6.4 Variable Annuities

What Makes an Annuity "Variable"

A variable annuity (VA) lets the owner direct premiums into investment subaccounts (similar to mutual funds) held in the insurer's separate account. Because values rise and fall with subaccount performance, the owner bears all the investment risk and the insurer makes no guarantee of principal or return during accumulation.

This is the defining contrast with fixed annuities:

Because a VA is both an insurance product and a security, it is dually regulated by the state insurance department and by the SEC/FINRA, and the prospect must receive a prospectus before or at the time of solicitation.

Licensing and Suitability

To sell variable annuities an agent must hold both a state life insurance license and a securities registration:

Under FINRA Rule 2111 (suitability), the representative must have a reasonable basis to believe the recommendation fits the customer's investment profile - age, income, risk tolerance, time horizon, and objectives - and must document that basis. Recommending a long-surrender-charge variable annuity to an elderly client with a short time horizon is a classic unsuitability violation.

Separate Account, Sub-Accounts, and Required Licensing

A variable annuity places premiums in the insurer's separate account, divided into sub-accounts that function like mutual funds. Because the contract value rises and falls with the sub-accounts, the investment risk shifts to the owner, and the product is a security. Selling it requires a state insurance license plus FINRA registration (Series 6 or 7) and delivery of a prospectus.

AIR and the Annuity Unit

During payout, variable income is based on an Assumed Interest Rate (AIR) - a benchmark used to set the first payment and measure later performance.

Worked example: AIR is 4%. If sub-account performance is 6%, the next variable annuity payment rises; if it is 2%, the payment falls. The number of annuity units is fixed at annuitization, but each unit's value floats, so the dollar income varies.

Trap: the accumulation unit measures value during the pay-in phase; the annuity unit measures income during payout. Mixing these terms is a common exam miss. Guarantees in a variable annuity (death benefit floors, living-benefit riders) come from the general account, not the separate account.

Variable-Annuity Suitability, Surrender, and Living Benefits

Because the owner bears market risk, variable annuities carry suitability scrutiny: they suit clients with a long horizon and tolerance for fluctuation, not those needing guaranteed principal soon. Many contracts add living-benefit riders - a Guaranteed Minimum Income Benefit (GMIB) or Guaranteed Minimum Withdrawal Benefit (GMWB) - that promise a floor of income or withdrawals regardless of sub-account performance, funded from the general account.

Worked trap: a GMWB guarantees a withdrawal floor but is not the same as the account value; markets can drop the account below the guaranteed base while the rider still pays the promised withdrawals. Surrender charges and rider fees reduce returns, so over-recommending riders can itself be a suitability concern.

Accumulation Units, Annuity Units, and the AIR

During accumulation, premiums buy accumulation units whose value floats with subaccount returns. At annuitization, accumulation units convert to a fixed number of annuity units. The number of annuity units stays constant; the dollar value of each unit varies each period.

The size of each variable payment is benchmarked to an Assumed Interest Rate (AIR) - a conservative projection set in the contract:

Worked example: the AIR is 5%. If the separate account earns 8%, the next annuity payment rises. If it earns only 3%, the next payment falls - even though the number of annuity units never changed. The AIR is a yardstick, not a guarantee.

Living Benefits, Death Benefits, and Taxation

Insurers add optional riders (at extra cost) that reintroduce guarantees:

Taxation mirrors other annuities: growth is tax-deferred, withdrawals from nonqualified contracts are LIFO (gain first, ordinary income), a 10% penalty applies before age 59 1/2, and annuitized payments use the exclusion ratio. A Section 1035 exchange can move a variable annuity to another annuity tax-free. Note: although subaccounts hold equities, gains are taxed as ordinary income, not at capital-gains rates - a frequently tested trap.