6.4 Variable Annuities

Variable Annuities: Investment Risk on the Owner

A variable annuity (VA) is the opposite of a fixed annuity: the owner bears the investment risk. Premiums are placed in the insurer's separate account and invested in subaccounts (mutual-fund-like portfolios of stocks, bonds, money market) chosen by the owner. The account value — and ultimately the income — rises and falls with subaccount performance. There is no guaranteed minimum interest rate on the basic contract; the company makes no promise about market returns.

The purpose is to combat the inflation/purchasing-power weakness of fixed annuities. Over time, equity growth can keep income ahead of inflation — but with the risk that payments can also fall.

Separate Account vs. General Account

Trap: A variable annuity is both an insurance product and a security. The producer must hold a life license, be FINRA-registered, AND deliver a prospectus at or before solicitation. Selling a VA without securities registration is an exam-favorite violation.

Accumulation Units and Annuity Units

The mechanics use two unit types — a classic exam point:

• Accumulation units — during the pay-in period, premiums buy a variable number of accumulation units; the value per unit fluctuates with the separate account. More units accumulate as you contribute.
• Annuity units — at annuitization, accumulation units convert to a fixed number of annuity units. From then on, the number of units is fixed, but the dollar value per unit still fluctuates, so each payment varies with market performance.

Think: during accumulation the number of units changes; during payout the value of each unit changes.

AIR — Assumed Interest Rate

Variable income payments are benchmarked to an Assumed Interest Rate (AIR) — a conservative target return used to set the first payment and to gauge subsequent ones:

• If actual separate-account 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 next payment falls.

Worked example: AIR is 4%. If the subaccount earns 6% this period, the next check increases. If it earns 4%, the check is unchanged. If it earns 2%, the check decreases — even though the account still earned money, it underperformed the AIR benchmark.

Charges, Riders, and Suitability

VAs carry layered fees: mortality & expense (M&E) charges, administrative fees, subaccount management fees, and surrender charges. Common guarantees sold as riders include a GMIB (guaranteed minimum income benefit) and a GMWB (guaranteed minimum withdrawal benefit), which provide income floors for an extra cost.

Because VAs are complex securities, suitability rules are strict. Producers must document that the recommendation fits the client's age, risk tolerance, time horizon, liquidity needs, and tax situation. Replacing an existing annuity with a new one (a 1035 exchange) must be justified — churning a senior into a fresh surrender-charge schedule is a serious, frequently tested violation.

Taxation of Variable Annuities

Despite the market exposure, a VA is still an annuity for tax purposes: growth is tax-deferred, withdrawals are LIFO (earnings first, taxed as ordinary income), and the 10% IRS penalty applies before age 59 1/2. Gains are never taxed as capital gains — a key reason to weigh a VA against a plain taxable investment account, which would get preferential capital-gains rates. A 1035 exchange lets an owner swap one annuity for another (or life-to-annuity) without triggering current tax.

Valid 1035 Exchanges

Section 1035 allows tax-free exchanges only in permitted directions. Memorize which way value may flow:

Trap: You can roll a life policy into an annuity, but you can never roll an annuity into life insurance — that would convert taxable annuity gains into a tax-free death benefit, which the IRS prohibits. Annuity-to-annuity and life-to-annuity are the most-tested valid exchanges.

Death Before Annuitization and Bonus Annuities

If the owner of a deferred VA dies during accumulation, the contract generally pays the beneficiary at least the greater of account value or total premiums paid (a common death-benefit guarantee), and the gain is taxable ordinary income to the beneficiary — there is no step-up in basis as with stocks. Bonus (premium-enhancement) annuities that credit an upfront percentage usually offset it with longer surrender schedules and higher M&E fees.

Exam Tip: A 'bonus' rarely creates free money — scrutinize the longer surrender period and higher ongoing charges, especially when a senior is being moved from an existing contract.

Living-Benefit Riders Compared

Modern VAs are sold heavily on optional living-benefit riders that re-introduce guarantees an owner gives up by bearing market risk:

• GMIB (Guaranteed Minimum Income Benefit) — guarantees a minimum annuitized income base regardless of market losses.
• GMWB (Guaranteed Minimum Withdrawal Benefit) — guarantees a minimum annual withdrawal (e.g., 5%) until principal is recovered, even if the account falls.
• GMAB (Guaranteed Minimum Accumulation Benefit) — guarantees a minimum account value at a future date.

Each rider adds an annual fee (often 0.5%-1.5%) on top of M&E charges, so total VA costs frequently exceed 2.5%-3% per year. Suitability analysis must weigh these fees against the value of the guarantee for the specific client.

Variable Annuity vs. Mutual Fund

A frequent exam comparison pits a VA against simply buying mutual funds in a taxable account:

• VA advantage — tax-deferred growth, optional living/death-benefit guarantees, and lifetime annuitization.
• VA disadvantage — higher layered fees, surrender charges, and gains taxed as ordinary income (mutual-fund long-term gains get preferential capital-gains rates).

Trap: For a client in a high tax bracket with a long horizon, the deferral can win; for a client who would otherwise hold long-term capital-gain investments, the VA may actually increase the eventual tax rate on gains. This ordinary-income-vs-capital-gains contrast is a classic test point.