6.4 Variable Annuities
Key Takeaways
- In a variable annuity the owner allocates premium to separate-account subaccounts and bears all investment risk; the accumulation value is never guaranteed.
- Variable annuities are securities, requiring both a life insurance license and a Series 6/7 registration, SEC registration, and prospectus delivery.
- Indexed annuities are NOT securities and need only an insurance license, despite their market-linked returns.
- During payout the number of annuity units is fixed but unit value varies, so VA payments fluctuate.
- VAs carry layered fees (M&E, admin, subaccount, riders) often totaling 2%-3%+, and gains are taxed LIFO as ordinary income with a 10% pre-59 1/2 penalty.
How Variable Annuities Work
In a variable annuity (VA), the owner allocates premium among subaccounts (stock, bond, balanced, money-market funds) held in the insurer's separate account. The contract value rises and falls with subaccount performance, so the owner bears all investment risk - the account can lose value, including principal. The trade-off is higher growth potential than fixed or indexed annuities.
The separate account is legally insulated from the insurer's general creditors, and it is valued daily. Because the value depends on securities performance, a VA is a security as well as an insurance product. That dual nature drives the licensing rule below.
| Account | Used For | Who Bears Risk |
|---|---|---|
| General account | Fixed annuities | Insurer |
| Separate account | Variable annuities | Owner |
Trap: A variable annuity has guarantees only on the insurance elements (e.g., a death benefit or an optional living-benefit rider). The accumulation value itself is never guaranteed - that is what makes it variable.
Licensing and Disclosure (Dual Regulation)
Because a VA is both insurance and a security, selling it requires two licenses:
- A state life insurance license, and
- A securities (FINRA) registration - typically Series 6 or Series 7 - plus affiliation with a broker-dealer.
Fixed and indexed annuities, by contrast, need only the insurance license. The product is registered with the SEC, FINRA oversees the registered representative, and the buyer must receive a prospectus at or before the sale. The prospectus discloses fees, subaccount options, risks (including possible loss of principal), the death benefit, surrender charges, and tax treatment.
Trap: "Which annuity requires a securities license?" The answer is always the variable annuity. Indexed annuities, despite market-linked returns, are NOT securities because principal is protected - so they need only an insurance license.
Units, Fees, and Suitability
Accumulation Units vs. Annuity Units
During accumulation, premiums buy accumulation units - the number purchased varies with the current unit value, and total value = units x unit value. At annuitization, accumulation units convert to a fixed number of annuity units. From then on the number of annuity units stays constant, but each unit's value (and thus the payment) varies with subaccount performance.
Trap: In the payout phase of a VA, the number of annuity units is fixed; the unit value - and therefore the monthly check - fluctuates. This is the single most-tested VA mechanics point.
Layered Fees
| Fee | Typical Range | Covers |
|---|---|---|
| Mortality & expense (M&E) | 0.50%-1.50% | Insurance guarantees |
| Administrative | 0.10%-0.30% | Contract servicing |
| Subaccount management | 0.50%-1.50% | Investment management |
| Rider charges (GMIB/GMWB/GMAB) | 0.50%-1.50% | Optional living benefits |
All-in costs commonly reach 2%-3%+ annually, materially higher than fixed annuities. Optional living-benefit riders (Guaranteed Minimum Income, Withdrawal, or Accumulation Benefits) add guarantees - and fees. VA gains are eventually taxed as ordinary income, not capital gains, and withdrawals follow the same LIFO and 10% pre-59 1/2 penalty rules as other annuities.
Suitability
VAs fit clients with a long time horizon and moderate-to-high risk tolerance who have already used tax-advantaged accounts. They are unsuitable for risk-averse, short-horizon, or cost-sensitive buyers - and replacing one annuity with another must clear a suitability and replacement review so the client is not churned into a fresh surrender period.
Living-Benefit Riders and Death Benefits
VA optional living-benefit riders address the owner's fear of losing money in the separate account by layering a guarantee on top, for an extra fee.
| Rider | Guarantee |
|---|---|
| GMIB (income benefit) | A minimum income base at annuitization regardless of account losses |
| GMWB (withdrawal benefit) | A minimum annual withdrawal amount for a set period or life |
| GMAB (accumulation benefit) | A minimum account value after a holding period |
Death benefits also vary: a return-of-premium death benefit pays the greater of account value or premiums paid; a stepped-up benefit locks in market gains on anniversaries; a roll-up grows the benefit base at a stated rate. Each guarantee adds cost and reduces net return.
The Bonus-Annuity and 1035 Replacement Trap
A VA "bonus" credit or free-look incentive often funds itself through higher M&E charges or a longer surrender schedule. Replacing an existing annuity to capture a bonus can restart surrender charges and trigger new fees - exactly the churning that FINRA and state suitability rules target.
Variable Annuity Taxation Recap
Deferred earnings are untaxed until withdrawn, then taxed as ordinary income under LIFO, with a 10% penalty before 59 1/2. There is no capital-gains treatment and no step-up in basis at death for the gain, so heirs owe income tax on the deferred earnings (income in respect of a decedent).
Dual Regulation, Licensing, and the Separate Account
Because a variable annuity passes investment risk to the owner, it is a security as well as an insurance product, so the producer must hold both a state insurance license and a FINRA registration (Series 6 or 7) and the contract is sold with a prospectus. Premiums flow to the insurer's separate account, which is registered with the SEC and insulated from the insurer's general creditors. This dual nature is one of the most heavily tested facts about variable contracts.
| Requirement | Variable annuity |
|---|---|
| Insurance license | Required |
| FINRA registration | Required (Series 6 or 7) |
| Disclosure | Prospectus |
| Account | SEC-registered separate account |
Accumulation Units, Annuity Units, and AIR
During pay-in, premiums buy accumulation units whose value floats with the subaccounts. At annuitization the value converts to a fixed number of annuity units; each payment then equals that fixed unit count times the current unit value, which is recalculated against an Assumed Interest Rate (AIR). If actual subaccount performance beats the AIR, the next payment rises; if it lags the AIR, the payment falls.
Worked AIR Payment Calculation
Assume an AIR of 4%. In a month where the subaccounts return 6%, performance exceeds the AIR, so the next annuity payment increases. In a month returning 2%, performance trails the AIR, so the payment decreases, even though the market still rose. The AIR is a benchmark, not a guarantee, and comparing actual return to the AIR -- not to zero -- determines whether the variable payout climbs or drops.
Living and Death Benefit Riders
Variable annuities often add guaranteed minimum income, withdrawal, or accumulation benefit riders and a guaranteed minimum death benefit that pays beneficiaries at least premiums paid, for an extra charge.
Additional Exam Traps
- A variable annuity requires both an insurance license and a FINRA registration plus a prospectus.
- Payments rise or fall depending on whether return beats the AIR, not zero.
- The separate account is SEC-registered and shielded from the insurer's general creditors.
An agent holds only a state life insurance license. Which annuity may the agent legally solicit and sell?
During the payout phase of a variable annuity, which statement is correct?