6.4 Variable Annuities

Variable Annuities: Securities and Separate Accounts

A variable annuity shifts the investment risk to the owner. Premiums are invested in separate-account subaccounts (similar to mutual funds), not the insurer's general account. The contract value and the income payments rise and fall with subaccount performance - there is no guaranteed minimum interest rate on the base contract.

Because the value fluctuates with securities, a variable annuity is a security AND an insurance product. The producer must hold both a life insurance license and a FINRA securities registration (Series 6 or 7) and the contract is regulated by both the state insurance department and the SEC/FINRA. A prospectus must be delivered.

Accumulation Units and Annuity Units

Variable annuities measure value in units, not dollars:

• During accumulation, premiums buy accumulation units. The number of units grows as deposits are made; the dollar value per unit floats with the subaccounts.
• At annuitization, accumulation units convert into a fixed number of annuity units. The unit count is then locked; the dollar value per annuity unit floats each period, so the income payment varies.

Key trap: after annuitization the number of annuity units is fixed - only the dollar value per unit changes. This is why variable income payments fluctuate.

The Assumed Interest Rate (AIR)

The AIR is a benchmark used to calculate variable payments, not a guarantee. Each period the actual subaccount return is compared to the AIR:

Worked example: AIR is 4%. If subaccounts return 7% this period, the payment rises; if they return 4%, it is unchanged; if they return 2%, the payment falls - even though 2% is a positive return, it is below the AIR, so the check shrinks. The comparison is always actual return versus the AIR, never versus the prior period.

Fees and Suitability

Variable annuities carry layered charges: mortality and expense (M&E) risk charge, administrative fees, subaccount management fees, and surrender charges. These make them more expensive than fixed annuities.

Suitability rules are strict. Replacing an existing annuity, selling to a senior who needs liquidity, or recommending a long-surrender contract to someone with a short horizon are common red flags. The producer must reasonably believe the contract suits the client's age, income needs, risk tolerance, and time horizon. Misrepresenting a variable annuity as guaranteed or as a safe alternative to a CD is a serious violation.

Separate Account, Units, and Dual Licensing

A variable annuity invests premiums in separate-account subaccounts (mutual-fund-like portfolios), so the owner bears the investment risk and the account value rises and falls with the markets. During accumulation, contributions buy accumulation units whose value floats; at annuitization the value converts to a fixed number of annuity units whose dollar value is recalculated each period against an assumed interest rate (AIR). If actual subaccount performance beats the AIR, the next payment rises; if it lags, the payment falls.

Because a variable annuity is both an insurance product and a security, the producer must hold a life license plus FINRA registration (Series 6 or 7), deliver a prospectus before or at solicitation, and document suitability. The general account guarantees do not protect the subaccount value.

Worked Numeric: Annuity Units and the AIR

Assume an AIR of 4%. If the subaccounts return 7% in a period, payments increase because performance exceeded the assumption; if they return only 2%, payments decrease. The number of annuity units stays fixed after annuitization - only the unit value changes - which is why variable-annuity income is never guaranteed in dollar terms.

Riders, Surrender Charges, and Suitability

Variable annuities are sold with optional living-benefit riders that the exam expects you to recognize. A guaranteed minimum income benefit (GMIB) guarantees a minimum annuitization income regardless of subaccount performance; a guaranteed minimum withdrawal benefit (GMWB) guarantees the owner can withdraw a set percentage of the benefit base for life; and a guaranteed minimum accumulation benefit (GMAB) guarantees the account value will at least equal premiums after a holding period. Each rider carries an extra fee that reduces net returns.

Worked Numeric: Subaccount Performance and Payments

Because the owner bears market risk, a market decline can erase gains. If $100,000 of subaccounts falls 20%, the account is worth $80,000, and only a living-benefit rider's guaranteed base would protect the income. Variable annuities also charge mortality and expense (M&E) fees plus fund expenses, so they are suitable mainly for long-horizon retirement savers comfortable with volatility - never for short-term cash needs. Surrender charges and possible IRS 10% early-withdrawal penalties before age 59½ make early access costly, reinforcing the suitability analysis a producer must document.

Bonus Credits, 1035 Exchanges, and Suitability Red Flags

A 1035 exchange lets an owner move funds from one annuity (or life policy) into a new annuity tax-free, but a new surrender-charge schedule usually restarts - so churning an existing annuity into a new variable contract purely to earn a commission is a classic unsuitable-replacement red flag the exam tests. Bonus (premium-enhancement) variable annuities add an up-front credit but typically pair it with higher fees and longer surrender periods, so the bonus is often recovered through charges.

Worked Numeric: Fee Drag Over Time

Assume subaccounts gross 7% but the contract charges 1.25% M&E plus 0.75% in fund expenses plus a 1.0% living-benefit rider - a 3% total drag. The owner's net return is roughly 4%, not 7%. Over 20 years on $100,000, the difference between 7% and 4% compounding is dramatic, which is why fee disclosure and a documented suitability analysis are mandatory. Variable annuities also offer a guaranteed minimum death benefit (GMDB) that pays the greater of account value or total premiums (less withdrawals) to a beneficiary, providing a floor the bare subaccount value lacks.