6.4 Variable Annuities

How Variable Annuities Work

A variable annuity (VA) lets the owner direct premium into investment subaccounts (mutual-fund-like portfolios of stocks and bonds). The contract value rises and falls with subaccount performance, so the owner - not the insurer - bears the investment risk. There is no guaranteed minimum interest rate on the basic contract; the trade-off for that risk is the potential to keep pace with or outrun inflation, the main weakness of fixed annuities.

Separate Account and Securities Status

Variable subaccount assets are held in the insurer's separate account, kept apart from the general account. Because returns are not guaranteed and the value depends on securities, a variable annuity is both an insurance product and a security. This dual nature drives the licensing rule.

Licensing, Disclosure, and Fees

Dual Licensing

To sell a variable annuity an agent must hold both a state life insurance license and a FINRA securities registration (Series 6 or Series 7, plus SEC/FINRA oversight). Selling a VA on a life license alone is a prohibited practice on the exam.

Mandatory Prospectus

Because a VA is a security, the prospectus must be delivered at or before the time of solicitation/sale - not after. The prospectus discloses subaccount choices, fees, and risks. Skipping or delaying it is a violation.

Stacked Fees

Variable annuities carry the heaviest fee load of any annuity, a frequently tested disadvantage:

Worked Example - Annual Cost Drag

A $100,000 variable annuity carries a 1.25% M&E charge, 0.15% administrative fee, and 0.85% average subaccount expense - a total of 2.25%, or about $2,250 per year. Even if the subaccounts earn 6% gross, the owner nets roughly 3.75% after fees. The exam expects you to recognize that high layered fees and the absence of a guaranteed return are the core disadvantages, while inflation protection and tax deferral are the advantages.

Accumulation Units vs. Annuity Units

The value inside a variable annuity is measured in two kinds of units, and the exam distinguishes them by phase.

During accumulation the owner accumulates more units; during payout the unit count is locked but the dollar value of each payment rises and falls with investment performance. That is why a variable payout check varies month to month.

Living and Death Benefit Riders

Because owners bear market risk, insurers sell optional riders for extra cost to soften that risk:

• Guaranteed Minimum Income Benefit (GMIB) - guarantees a minimum income at annuitization regardless of market losses.
• Guaranteed Minimum Withdrawal Benefit (GMWB) - guarantees the return of premium through periodic withdrawals.
• Enhanced death benefit - pays the beneficiary the greater of premiums paid or peak account value.

Each rider adds to the already-high fee load, reinforcing the tested disadvantage.

Suitability and Replacement

Variable annuity sales draw heavy regulatory scrutiny. FINRA suitability rules and state replacement rules both apply. Recommending a VA to an elderly, risk-averse client who needs liquidity, or churning one contract into another to earn commission, are prohibited practices the exam flags as unsuitable. A fixed payout under a variable contract is still measured in annuity units, so even the so-called fixed option fluctuates with the separate account.

Taxation Echoes the Other Annuities

Like all non-qualified annuities, a variable annuity grows tax-deferred, and withdrawals follow LIFO - earnings come out first and are taxed as ordinary income, with the 10% IRS penalty applying before age 59 1/2.

Gains are taxed as ordinary income even though the subaccounts hold equities; the annuity wrapper converts what would have been capital-gains treatment into ordinary-income treatment. The exam contrasts this with directly held mutual funds, where long-term gains and qualified dividends receive favorable rates.

The offsetting benefit is unlimited tax deferral with no annual contribution cap, which is why a variable annuity best suits a younger investor with a long horizon who has maxed out other tax-advantaged accounts and can tolerate market risk.

Variable Annuities — Risk Shifts to the Owner

A variable annuity invests premiums in subaccounts (mutual-fund-like portfolios) held in the insurer's separate account. The owner bears all investment risk; values and future payments rise and fall with the subaccounts. Because of this market risk, a variable annuity is both an insurance and a securities product.

Accumulation Units vs. Annuity Units

During accumulation, premiums buy accumulation units whose value floats with the separate account. At annuitization the units convert to a fixed number of annuity units; each payment then equals the number of annuity units times their current value — so the number of units is fixed but the dollar payment varies with market performance.

Worked Example: An owner annuitizes holding 1,000 annuity units. If the unit value is $10 one month and $10.40 the next, the payment rises from $10,000 to $10,400. The AIR (assumed interest rate) is the benchmark: actual separate-account returns above the AIR increase the payment; returns below it decrease the payment.

Exam Trap: Only variable annuities require securities licensing and a prospectus; fixed and indexed annuities do not, because their principal is guaranteed in the general account.