this
undertaking on 30 days' written notice to the Fund. AAL has informed the Fund's
Board of Directors that it currently intends to bear all of the Fund's operating
expenses, other than those specified immediately above, through at least
December 31, 1998.
AAL has also engaged two sub-advisers, each with its own distinct
contract with AAL. AAL Capital Management Corporation (a wholly-owned subsidiary
of AAL) has agreed to act as sub-adviser for the High Yield Bond Portfolio. AAL
Capital Management Corporation also sells, distributes and advises the AAL
Mutual Funds. The principal offices for AAL Capital Management Corporation is
222 West College Avenue, Appleton, Wisconsin, 54919-0007. Oechsle has agreed to
act as sub-adviser for the International Stock Portfolio. The principal offices
for Oechsle is One International Place, Boston, Massachusetts, 02210. Oechsle is
a Delaware limited partnership. The general partner of Oechsle is Oechsle Group,
L.P., and the managing general partner of Oechsle Group, L.P. is Walter Oechsle.
According to the terms of the agreements with each of the sub-advisers, they are
subject to our direction and that of the Board of Directors. However, each
sub-adviser determines the securities to be purchased or sold. The sub-advisers
may assist AAL in formulating and implementing the investment program for its
respective Portfolio. Both sub-advisers are registered as investment advisers
with the Securities and Exchange Commission.
The Administrator
We have entered into an agreement with AAL Capital Management
Corporation (AAL CMC) to perform certain administrative services including
portfolio accounting, expense accrual, valuation and financial reporting, and
tax accounting services for each Portfolio. We pay AAL CMC a specified rate not
to exceed the rates charged by unaffiliated vendors for comparable services. In
addition, we reimburse certain expenses as may be approved annually by a
majority of the Fund's Board of Directors. The Fund does not directly reimburse
us for the cost of services provided by AAL CMC.
Our agreement with AAL CMC will continue year to year as long as it is
specifically approved at least annually by the Fund's Board of Directors or by a
vote of a majority of the outstanding voting securities, and, in either case, a
majority of the Fund's disinterested Directors.
Third Party Administrator
We have entered into a Service Agreement with The Continuum Company,
Inc. (Continuum), pursuant to which Continuum will provide certain services in
connection with the Variable Accounts including, among other things, application
and premium processing. Continuum has the necessary equipment and personnel to
provide and support remote terminal access to our annuity processing system for
the establishment and maintenance of annuity records, processing information,
and the generation of output with respect to the records and information. Our
contract with Continuum expires March 6, 1998. After that time, we will assume
these responsibilities.
Portfolio Transactions
We direct the placement of orders for the purchase and sale of the
Fund's securities. In directing orders, we will consider a number of factors to
attain what we believe is the best combination of price and execution for the
Portfolios including when we believe that more than one broker or dealer is
capable of providing the best combination of price and execution in a
transaction. Normally we will select a broker or dealer who furnishes brokerage
and research services.
In addition to the Fund, we make investment decisions for our general
account and other clients. If these entities desire to buy or sell the same
securities at about the same time, combined purchases and sales may be made and
allocated at the average net unit price for the securities and, as nearly as
practicable, on a pro-rata basis in proportion to the amounts desired to be
purchased or sold by each entity. It is possible that this procedure could have
a detrimental effect on the price or volume of the security to be purchased or
sold. However, as far as a Portfolio is concerned, we believe that this
procedure would generally contribute to better overall execution of the Fund's
Portfolio transactions, including the realization of lower commission rates and
advantageous prices. For example, coordination with transactions for other
clients and the ability to participate in volume transactions could benefit the
Fund. Where combined purchases and sales are not made, volume transactions and
any resulting benefit, of course, would not be available. We do not expect that
the opportunity to make such combined purchases and sales will arise in the
ordinary course of its business.
