2.4 Variable Annuities and Variable Life Insurance: Structure, Charges, and Rule 2320
Key Takeaways
A variable contract's subaccounts are held in an insurance company separate account registered under the 1940 Act, usually as a unit investment trust that invests in underlying fund portfolios.
During annuitization, the first payment depends on the assumed interest rate (AIR); later payments rise when subaccount returns exceed the AIR and fall when they lag it.
Rule 22d-2 lets variable annuity sales loads and charges vary if the variations are disclosed in the prospectus, reflect cost differences and are not unfairly discriminatory, and Rule 22e-1 suspends redemption rights once payments are based on life contingencies.
Rule 2320 requires members to transmit variable contract applications and payments promptly, and selling agreements must return the commission if a contract is redeemed within seven business days after acceptance.
Annuity earnings are taxed as ordinary income when withdrawn, withdrawals before age 59 1/2 generally add a 10% federal penalty, and Section 1035 allows tax-free exchanges of annuity for annuity or life insurance for annuity, but not annuity for life insurance.
Why Variable Contracts Are Securities
A variable annuity (VA) or variable life insurance (VLI) policy is issued by an insurance company, but the contract owner bears the investment risk of the subaccounts chosen. Because of that risk, the contracts are securities. They must be registered under the Securities Act of 1933 and sold with a prospectus, and the separate account holding the subaccounts must register under the Investment Company Act. VA separate accounts register on Form N-4 and VLI separate accounts on Form N-6. Most are organized as unit investment trusts investing in underlying fund portfolios, although a separate account can also be registered as an open-end management company.
The separate account's assets are kept apart from the insurer's general account, so subaccount values reflect investment performance. Any guarantees, such as a guaranteed death benefit, a fixed account or a living benefit rider, are backed by the insurer's general account and claims-paying ability. That is why FINRA Rule 2211 forbids communications implying that a guarantee covers the separate account's investment return (Section 4.3).
Variable Annuity Phases
Accumulation phase. Purchase payments buy accumulation units in the chosen subaccounts. The value of each unit moves with the underlying portfolio, net of charges. Earnings grow tax-deferred until withdrawn.
Annuity (payout) phase. At annuitization, the accumulated value is converted into annuity units. The first payment is set using the owner's age, the payout option and the assumed interest rate (AIR). After that:
- if the subaccounts earn more than the AIR, payments increase;
- if they earn less than the AIR, payments decrease; and
- if they earn exactly the AIR, payments stay level.
Common payout options include life only (the highest payment, with nothing for heirs), life with period certain, joint and last survivor, and unit refund. Once payments depend on life contingencies, Rule 22e-1 exempts the separate account from Section 22(e)'s redemption requirement, so the owner generally cannot cash out the contract.
Charges and Riders
| Charge | What it pays for |
|---|---|
| Mortality and expense (M&E) risk charge | The insurer's guarantees (such as the death benefit) and expense risk; typically a significant annual percentage of account value |
| Administrative fees | Recordkeeping; often a flat annual contract fee plus a small percentage |
| Underlying fund expenses | Management fees and other expenses of each subaccount portfolio |
| Surrender charge (CDSC) | A declining charge on withdrawals during the surrender period, often 6 to 10 years |
| Rider charges | Optional enhanced death benefits and living benefits such as guaranteed minimum income or withdrawal benefits |
Rule 22d-2 exempts registered separate accounts from Section 22(d)'s uniform-price requirement so that sales loads, administrative charges and deductions may vary. The variations must be disclosed in the prospectus as precisely as possible, reflect differences in costs or services, and not be unfairly discriminatory. Many contracts also let owners withdraw a stated percentage each year free of surrender charges.
Tax Treatment
- Non-qualified VA earnings are taxed as ordinary income when withdrawn. Withdrawals are generally treated as coming from earnings first.
- Taxable withdrawals before age 59 1/2 generally incur an additional 10% federal tax penalty unless an exception, such as death or disability, applies.
- Heirs do not receive a stepped-up basis on annuity gains.
- Under Internal Revenue Code Section 1035, an owner may exchange a life insurance policy for a life policy or an annuity, and an annuity for an annuity, without current tax. Exchanging an annuity for a life insurance policy does not qualify.
- Placing a VA inside an IRA or other qualified plan adds no additional tax deferral. The recommendation must rest on other features, such as the death benefit or lifetime income (Section 5.4).
Variable Life Insurance
VLI provides a death benefit plus a cash value that fluctuates with the subaccounts. Scheduled-premium VLI has fixed premiums and typically a guaranteed minimum death benefit. Variable universal life has flexible premiums, and the policy can lapse if cash value falls too low. Policy loans and withdrawals reduce cash value and the death benefit. Hypothetical illustrations in VLI communications are limited to gross rates of 12% and must include a 0% illustration (Rule 2211, Section 4.3).
FINRA Rule 2320: Member Obligations for Variable Contracts
| Provision | Requirement |
|---|---|
| Receipt of payment (2320(c)) | A member may sell a variable contract only at a value determined after payment is received under the contract and prospectus. Payment is generally treated as received when the insurer accepts the application. |
| Transmittal (2320(d)) | A member that receives applications or purchase payments must transmit them promptly to the issuer, along with at least the portion of the payment to be credited to the contract. |
| Selling agreements (2320(e)) | A principal underwriter may sell through another broker-dealer only if that firm is a FINRA member with a sales agreement. The agreement must require return of the commission if the contract is redeemed within seven business days after the application is accepted. |
| Redemption (2320(f)) | A member may sell only contracts whose insurer undertakes to make prompt payment on proper redemption requests. |
| Compensation (2320(g)) | Cash and non-cash compensation rules, including the $300 gift limit and training-meeting conditions (Sections 6.1 to 6.3). |
Rule 2330's suitability, disclosure and principal-review rules for deferred VAs build on this foundation and are covered in Section 5.4.
An annuitant's variable annuity uses a 4% assumed interest rate. In the most recent period, the separate account subaccounts earned 2% net of charges. What happens to the next annuity payment?
It is suspended until returns exceed the AIR again
It increases, because the contract still earned a positive return
It stays the same, because the insurer guarantees level payments after annuitization
It decreases, because the subaccounts earned less than the assumed interest rate
A broker-dealer that is not the principal underwriter wants to sell an insurer's variable annuities. Under Rule 2320(e), what must the principal underwriter's selling agreement with that firm provide?
That the selling firm will hold all purchase payments until the free-look period ends
That the sales commission will be returned to the insurer if the contract is tendered for redemption within seven business days after the application is accepted
That the selling firm will pay the insurer a fee for every contract surrendered within the first year
That the selling firm need not be a FINRA member if its representatives hold insurance licenses
A client wants to move the value of an existing variable annuity into a new variable universal life policy without paying current tax on the annuity's gain. What is the correct supervisory response?
Approve it if the new policy's death benefit exceeds the annuity's value
Approve it if the exchange is completed within the free-look period
Approve it, because Section 1035 allows any exchange between insurance products
Explain that Section 1035 does not permit a tax-free exchange of an annuity for a life insurance policy, so the gain would be taxable
Sections you finish are checked off in the contents.