6.4 Variable Annuities

What a Variable Annuity Is

A variable annuity (VA) lets the owner direct premiums into separate-account subaccounts — portfolios of stocks, bonds, or money-market instruments. Unlike a fixed annuity, the insurer makes no guarantee of principal or interest; the contract value rises and falls with subaccount performance, so the owner (annuitant) bears the investment risk. The reward for accepting that risk is the potential for returns that outpace inflation over a long accumulation period.

Because the value is held in the separate account (not the insurer's general account) and is subject to market risk, a variable annuity is both an insurance product and a security. To sell one, a producer needs both a state life insurance license and a FINRA securities registration (typically Series 6 or 7 plus a Series 63), and the insurer must deliver a prospectus. This dual-regulation point is one of the most heavily tested facts on the exam.

Accumulation Units vs. Annuity Units

A variable annuity measures value in two kinds of units, and confusing them is a classic trap:

So during accumulation the number of units varies; during payout the number is fixed but the value per unit varies. The income check therefore changes month to month based on an assumed interest rate (AIR) versus actual separate-account performance.

The Assumed Interest Rate (AIR) and Payment Changes

The AIR is a benchmark used to calculate the first variable annuity payment and to test future payments. The rule the exam loves:

• If actual subaccount 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 payment falls.

Worked example: with a 4% AIR, if the separate account earns 6%, the next check increases (6% > 4%). If it earns exactly 4%, the check is unchanged. If it earns 2%, the check decreases (2% < 4%) — even though the account still earned a positive return. The comparison is always actual return versus the AIR, not versus zero. This is why a variable annuitant can see a smaller check in a year the market was up modestly.

Sales Suitability, Exchanges, and the MEC Trap

Variable annuities are long-term retirement vehicles, so suitability rules are strict. A 1035 exchange lets an owner swap one annuity (or life policy) for another annuity without triggering current tax, but agents must justify any exchange that resets surrender charges — unjustified swaps are a regulatory red flag (twisting/churning).

Watch the Modified Endowment Contract (MEC) 7-pay rule when annuities and life insurance are compared: a life insurance policy funded faster than the 7-pay limit becomes a MEC, losing FIFO/tax-free-loan treatment so withdrawals are taxed LIFO (earnings first) with a possible 10% penalty before age 59 1/2. Annuities are already LIFO and always penalty-exposed before 59 1/2 on the gain — they never enjoyed life-insurance FIFO treatment. Distinguish: the MEC test applies to life insurance, while annuity gains are inherently LIFO/penalty-taxed.

General Account vs. Separate Account

The general account holds an insurer's guaranteed-product reserves (fixed annuities, traditional life) and is invested conservatively; the insurer guarantees those values and bears the risk. The separate account holds variable-product funds segregated from general creditors; its performance flows directly to contract owners, who therefore bear the risk and the reward.

This distinction drives regulation. General-account products are regulated by the state insurance department only. Separate-account variable products are also regulated as securities by the SEC and FINRA. A variable annuity buyer must receive a prospectus (not merely a buyer's guide), and the selling producer needs securities registration in addition to the life license — the single most-tested compliance fact about variable contracts.

Bonus Annuities, Riders, and Suitability Red Flags

Variable annuities are sold with optional living-benefit riders at extra cost:

• GMIB (guaranteed minimum income benefit): guarantees a floor on the future annuitization income regardless of subaccount losses.
• GMWB (guaranteed minimum withdrawal benefit): guarantees the return of premium through periodic withdrawals.
• GMAB (guaranteed minimum accumulation benefit): guarantees a minimum account value at a future date.

A bonus (premium-enhancement) annuity credits an upfront bonus but typically offsets it with higher fees and longer surrender periods. Selling a variable annuity inside a tax-qualified plan (like an IRA) purely for the annuity wrapper is a classic suitability red flag, because the IRA already provides tax deferral — the annuity's deferral adds no benefit and layers on extra cost. Producers must document why the recommendation suits the client's time horizon and risk tolerance.

Securities Regulation and Suitability of Variable Annuities

A variable annuity is both an insurance product and a security, so it is dual-regulated: the producer must hold a life insurance license AND a FINRA securities registration (Series 6 or 7), and the contract is sold with a prospectus. Premiums go into the insurer's separate account, invested in subaccounts (stock, bond, money-market) chosen by the owner, who bears all investment risk — values can rise or fall, and there is no guaranteed minimum interest on the base contract.

Riders That Add Guarantees

Because the base contract has no guarantees, insurers sell living-benefit riders at extra cost:

• GMIB (guaranteed minimum income benefit) — guarantees a minimum annuitization income floor.
• GMWB (guaranteed minimum withdrawal benefit) — guarantees a withdrawal stream regardless of account performance.
• GMAB (guaranteed minimum accumulation benefit) — guarantees a minimum account value at a future date.

Trap: Suitability turns on the client's risk tolerance and time horizon; recommending a variable annuity to a risk-averse retiree seeking guaranteed income is a suitability violation.