PURCHASE AND REDEMPTION OF SHARES
Shares of the Fund are currently offered only to AAL Variable Annuity
Account I and AAL Variable Life Account I to fund benefits payable under the
Certificates. You may not purchase or redeem shares of the Fund directly. If you
wish to make a purchase or redemption, please refer to the applicable Account
Prospectus. We may at some later date, also offer shares of the Fund to other
separate accounts of AAL or a subsidiary or affiliated company of AAL. Shares of
the Fund were sold directly to AAL in connection with the initial capitalization
of the Portfolios.
Shares of all Portfolios are continuously offered and redeemed by the Fund,
without sales charge, at prices equal to the respective per share net asset
value (NAV) of each Portfolio. The Variable Accounts purchase and redeem shares
of each Portfolio at the NAV next determined after the Fund receives such
request. The Variable Account forwards share purchase and redemption requests to
the Fund when the accumulation unit value is next determined after you submit
your purchase or redemption request to your Subaccount.
Orders to purchase or redeem Fund shares which are not based on actions
by Certificate Owners, Annuitants or Beneficiaries or routine deductions of
charges by AAL will be effected at the Portfolio's NAV per share next computed
after the order is placed.
We are required to pay the proceeds for redemption of all full and
fractional shares of the Fund within seven days after the date as of which the
redemption is priced. There are specific events which may require us to suspend
the right to redeem shares or to receive payment with respect to any redemption
including: any period during which trading on the New York Stock Exchange is
restricted as determined by the Securities and Exchange Commission; when such
exchange is closed (other than customary weekend and holiday closings); any
period during which an emergency exists as defined by the Securities and
Exchange Commission as a result of which disposal of a Portfolio's securities or
determination of the Portfolio's NAV is not reasonably practicable; and for such
other periods as the Securities and Exchange Commission may by order permit for
the protection of shareholders of any Portfolio.
NET ASSET VALUE
Once each day that we are open for business, we determine the NAV per
share of any Portfolio at the close of regular trading on the New York Stock
Exchange, currently 4:00 p.m. We do not determine the NAV on holidays observed
by the Exchange. The Exchange is regularly closed on Saturdays and Sundays and
on New Year's Day, Martin Luther King Day, the third Monday in February, Good
Friday, the last Monday in May, Independence Day, Labor Day, Thanksgiving, and
Christmas. If one of these holidays falls on a Saturday or Sunday, the Exchange
will be closed on the preceding Friday or the following Monday, respectively. In
addition, during 1998, AAL will be closed for business on the Friday following
Thanksgiving and the day before Christmas. On those days, we will not redeem any
shares notwithstanding the fact that the New York Stock Exchange will be open.
We compute the NAV of shares by adding the sum of the value of the
securities held by each Portfolio plus any cash or other assets it holds, less
all of that Portfolio's liabilities, and dividing the result by the total number
of outstanding shares of that Portfolio at such time. We value securities owned
by the Fund for which market quotations are readily available at current market
value. However, we value all securities of the AAL Variable Product Money Market
Portfolio on the basis of its amortized cost, which approximates market value.
We determine, in good faith, the value of all other securities and assets at
fair value by or under the direction of the Fund's Board of Directors.
DIVIDENDS, DISTRIBUTIONS AND TAXES
We intend to have each Portfolio of the Fund to qualify as a regulated
investment company under Subchapter M of the Internal Revenue Code (the Code),
as amended. We intend to take all other actions that are required so that no
federal income tax will be owed by any Portfolio of the Fund. Accordingly, each
Portfolio will be treated as a separate entity for federal income tax purposes.
The Portfolios will qualify as regulated investment companies if they distribute
all of heir respective investment company income and net capital gains for each
fiscal year according to the Code. Additionally, we intend to have each
Portfolio comply with the diversification requirements under 817(h) of the Code
related to the tax-deferred status of insurance company separate accounts (the
Variable Accounts). Our failure to comply with these diversification
requirements may result in immediate taxation to you. The tax status of your
investment in the Fund depends upon the features of your Certificate. See the
Account Prospectus for more information.
