6.4 Variable Annuities
Key Takeaways
- In a variable annuity the owner bears the investment risk, with premiums invested in separate-account subaccounts whose value fluctuates.
- A variable annuity is both insurance and a security, requiring a life license plus a securities registration and delivery of a prospectus.
- Accumulation units grow in number during pay-in; annuity units are fixed in number at annuitization while their dollar value varies.
- Variable payments rise only when actual performance exceeds the Assumed Interest Rate (AIR); a positive return below the AIR still lowers the check.
What Makes a Variable Annuity Different
A variable annuity (VA) lets the owner direct premiums into separate-account subaccounts (stock, bond, and money-market portfolios resembling mutual funds). The contract value and the resulting income fluctuate with investment performance. Critically, the owner bears the investment risk — the opposite of a fixed annuity, where the insurer bears it.
Because the owner's money is invested in securities, a VA is both an insurance product and a security. The producer must hold a life insurance license AND a securities (FINRA) registration (typically Series 6 or 7 plus Series 63), and the sale is regulated by both the state insurance department and the SEC/FINRA. A prospectus must be delivered to the buyer.
| Feature | Fixed Annuity | Variable Annuity |
|---|---|---|
| Investment risk | Insurer | Owner |
| Account | General account | Separate account |
| Payout dollars | Level | Fluctuate with subaccounts |
| Inflation hedge | Weak | Potentially strong |
| Licensing | Life only | Life + securities registration |
| Disclosure | None special | Prospectus required |
The separate account is insulated from the insurer's general creditors and is not part of the general account, which is why investment gains and losses pass through directly to the owner rather than being smoothed by the insurer.
Accumulation Units and Annuity Units
A VA measures value in two kinds of units the exam tests directly:
- Accumulation units — used during the accumulation phase. Each premium buys units at the current unit value, so the number of units grows as deposits continue, while the dollar value per unit varies daily with the subaccounts.
- Annuity units — fixed at annuitization. The number of annuity units is set and stays level; only the dollar value per unit fluctuates, so each income check varies in size period to period.
Worked Numeric — AIR and the Variable Payout
After annuitization, each payment moves up or down depending on whether actual separate-account performance beats the Assumed Interest Rate (AIR) — a benchmark, not a guarantee.
| Period | Actual return | AIR | Result on next check |
|---|---|---|---|
| 1 | 8% | 5% | Check increases (8% > AIR) |
| 2 | 5% | 5% | Check unchanged (5% = AIR) |
| 3 | 3% | 5% | Check decreases (3% < AIR) |
Rule to memorize: the payment rises only when actual performance exceeds the AIR, stays flat when it equals the AIR, and falls when it is below the AIR — even a positive 3% return lowers the check if the AIR is 5%. This is a classic trap: a positive return can still reduce the payment.
Common VA Riders and Charges
- Guaranteed Minimum Income Benefit (GMIB) and Guaranteed Minimum Withdrawal Benefit (GMWB) — guarantee a floor income or withdrawal despite market losses, for an extra fee.
- Mortality and expense (M&E) charge, administrative fees, and subaccount management fees make VAs the highest-cost annuity type.
- Death benefit during accumulation — the beneficiary receives the greater of current value or total premiums paid, protecting heirs from a market dip.
Suitability Trap
A VA's tax deferral is redundant inside an IRA or 401(k), because those accounts are already tax-deferred. Recommending a high-fee VA solely for tax deferral inside a qualified plan is a classic unsuitable sale flagged on exams. Likewise, a VA is generally unsuitable for a risk-averse client who needs guaranteed level income — that client wants a fixed annuity. Always match product risk to client objectives and time horizon.
The Two Sub-Phases of Risk
During accumulation, a VA owner can lose principal because the subaccounts can fall in value — there is no guaranteed minimum on the bare contract. During the payout phase, the income amount fluctuates with the AIR comparison, so even an annuitized VA does not pay a level check. This dual exposure is why a VA carries securities regulation: the owner shoulders market risk in both phases.
| Phase | What fluctuates | Who bears the risk |
|---|---|---|
| Accumulation | Number x value of accumulation units | Owner |
| Payout | Dollar value per annuity unit | Owner |
Worked Numeric: Accumulation Units
An owner deposits $300 when the accumulation unit value is $12.00, buying $300 / $12.00 = 25 units. The next month the unit value rises to $15.00; a second $300 deposit buys $300 / $15.00 = 20 units. After two deposits the owner holds 45 units, and the account value is 45 x $15.00 = $675 versus $600 contributed. Notice the number of units changes with each deposit — this is the hallmark of the accumulation phase, the opposite of the fixed number of annuity units established at annuitization.
Disclosure and Replacement
VA sales require a current prospectus and trigger replacement rules if the buyer is funding the VA by surrendering an existing annuity or life policy; the producer must document why the exchange benefits the client. A 1035 exchange can move value from one annuity to another (or from life insurance to an annuity) tax-free, but never from an annuity back into life insurance.
A variable annuity is annuitized with an Assumed Interest Rate (AIR) of 5%. In a month the separate account actually earns 3%. What happens to the next income payment?
Which licensing is required to sell a variable annuity?