6.4 Variable Annuities
Key Takeaways
- In a variable annuity the owner bears investment risk; premiums go into separate-account subaccounts that resemble mutual funds.
- Variable annuities are securities, so the producer needs both a life license and a FINRA securities registration, and a prospectus must be delivered.
- During accumulation the number of accumulation units varies; during payout the number of annuity units is fixed but their value varies.
- Common fees include mortality and expense (M&E) charges, administrative fees, subaccount expenses, and rider charges.
- Living-benefit riders (GMIB, GMWB) and a guaranteed death benefit add cost but add guarantees.
How a Variable Annuity Works
In a variable annuity (VA) the owner directs premium into subaccounts held in the insurer's separate account. Subaccounts function like mutual funds (stock, bond, money-market portfolios). The owner — not the insurer — bears the investment risk, so there is no guaranteed minimum return on the invested value.
| Account | Backs | Who bears risk |
|---|---|---|
| General account | Fixed annuities | Insurer |
| Separate account | Variable annuities | Owner |
Dual licensing and disclosure
A variable annuity is both an insurance product and a security. To sell one, a producer must hold:
- a life insurance license, and
- a FINRA securities registration (e.g., Series 6 or 7) with the appropriate state securities (blue-sky) registration.
A prospectus must be delivered — it is the required disclosure document for the separate account.
Accumulation Units vs. Annuity Units
This is one of the most heavily tested distinctions on the exam.
| Phase | Unit type | Number of units | Value per unit |
|---|---|---|---|
| Accumulation | Accumulation units | Varies (each premium buys more) | Varies |
| Payout | Annuity units | Fixed at annuitization | Varies with subaccount performance |
Accumulation purchase example
| Premium | Unit value | Units bought |
|---|---|---|
| $1,000 | $10.00 | 100 |
| $1,000 | $12.50 | 80 |
| $1,000 | $8.00 | 125 |
| Total | — | 305 units |
Payout example (fixed number of annuity units = 100)
| Month | Annuity unit value | Payment |
|---|---|---|
| January | $12.00 | 100 × 12.00 = $1,200 |
| February | $11.50 | 100 × 11.50 = $1,150 |
| March | $13.00 | 100 × 13.00 = $1,300 |
Exam trap: In the payout phase the number of annuity units is fixed; the value of each unit (and thus the payment) fluctuates. Payments can rise or fall.
Fees and Riders
Variable annuities carry more fees than fixed annuities because of the separate-account structure and optional guarantees.
| Charge | What it covers |
|---|---|
| Mortality & expense (M&E) | Insurer's mortality guarantee and expense risk; funds the death benefit |
| Administrative fee | Recordkeeping and servicing |
| Subaccount (fund) expenses | Investment management of each subaccount |
| Surrender charge | Early excess withdrawals during surrender period |
| Rider charges | Cost of optional living/death-benefit guarantees |
Living-benefit and death-benefit riders
| Rider | Guarantee |
|---|---|
| GMIB (guaranteed minimum income benefit) | Minimum income base for future annuitization regardless of market |
| GMWB (guaranteed minimum withdrawal benefit) | Withdraw a set percentage for life even if the account hits zero |
| Guaranteed minimum death benefit | Heirs receive at least premiums paid (or a stepped-up value) |
These riders add cost but transfer downside risk back to the insurer — a key suitability discussion point.
Suitability and Taxation Notes
- A VA suits investors who want growth potential plus tax deferral and can tolerate market risk over a long horizon.
- It is generally not suitable for short-horizon, risk-averse, or already tax-advantaged buyers who haven't maxed an IRA/401(k).
- Like all non-qualified annuities, gains are taxed LIFO as ordinary income, and a 10% penalty applies to the taxable portion of withdrawals before age 59½.
- A like-kind 1035 exchange lets an owner move from one annuity to another (or life-to-annuity) without immediate tax — but never annuity-to-life insurance.
Exam trap: A 1035 exchange is tax-free in one direction set: life → life, life → annuity, annuity → annuity. You may not exchange an annuity into life insurance tax-free.
Securities Regulation and the Prospectus
A variable annuity is both an insurance product and a security, so the producer must hold a life insurance license plus a FINRA securities registration (Series 6 or 7) and deliver a prospectus before the sale. Because subaccount values fluctuate with the markets, the owner bears the investment risk — the opposite of a fixed annuity where the insurer guarantees principal.
This dual nature drives most VA exam questions: misrepresenting a VA as principal-guaranteed, omitting the prospectus, or selling without securities registration are all violations. The owner can typically transfer among subaccounts without current tax (the transfer is inside a tax-deferred contract), which is an advantage over taxable mutual-fund switching.
Guaranteed Living Benefit Riders
Variable annuities offer optional riders that soften the owner's investment risk for an added fee:
- GMIB (Guaranteed Minimum Income Benefit) — guarantees a minimum income base for annuitization regardless of subaccount performance.
- GMWB (Guaranteed Minimum Withdrawal Benefit) — guarantees the owner can withdraw a set percentage of the benefit base each year even if the account drops to zero.
- GMAB (Guaranteed Minimum Accumulation Benefit) — guarantees a minimum account value at a future date.
These riders, plus the standard death benefit (often return of premium), are why VA fees exceed those of fixed annuities. The exam expects you to recognize that these guarantees cost extra and reduce net returns, and that they do not convert the VA into a fixed product — the underlying subaccounts still fluctuate.
To sell a variable annuity, a producer must hold:
During the payout (annuitization) phase of a variable annuity, which is TRUE?