We expect to distribute substantially all of each Portfolio's ordinary
income and capital gains each year. For each Portfolio, this consists of all net
investment income (including cash dividends and interest paid on the Portfolio's
investments), all net realized short-term and long-term capital gains if any,
earned during the year, less estimated expenses (including the Advisory Fee).
Net investment income of the Money Market Portfolio consists of accrued interest
and/or earned, plus or minus all realized gains and losses, less the estimated
expenses of the Portfolio (including the Advisory Fee).
We reinvest all income dividends and capital gains distributions in the
form of additional shares of the respective Portfolio at NAV. Except for the
Money Market Portfolio, the value of each Portfolio's shares is based on the
amount of its net assets, including any undistributed net income, any
distribution of income or capital gains results in a decrease in the value of
the Portfolio's shares equal to the amount of the distribution.
Shares of a Portfolio begin accruing dividends on the day following the
date as of which the shares are credited to a Variable Account. Dividends are
generally declared and reinvested daily on the Money Market Portfolio, and
monthly on all other Portfolios except for the International Stock Portfolio
which declares dividends annually. However, we may distribute dividends on any
Portfolio more or less frequently, as needed. We will also declare and
distribute annually all net realized capital gains of the Fund, other than
short-term gains of the Money Market Portfolio, which are declared as dividends
daily. We usually make a capital gain distribution in December.
ADDITIONAL INFORMATION
Fund Organization and Description of Shares
We organized the Fund as a Maryland business corporation on June 14,
1994. The Fund may issue up to 2 billion shares of common stock, $.001 par
value, in one or more series (Portfolios) as the Board of Directors may
authorize. Currently, the Board has authorized seven series which bear the
designation of the names of the respective Portfolios. The Board of Directors
may, in the future, authorize the issuance of more series of shares. Each share
of a Portfolio is entitled to participate in a pro rata basis any dividend or
other distribution declared by the Board with respect to that Portfolio. All
shares of a Portfolio have equal rights in the event of liquidation of that
Portfolio.
We provided the initial capitalization of each Portfolio.
Voting Privileges
Your voting privileges are explained in the accompanying Account
Prospectus relating to the Certificates. As the owner of the assets in both the
AAL Variable Annuity Account I and the AAL Variable Life Account I, we will
attend shareholder meetings and vote all of the shares of the Portfolios held to
fund the benefits under the Certificates. Still we generally will do so in
accordance with your instructions as the Certificate Owner. We will vote in
proportion to the voting instructions that are received with respect to all
Certificates participating in a Portfolio for any shares for which no timely
voting instructions are received, and any shares held by us or any of our
subsidiaries or affiliates for our own account, However, we may disregard voting
instructions received from you under certain circumstances as described in
Voting Privileges in the Fund's Statement of Additional Information.
Shareholders are entitled to one vote for each share held with proportionate
voting for fractional shares.
We are not required to hold annual shareholder meetings for the Fund.
However, we may call special meetings for purposes such as electing or removing
Directors, changing fundamental policies, or approving an investment advisory
contract. Matters that may affect one Portfolio distinctly from the other
Portfolios require a separate vote of shares of that Portfolio. Shares of all
the Portfolios vote together on matters that affect all of the Portfolios such
as the election of Directors. Shareholders of a total of 10% or more of the
outstanding shares of the Fund may request a meeting at any time for the purpose
of voting to remove a Director or Directors.
Indemnity and Limitation of Liability of Directors and Officers
To the fullest extent permitted by Maryland and federal law, the Fund
will indemnify and limit the liability of Directors and officers of the Fund
from any personal liability to the Fund or the holders of shares of its series
or classes for money damages. However, this limitation and indemnification does
not protect any Director or officer from liability to which the Director or
officer would otherwise be subject by reason of willful misfeasance, bad faith,
gross negligence, or reckless disregard of the duties involved in the conduct of
his or her office.
