6.4 Variable Annuities

The Variable Annuity: Investment Risk Shifts to the Owner

A variable annuity (VA) is fundamentally different from fixed and indexed annuities: it offers no guaranteed value. The owner directs premiums into subaccounts (mutual-fund-like investment options) held in the insurer's separate account, and the contract value rises and falls with subaccount performance. The owner bears the investment risk; the insurer does not guarantee principal or a minimum return.

Because the value floats with the market, a variable annuity offers inflation-hedging growth potential — the classic contrast with the fixed annuity, where the insurer bears investment risk and the owner bears inflation risk. With a variable annuity, those roles flip: the owner bears investment risk in exchange for the chance to outpace inflation.

General Account vs. Separate Account

The account that holds the money is the key distinction the exam tests:

• General account — backs fixed annuity guarantees; invested conservatively by the insurer, which bears the risk and guarantees principal and a minimum rate.
• Separate account — holds variable annuity subaccounts; kept apart from the insurer's general assets, invested in stocks/bonds chosen by the owner, with no guarantee. Because the separate account holds securities, it is registered with the SEC.

If a question describes guaranteed principal and a minimum rate, it is the general account (fixed). If it describes owner-directed subaccounts with market risk, it is the separate account (variable).

Dual Regulation and Licensing

Because a variable annuity is both an insurance product and a security, it is dually regulated by the state insurance department and by federal securities regulators (the SEC under federal securities law, with FINRA overseeing the selling representatives).

To sell variable annuities a producer must hold both:

1. A life insurance license (state), and
2. A securities registration — a FINRA registration (commonly a Series 6 or Series 7) plus a state securities (Series 63) registration.

The sale must be accompanied by a prospectus — the disclosure document required for any security — delivered to the prospect at or before solicitation. This dual-license, prospectus-required combination is one of the most frequently tested variable-annuity facts.

Accumulation Units and Annuity Units

Variable annuities track value using two kinds of units, and the exam tests the difference precisely.

• Accumulation units — used during the accumulation phase. As the owner pays premiums, the number of accumulation units grows; each unit's value floats with subaccount performance. More money in equals more units.
• Annuity units — fixed at annuitization. When the owner annuitizes, the accumulation units convert to a fixed number of annuity units. From then on the number stays constant, but each unit's value floats, so the monthly check varies with the separate account.

Memory hook: during accumulation the number of units changes (value per unit floats); during payout the number is fixed (value per unit floats). The income check therefore rises and falls after annuitization.

The Assumed Interest Rate (AIR) and Payment Direction

The variable payout uses an assumed interest rate (AIR) — a benchmark the insurer uses to set the first annuity payment. After that, whether each payment rises or falls depends on how actual separate-account performance compares to the AIR:

• If actual return exceeds the AIR, the next payment increases.
• If actual return equals the AIR, the payment stays the same.
• If actual return is below the AIR, the payment decreases.

The AIR is not a guaranteed rate; it is only a measuring stick. This comparison (actual vs. AIR) is a classic exam item: a strong market year following a high-AIR assumption can still produce a lower check if the return did not beat the AIR.

Annuity Taxation: Exclusion Ratio, LIFO, and the Penalty

Annuity income tax follows the same rules across annuity types. During payout, each payment is split into a tax-free return of principal (the cost basis the owner already paid) and a taxable gain, using the exclusion ratio:

Exclusion ratio = investment in the contract (cost basis) / expected total return.

The resulting percentage of each payment is excluded (tax-free); the rest is taxed as ordinary income (annuity gains are never capital gains). Once the entire cost basis has been recovered, all further payments are fully taxable.

Worked example: Cost basis $100,000; expected total return $200,000. Exclusion ratio = 100,000 / 200,000 = 50%. On a $1,000 monthly payment, $500 is tax-free and $500 is ordinary income — until the $100,000 basis is fully recovered, after which the full $1,000 is taxable.

For non-annuitized withdrawals, deferred annuities use LIFO (last-in, first-out): gains come out first and are fully taxable. Withdrawals of gain before age 59 1/2 also trigger a 10% IRS penalty on top of ordinary income tax.

Recap: variable annuities put investment risk on the owner via separate-account subaccounts, require dual licensing and a prospectus, track value in accumulation units (growing number) then annuity units (fixed number, floating value vs. the AIR), and are taxed via the exclusion ratio with LIFO and a pre-59 1/2 penalty on gains.

Suitability and the 1035 Exchange

Because variable annuities carry market risk, fees, and surrender charges, suitability is heavily regulated: the producer must have reasonable grounds to believe the product fits the client's age, income, risk tolerance, and time horizon. Replacing one annuity with another must clear a suitability review and is typically done through a Section 1035 exchange, which lets the owner move value from one annuity (or life policy) to another annuity without triggering current income tax on the gain. A 1035 exchange preserves cost basis and tax deferral; taking the money in cash and re-buying would not.