6.4 Variable Annuities

Variable Annuities

A variable annuity (VA) allows the owner to allocate premium among investment subaccounts (similar to mutual funds) held in the insurer's separate account. Because returns track market performance, the owner bears the investment risk - there is no guaranteed minimum credited rate on the base contract.

Dual Regulation

A variable annuity is both an insurance product and a security. To sell one, a producer must hold:

• A state life insurance license, AND
• A securities registration (FINRA Series 6 or 7 plus, in most states, a Series 63), and the issuer must deliver a prospectus.

The separate account is registered with the SEC and regulated under federal securities law in addition to state insurance law. This dual regulation is a frequent exam point.

Accumulation Units vs. Annuity Units

The exam consistently tests the unit mechanics:

• During accumulation, premiums buy accumulation units. The NUMBER of units changes with each purchase, and the VALUE per unit fluctuates with subaccount performance. Account 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 the VALUE per unit varies - so the income payment fluctuates each period.

Exam tip: Memorize the contrast. Accumulation phase: number of units VARIES. Payout phase: number of annuity units is FIXED, unit VALUE varies. Both phases involve fluctuating value, never a guaranteed dollar payment on the base VA.

The Assumed Interest Rate (AIR)

When a variable annuity is annuitized, the first payment is set using an assumed interest rate (AIR) - a benchmark return the insurer assumes:

• 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.

The AIR is a hurdle rate, not a guarantee. A common error is to think a high AIR is always better; a high AIR produces a larger first check but makes future increases harder to achieve.

Worked Example: AIR and the Next Payment

A VA pays $1,000 this month with an AIR of 4% (annualized). If the subaccount returns the equivalent of 6% for the period, performance beat the AIR, so the next payment rises above $1,000. If the subaccount returns only 2%, performance lagged the 4% AIR, so the next payment falls below $1,000. If it returns exactly 4%, the payment stays at $1,000.

Living and Death Benefit Riders

VAs are often sold with optional, fee-bearing guarantees that override the no-guarantee base contract:

These riders add cost (often 1%+ annually) and reduce net return - a suitability factor.

Taxation Note (carryover from accumulation)

Non-qualified annuity gains accumulate tax-deferred and are taxed as ordinary income, never capital gains. Withdrawals are LIFO - gains come out first and are taxable - and a 10% penalty applies to the taxable portion withdrawn before age 59 1/2. There is no step-up in basis at death for a non-qualified annuity; the beneficiary owes income tax on the gain.

Subaccounts and the Separate Account

The separate account holds the subaccounts the owner selects - equity, bond, balanced, and money-market options resembling mutual funds. Because separate-account assets are not part of the insurer's general account, they are generally shielded from the insurer's creditors, but they carry full market risk for the owner.

During accumulation the owner may move money among subaccounts. Transfers between subaccounts are not taxable events (the contract is the tax wrapper), unlike selling and rebuying mutual funds in a taxable account.

Variable Annuity Fees

VAs carry layered charges the exam expects you to recognize:

Total annual costs often exceed 2%-3%, which directly reduces net return and is central to any suitability analysis.

Sales-Practice and Disclosure Rules

Because a VA is a security, the producer must deliver a prospectus before or at the point of sale and make a suitability determination under both NAIC and FINRA standards. Improper practices the exam tests include:

• Switching - churning VAs to generate commissions.
• Recommending a VA to a client with a short time horizon or no risk tolerance.
• Selling a tax-deferred annuity inside an already tax-deferred IRA solely for the deferral, with no other benefit.

Annuitization Recap

At annuitization the owner trades the account value for income based on age, payout option, and the AIR. The decision is irrevocable. Many owners instead take systematic withdrawals to retain control and a death benefit, accepting that systematic withdrawals carry no lifetime-income guarantee.