6.4 Variable Annuities

What Makes an Annuity "Variable"

A variable annuity places premiums in the insurer's separate account, where the owner directs the money into subaccounts that function like mutual funds (stocks, bonds, money market). The owner — not the insurer — bears the investment risk, so the account value and ultimately the income payments rise and fall with market performance.

Variable annuities were designed to combat the purchasing-power (inflation) risk of fixed annuities. By keeping assets in equities, the contract gives the annuitant a chance to keep pace with or beat inflation — at the cost of no guaranteed principal or rate.

Dual Licensing and Regulation

Because the value depends on securities, a variable annuity is both an insurance product and a security. This creates the most-tested licensing rule in the topic:

• The producer must hold a life insurance license (state insurance department), and
• A FINRA registration (Series 6 or Series 7), and the firm must be a registered broker-dealer.

Variable products are regulated by state insurance departments, FINRA, and the SEC. The owner must receive a prospectus before or at the time of solicitation. The separate account is registered as an investment company. Recommendations are subject to FINRA suitability and Reg BI best-interest standards.

Accumulation Units and Annuity Units

A variable annuity measures value in units rather than dollars, and the exam draws a sharp line between two:

Key distinction: during accumulation, the number of accumulation units changes as you add money. At annuitization the units are converted to a fixed number of annuity units; thereafter the number stays fixed but the value per unit fluctuates, so each income check varies in dollar amount.

The AIR and How Payments Move

The size of each variable payment is governed by the Assumed Interest Rate (AIR) — a benchmark, not a guarantee, used to set the initial payment and to gauge subsequent ones:

• If actual subaccount performance exceeds the AIR, the next payment rises.
• If performance equals the AIR, the payment stays the same.
• If performance is below the AIR, the payment falls.

Worked example: AIR is 4%. In a month the subaccount earns 6%. Because 6% > 4%, the next annuity payment increases. The following month it earns 2%; because 2% < 4%, the payment decreases relative to the prior one — even though the account still earned money. The comparison is always actual vs. AIR, not actual vs. zero.

Taxation of Annuities (applies to all types)

Annuity earnings grow tax-deferred; tax is due when money comes out. Key national tax rules:

• Nonqualified annuity (after-tax dollars): only the gain is taxable as ordinary income; the principal returns tax-free. The exclusion ratio determines the tax-free portion of each annuitized payment.
• LIFO ordering: on a withdrawal from a deferred annuity, the IRS treats interest (gain) as coming out first and fully taxable.
• 10% IRS penalty applies to taxable amounts withdrawn before age 59½ (with exceptions like death or disability).
• Exclusion ratio = Investment in the contract ÷ Expected return. Example: $100,000 cost, $200,000 expected return → ratio 0.50, so 50% of each payment is tax-free return of principal and 50% is taxable gain.

1035 Exchanges and Living Benefit Riders

Under IRC Section 1035, an owner may exchange one annuity for another (or a life policy for an annuity) without triggering current income tax on the gain. The transfer must be insurer-to-insurer; you can move life-to-annuity, but never annuity-to-life (that direction is not tax-free). This lets clients upgrade to a better contract without a taxable event.

Modern variable annuities add living benefit riders for extra cost:

• GMIB (Guaranteed Minimum Income Benefit) — guarantees a minimum annuitization income floor regardless of market losses.
• GMWB (Guaranteed Minimum Withdrawal Benefit) — guarantees the owner can withdraw a set percentage annually until principal is recovered.
• GMAB (Guaranteed Minimum Accumulation Benefit) — guarantees a minimum account value at a future date.

Bonus Annuities and Replacement Cautions

Some variable and indexed contracts offer a bonus (premium-enhancement) that adds a percentage (e.g., 3%–5%) to deposits up front. The exam flags these as a suitability concern: the bonus is typically recovered through longer surrender periods, higher fees, or lower caps, so the headline bonus rarely makes a replacement worthwhile by itself.

Producers must follow replacement regulations — providing required notices and a side-by-side comparison — whenever a new annuity replaces an existing one, and must document why the exchange is in the client's best interest. Replacing a contract solely to earn a new commission, or to capture a bonus that is offset by a fresh surrender schedule, is a classic unsuitable-recommendation trap and a frequent disciplinary fact pattern.

Finally, note that the variable annuity's separate account assets are insulated from the insurer's general creditors, an added protection for the owner. But that same separation means there is no guarantee of principal: the value the owner sees reflects the subaccounts directly, which is why the prospectus and ongoing suitability supervision are mandated.