6.4 Variable Annuities

What makes an annuity "variable"

In a variable annuity the owner's premiums (net of charges) are invested in subaccounts — mutual-fund-like portfolios of stocks, bonds, and money-market instruments — held in the insurer's separate account. Unlike the general account, the separate account is not guaranteed: its value rises and falls with the underlying investments, and the owner bears all investment risk.

The trade-off versus a fixed annuity:

The variable annuity's purpose is to combat the purchasing-power (inflation) risk that erodes a fixed annuity's level payment, by giving the owner market participation.

Dual regulation and licensing

Because the owner assumes investment risk and the subaccounts are securities, a variable annuity is regulated as both an insurance product and a security. Consequences for the producer:

• A producer selling variable annuities must hold a state life insurance license and a FINRA securities registration (Series 6 for variable products and mutual funds, or Series 7 for general securities), with the SEC and FINRA in the regulatory picture alongside the state insurance department.
• The sale requires delivery of a prospectus — the disclosure document describing the subaccounts, fees, and risks — at or before solicitation.
• The separate account itself is registered with the SEC, and the insurer must follow both insurance and securities advertising/disclosure rules.

Trap

An insurance-only licensee may not solicit, recommend, or sell variable annuities. Selling a variable product without the required securities registration is a serious violation.

Accumulation units vs. annuity units

Variable contracts use two unit types, one for each phase.

• Accumulation units — purchased during the pay-in phase. Their number grows as the owner deposits money; their value floats with subaccount performance. Total accumulated value = number of accumulation units × current unit value.
• Annuity units — created at annuitization. The number is fixed at the moment of annuitization (based on the account value, the annuitant's age, and the assumed interest rate); thereafter only their dollar value floats. Each payment = fixed number of annuity units × current annuity unit value.

This is a frequently tested distinction: during accumulation the unit count changes and the value changes; during payout the unit count is locked and only the value changes.

The Assumed Interest Rate (AIR) and changing payments

The Assumed Interest Rate (AIR) is a conservative benchmark the insurer uses to set the first variable annuity payment and to value annuity units thereafter. After that, whether each payment rises, falls, or stays level depends on how actual separate-account performance compares to the AIR — not to the prior payment.

Worked example (AIR = 5%)

• Month 1: account earns 8%. 8% > 5% AIR → the next payment rises.
• Month 2: account earns 5%. Exactly equals the AIR → payment stays level (it does not fall just because the prior month was higher).
• Month 3: account earns 3%. 3% < 5% AIR → payment falls.

The classic trap: a 6% return one month followed by a lower but still above-AIR return the next month — many candidates wrongly say the payment falls. Compare against the AIR, not against last month's return.

Variable Annuity Regulation and the AIR in Depth

Like variable life, a variable annuity is a security, so the producer needs both an insurance license and a securities registration, the insurer must be SEC-registered, and a prospectus must precede or accompany the sale. The accumulation phase buys accumulation units whose value floats with the subaccounts; at annuitization those convert to a fixed number of annuity units, and each monthly payment equals that fixed unit count times the current annuity unit value. The payment therefore changes with markets, which is why the variable annuity transfers investment risk to the owner in both phases.

The assumed interest rate is the benchmark that decides whether each variable payment rises or falls, and the exam tests it relentlessly. If the actual subaccount return for the period exceeds the AIR, the next payment rises; if it equals the AIR, the payment stays level; if it falls below the AIR, the payment drops, even when the return is positive. Work the trap: with a 5% AIR, a month earning 8% raises the payment, and a following month earning 6% still beats the 5% AIR, so the payment rises again, just by less; only a return under 5% would cut it. Candidates routinely mistake a smaller-but-still-above-AIR return for a payment decrease.

Variable annuities also typically guarantee a minimum death benefit during accumulation, returning at least premiums paid if the annuitant dies before payout, and modern contracts add living-benefit riders such as guaranteed minimum income or withdrawal benefits for an extra fee.

Accumulation Units, Annuity Units, and Suitability

The two-unit mechanics are a reliable source of exam questions. During accumulation, each premium buys a number of accumulation units whose value floats daily with the chosen subaccounts, so the owner's balance is units times unit value and bears full market risk. At annuitization the contract converts the balance into a fixed number of annuity units; that count never changes, but each payment equals the fixed unit count times the current annuity unit value, which is why the income amount rises and falls with the markets in the payout phase too.

Because both phases carry market risk, a variable annuity suits a client with a long horizon and tolerance for fluctuation, not someone who needs a guaranteed, level retirement check. Add the regulatory overlay: the producer needs both insurance and securities licenses, must deliver a prospectus at or before solicitation, and must document a best-interest recommendation, so pitching a variable annuity to a conservative retiree who cannot tolerate a falling payment is the classic unsuitable-recommendation answer.