Custodian, Transfer Agent And Independent Auditors
Citibank, N.A., 111 Wall Street, New York, NY 10043, serves as Custodian
for the Fund. We serve as Transfer Agent for the Fund. Ernst & Young LLP, 111
East Kilbourn Avenue, Suite 900, Milwaukee, Wisconsin 53202, serves as
independent auditors for the Fund. The Financial Highlights included in this
Prospectus and the financial statements of the Fund incorporated by reference
into the Statement of Additional Information were audited by Ernst & Young LLP,
and were included in reliance on their report as experts in accounting and
auditing.
SHAREHOLDER INQUIRIES
All inquiries from Certificate Owners regarding the Fund should be
directed to the Fund at AAL Variable Annuity Service Center, 4321 North Ballard
Road, Appleton, Wisconsin, 54919-0001 or telephone number 1-800-225-5225.
<PAGE>
APPENDIX: SECURITY RATINGS
Ratings in General
A rating by a rating service represents the service's opinion as to the
credit quality of the security being rated. However, the ratings are general and
are not absolute standards as to the creditworthiness of an issuer. We
continuously monitor the ratings given to securities in the Portfolios by rating
services. individual analysts give different weightings to the various factors
involved in credit analysis. A rating is not a recommendation to purchase, sell
or hold a security, because it does not take into account market value or
suitability for a particular investor. When a security has received a rating
from more than one service, each rating should be evaluated independently.
Ratings are based on current information furnished by the issuer or obtained by
the rating services from other sources which they consider reliable. Ratings may
be changed, suspended, or withdrawn as a result of changes in, or unavailability
of, such information, or for other reasons.
The following is a description of the characteristics of ratings used by
Moody's, S&P and Duff & Phelps:
CORPORATE BOND RATINGS
Ratings by Moody's
Aaa: Bonds which are rated Aaa are judged to be of the best quality and carry
the smallest degree of investment risk. Interest payments are protected by a
large or by an exceptionally stable margin, and principal is secure. While the
various protective elements are likely to change, such changes as can be
visualized are most unlikely to impair the fundamentally strong position of such
issues.
Aa: Bonds which are rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high grade
bonds. They are rated lower than the best bonds because margins of protection
may not be as large as in Aaa securities or fluctuation of protective elements
may be of greater amplitude or there may be other elements present which make
the long term risks appear somewhat larger than in Aaa securities.
A: Bonds which are rated A possess many favorable investment attributes and are
to be considered as upper medium-grade obligations. Factors giving security to
principal and interest are considered adequate but elements may be present which
suggest a susceptibility to impairment sometime in the future.
Baa: Bonds rated Baa are considered medium-grade obligations, i.e., they are
neither highly protected nor poorly secured. Interest payments and principal
security appear adequate for the present but certain protective elements may be
lacking or may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact may have
speculative characteristics as well.
Ba: Bonds that are rated Ba are judged to have speculative elements; their
future cannot be considered as well assured. Often the protection of interest
and principal payments may be very moderate and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B: Bonds that are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over a long period of time may be small.
Caa: Bonds that are rated Caa have poor standing. Such issues may be in default
or present elements of danger with respect to principal or interest.
Ca: Bonds that are rated Ca represent obligations that are speculative in a high
degree. Such issues are often in default or have other marked shortcomings.
C: Bonds that are rate C are the lowest-rated class of bonds and issues so rated
can be regarded as having extremely poor prospects of ever attaining any real
investment standing.
Note: Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification from Aa to B. The modifier 1 indicates that the company ranks in
the higher end of its generic rating category; the modifier 2 indicates a
mid-range ranking; and the modifier 3 indicates that the company ranks in the
lower end of its generic rating category.
Ratings by Standard & Poor's
AAA: Debt rated AAA has the highest rating assigned by Standard & Poor's to a
debt obligation. Extremely strong capacity to pay principal and interest.
AA+,AA,AA-: Bonds rated AA also qualify as high-quality debt obligations.
