6.4 Variable Annuities

What Makes an Annuity "Variable"

A variable annuity (VA) places the owner's premium in a separate account divided into subaccounts (stock, bond, money-market funds) chosen by the owner. The owner bears the investment risk - there is no guaranteed principal and no guaranteed minimum interest rate. Because returns depend on securities, a variable annuity is regulated as both an insurance product and a security.

This dual nature drives the licensing rule the exam loves: to sell a variable annuity a producer needs a life insurance license and FINRA registration (Series 6 or 7) plus a state securities (Series 63) license. The separate account is registered with the SEC under the Investment Company Act, and prospectus delivery is mandatory.

The separate account is legally insulated from the insurer's general creditors, so subaccount assets belong to contract owners even if the carrier becomes insolvent - a key contrast with fixed annuities held in the general account. The owner directs allocation among subaccounts and may make tax-free transfers between them. Because the owner shoulders all market risk and pays multiple layered fees, a variable annuity is generally suitable only for buyers with a long time horizon, tolerance for loss, and a desire for tax-deferred growth beyond what an IRA or 401(k) already provides.

Accumulation Units vs. Annuity Units

The two-phase structure works differently than a fixed annuity:

• Accumulation phase: each premium buys accumulation units, whose value floats with the subaccounts. The number of units grows as you invest; the value per unit changes daily.
• Annuitization phase: accumulation units are converted into a fixed number of annuity units. From then on the number of annuity units never changes, but the dollar value of each unit fluctuates with subaccount performance - so the monthly check varies.

This is a top exam point: during payout, the number of annuity units is fixed; the value per unit (and thus the payment) varies. Mixing this up is a classic distractor.

The Assumed Interest Rate (AIR)

The Assumed Interest Rate (AIR) is a benchmark the insurer uses to compute the first variable annuity payment and to test each later payment. It is not a guaranteed return - it is a hurdle rate.

The rule for whether the next check rises or falls:

• Actual subaccount return > AIR -> next payment increases.
• Actual subaccount return = AIR -> next payment stays the same.
• Actual subaccount return < AIR -> next payment decreases.

Worked example: AIR is 4%. If the subaccount earns 6% this period, 6% > 4%, so the next payment goes up. The following period it earns 4% exactly, so that payment is unchanged from the prior (higher) level. Then it earns 2%; 2% < 4%, so the payment drops. Students wrongly assume a payment rises whenever the account simply earns money - it only rises when earnings beat the AIR.

Taxation and Charges

Variable annuities grow tax-deferred; gains are taxed as ordinary income (not capital gains) on withdrawal, with the exclusion ratio applying to annuitized non-qualified contracts and LIFO ordering (interest out first, then basis) applying to pre-annuitization withdrawals. Withdrawals before 59 1/2 add the 10% IRS penalty on the taxable amount.

Typical VA charges include:

• Mortality & expense (M&E) risk charge - covers the death-benefit guarantee and expense guarantees.
• Administrative fee and subaccount/fund management fees.
• Surrender charges during the surrender period.

Many VAs add a guaranteed minimum death benefit (GMDB) - the beneficiary receives at least total premiums (or a stepped-up value) even if subaccounts fell. Living benefit riders (GMIB, GMWB, GMAB) guarantee minimum income, withdrawals, or accumulation regardless of market performance, for an extra fee.

Distinguish the three living benefits: GMIB guarantees a minimum future income base for annuitization; GMWB guarantees a minimum percentage you may withdraw each year even if the account drops to zero; and GMAB guarantees a minimum accumulation value at the end of a set period. Each rider raises the contract's total expense, so the M&E plus rider charges can exceed 2-3% annually - a fee load the producer must disclose and weigh against the value of the guarantee.

Suitability and the 1035 Exchange

Because VAs carry market risk and high fees, suitability is heavily regulated (FINRA Rule 2330 requires reasonable basis that the VA - and any subaccount allocation or exchange - fits the customer's age, income, risk tolerance, and time horizon). Recommending a VA to a very elderly client needing liquidity, or replacing a contract solely to generate commission (churning/twisting), is a violation.

A Section 1035 exchange lets an owner swap one annuity for another (or life-to-annuity) without triggering current income tax, carrying the cost basis forward. Note the one-way rule: you may exchange life to an annuity tax-free, but not an annuity to life insurance. Always evaluate surrender charges and new surrender periods before recommending a 1035 exchange.

Under a valid Section 1035 exchange the funds must pass directly between insurers (the owner never takes constructive receipt); handing the client a check breaks the exchange and triggers tax. A replacement that resets a new multi-year surrender schedule, adds higher fees, or sacrifices a valuable existing rider for no clear benefit is a red flag for unsuitable replacement.

Producers must complete state replacement forms, deliver required disclosures, and document the comparative benefit. The exam rewards answers that weigh the new contract's features against the surrender charges and lost guarantees of the old one rather than assuming any exchange is automatically advantageous.