Capacity to pay principal and interest is very strong, and in the majority of
instances they differ from AAA issues only in small degree.
A+,A,A-: Bonds rated A have a strong capacity to pay principal and interest,
although they are somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB+,BBB,BBB-: Bonds rated BBB are regarded as having an adequate capacity to
pay principal and interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay principal and interest for bonds in
this category than for bonds in higher rated categories.
BB, B, CC, C , C: Debt rated BB, B, CCC, CC and C is regarded, on balance, as
predominantly speculative with respect to capacity to pay interest and repay
principal in accordance with the terms of the obligation. BB indicates the
lowest degree of speculation and C the highest degree of speculation. While such
debt will likely have some quality and protective characteristics, these are
outweighed by large uncertainties or major risk exposures to adverse conditions.
BB: Debt rated BB has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure to
adverse business, financial or economic conditions that could lead to inadequate
capacity to meet timely interest and principal payments. The BBB rating category
is also used for debt subordinated to senior debt that is assigned an actual or
implied BBB- rating.
B: Debt rated B has a greater vulnerability to default but currently has the
capacity to meet interest payments and principal repayments. Adverse business,
financial or economic conditions likely will impair capacity or willingness to
pay interest and repay principal. The B rating is also used for debt
subordinated to senior debt that is assigned an actual or implied BB or BB-
rating.
CCC: Debt rated CCC has a currently identifiable vulnerability to default and is
dependent upon favorable business, financial and economic conditions to meet
timely payment of interest and repayment of principal. In the event of adverse
business, financial or economic conditions, it is not likely to have the
capacity to pay interest and repay principal. The CCC rating category is also
used for debt subordinated to senior debt that is assigned an actual or implied
B or B- rating.
CC: The rating CC is typically applied to debt subordinated to senior debt that
is assigned an actual or implied CCC rating.
C: The rating C is typically applied to debt subordinated to senior debt that is
assigned an actual or implied CCC- debt rating. The C rating may be used to
cover a situation in which a bankruptcy petition has been filed, but debt
service payments are continued.
CI: The rating CI is reserved for income bonds on which no interest is paid.
D: Debt rated D is in payment default. The D rating category is used when
interest payments or principal payments are not made on the date due even if the
applicable grace period has not expired, unless S&P believes such payments will
be made during such grace period. The D rating also will be used upon the filing
of a bankruptcy petition if debt service payments are jeopardized.
NR: Indicates that no public rating has been requested, that there is
insufficient information on which to base a rating, or that S&P does not rate
the particular type of obligation as a matter of policy.
Note: The ratings from AA to CCC may be modified by the addition of a plus (+)
or minus (-) sign to show relative standing within the major category.
Ratings by Duff & Phelps
AAA: Highest credit quality. The risk factors are negligible, being only
slightly more than for risk-free U.S. Treasury debt.
AA+,AA,AA-: High credit quality. Protection factors are strong. Risk is modest
but may vary slightly from time to time because of economic conditions.
A+,A,A-: Good quality investment-grade securities. Protection factors are
average but adequate. However, risk factors are more variable and greater in
periods of economic stress.
BBB+,BBB,BBB-: Below average protection factors but still considered sufficient
for institutional investment. Considerable variability risk during economic
cycles.
BB+, BB, BB-: Below investment-grade but deemed likely to meet obligations when
due. Present or prospective financial protection factors fluctuate according to
industry conditions or company fortunes. Overall quality may move up or down
frequently within this category.
B+, B, B-: Below investment-grade and possessing risk that the obligation might
no be met when due. Financial protection factors will fluctuate widely according
to economic cycles, industry conditions and/or company fortunes. Potential
exists for frequent changes in the rating within this category or into a higher
or lower rating category.
CCC: Well below investment-grade securities. Considerable uncertainty exists as
to timely payment of principal, interest or preferred dividends. Protection
factors are narrow and risk can be substantial with unfavorable
economic/industry conditions and/or with unfavorable company developments.
DD: Defaulted debt obligations. Issuer failed to meet scheduled principal and or
interest payments.
Note: The Duff & Phelps ratings may be modified by the addition of a plus (+) or
minus (-) sign to show relative standing within the major ratings categories.
COMMERCIAL PAPER RATINGS
Ratings by Moody's
Moody's commercial paper ratings are opinions of the ability to repay
punctually the obligations. Moody's employs the following three investment-grade
designations to indicate the relative repayment capacity of the rated issuers:
Prime 1 (Highest Quality); Prime 2 (Higher Quality); Prime 3 (High Quality).
The rating Prime is the highest commercial paper rating assigned by
Moody's. Among the factors considered by Moody's in assigning ratings are the
following: evaluation of the management of the issuer; economic evaluation of
the issuer's industry or industries and an appraisal of speculative-type risks
which may be inherent in certain areas; evaluation of the issuer's products in
relation to competition and customer acceptance; liquidity; amount and quality
of long-term debt; trend of earnings over a period of 10 years; financial
strength of any parent company and the relationships which exist with the
issuer; and recognition by the management of obligations which may be present or
may arise as a result of public interest questions and preparations to meet such
obligations. These factors are all considered in determining whether the
relative repayment capacity of the issuer is rated Prime-1 (Highest Quality),
Prime-2 (Higher Quality), or Prime-3 (High Quality). The Portfolios will not
invest in commercial paper rated Prime-3.
Ratings by Standard & Poor's
A Standard & Poor's commercial paper rating is a current assessment of the
likelihood of timely payment. Ratings are graded into four categories, ranging
from A for the highest quality obligations to D for the lowest.
A: Issues assigned the highest rating category, A, are regarded as having the
greatest capacity for timely payment. Issues in this category are delineated
with the numbers 1, 2 and 3 to indicate the relative degree of safety.
A-1: The designation A-1 indicates that the degree of safety regarding timely
payment is either overwhelming or very strong. A + designation is applied to
those issues rated A-1 that possess extremely strong safety characteristics.
A-2: Capacity for timely payment on issues with the designation A-2 is strong.
However, the relative degree of safety is not as high as for issues designated
A-1.
A-3: Issues carrying the designation A-3 have a satisfactory capacity for timely
payment. They are, however, somewhat more vulnerable to the adverse effect of
changes in circumstances than obligations carrying the higher designations.
Ratings by Duff & Phelps
Category 1:Top Grade
Duff 1 plus: Highest certainty of timely payment. Short-term liquidity,
including internal operating factors and/or ready access to alternative sources
of funds, is clearly outstanding, and safety is just below risk-free U.S.
Treasury short-term obligations.
Duff 1: Very high certainty of timely payment. Liquidity factors are excellent
and supported by strong fundamental protection factors. Risk factors are minor.
Duff 1 minus: High certainty of timely payment. Liquidity factors are strong and
supported by good fundamental protection factors. Risk factors are very small.
Category 2:Good Grade
Duff 2: Good certainty of timely payment. Liquidity factors and company
fundamentals are sound. Although ongoing internal funds needs may enlarge total
financing requirements, access to capital markets is good. Risk factors are
small.
Category 3: Satisfactory Grade
Duff 3: Satisfactory liquidity and other protection factors qualify issue as to
investment-grade. Risk factors are larger and subject to more variation.
Nevertheless timely payment is expected.
<PAGE>
[Back Cover of Prospectus]
Investment Adviser and Transfer Agent:
Aid Association for Lutherans
4321 North Ballard Road
Appleton, Wisconsin 54919-0001
Service Center:
AAL Variable Products Service Center
4321 North Ballard Road
Appleton, Wisconsin 54919-0001
Telephone (800) 225-5225
Custodian:
Citibank, N.A.
111 Wall Street
New York, NY 10043
Independent Auditors:
Ernst & Young LLP
111 East Kilbourn Avenue, Suite 900
Milwaukee, Wisconsin 53202
