6.1 Annuity Basics
Key Takeaways
- An annuity is an insurance contract that converts a lump sum or stream of premiums into guaranteed lifetime income, hedging longevity risk.
- Fixed annuities live in the insurer's general account, carry a guaranteed minimum rate, and are NOT securities (state-insurance regulated only).
- Variable annuities use a separate account, shift investment risk to the owner, and ARE securities (SEC-registered, FINRA-regulated).
- Immediate annuities begin payout within 12 months of a single premium; deferred annuities have an accumulation phase first.
- Every annuity has two phases: accumulation (pay-in, reversible) and the annuity/payout phase (annuitization is generally irreversible).
What an Annuity Is
An annuity is a contract between an investor and an insurance company in which the investor pays premiums and the insurer promises a future stream of income. The core purpose tested on the Series 7 is longevity risk management — the danger of outliving your money. Annuities are the only retail product that can pay income for the rest of an investor's life no matter how long that is.
Variable products represent a meaningful slice of the Series 7's 125 scored questions (225 minutes, 72% to pass, $395 fee through Prometric/FINRA). Because variable annuities are securities, the exam expects you to separate insurance features from securities features precisely.
Fixed vs. Variable Annuities
| Feature | Fixed Annuity | Variable Annuity |
|---|---|---|
| Where premiums go | General account | Separate account |
| Return | Guaranteed minimum rate | Subaccount performance |
| Who bears investment risk | Insurer | Contract owner |
| Inflation protection | Weak (purchasing-power risk) | Stronger (equity-linked) |
| Is it a security? | No | Yes (SEC registered) |
| Regulator | State insurance dept. | SEC + FINRA and state insurance |
| License to sell | State insurance only | Insurance + Series 6/7 + 63/66 |
A fixed annuity guarantees principal and a floor rate but exposes the owner to purchasing-power (inflation) risk: a level $1,200/month check buys less every year. A variable annuity ties value to subaccounts so income can rise with markets, trading inflation risk for investment risk borne by the owner.
Immediate vs. Deferred
| Feature | Immediate Annuity | Deferred Annuity |
|---|---|---|
| Premium | Single lump sum | Single or periodic |
| Payout begins | Within 12 months | Future date (years out) |
| Accumulation phase | None | Yes |
| Typical use | Income now (e.g., new retiree) | Retirement savings build-up |
An immediate annuity (a Single Premium Immediate Annuity, or SPIA) is bought with one lump sum and starts paying within a year — there is no accumulation phase. A deferred annuity accumulates tax-deferred for years, then annuitizes later. Watch the trap: an immediate annuity must be a single premium, so a client who wants to contribute monthly over time needs a deferred product, not an immediate one.
The Two Phases
Accumulation Phase (pay-in)
The owner contributes; value grows tax-deferred; in a variable contract the owner buys accumulation units. The owner can still surrender or withdraw (subject to charges/penalties). No income is paid.
Annuity/Payout Phase
At annuitization the contract converts accumulation units into a fixed number of annuity units, and income begins. Annuitization is generally irreversible — a common exam point.
Payout (Settlement) Options — ranked by check size
| Option | Description | Relative monthly check |
|---|---|---|
| Straight life (life only) | Pays until annuitant dies; nothing to heirs | Highest |
| Life with period certain | Life income, guaranteed min. years (e.g., 10/20-yr) | Lower |
| Joint and last survivor | Pays until BOTH annuitants die | Lowest |
Worked example: A 67-year-old wants the biggest possible check and has no dependents. Straight life pays the most because the insurer's obligation ends at death with no residual guarantee. If she instead chooses joint-and-survivor with a spouse, the insurer expects to pay over two lifetimes, so each check shrinks.
Common traps: (1) Fixed annuities are NOT securities — do not say they require a Series 7. (2) The owner, annuitant, and beneficiary can be three different people; the annuitant is the measuring life for payout. (3) "Tax-deferred" is not "tax-free."
Parties to the Contract
The Series 7 expects you to keep three roles straight. The owner controls the contract, makes premium decisions, names the beneficiary, and is taxed on withdrawals. The annuitant is the measuring life whose age and life expectancy set the payout amount and on whose death a life-contingent payout ends. The beneficiary receives any death proceeds. On most retail contracts the owner and annuitant are the same person, but exam questions deliberately split them — for example, a parent (owner) buying a contract on a child (annuitant). Remember: payout size is always computed from the annuitant's life expectancy, not the owner's.
Bonus, Indexed, and Hybrid Variations
Beyond the core fixed/variable split, expect to recognize a few named variations. An equity-indexed (or fixed-indexed) annuity credits a return tied to an index such as the S&P 500 but with a participation rate and a cap, plus a guaranteed floor (often 0%); it is generally treated as a fixed product (not a security) for licensing. A bonus annuity adds a premium credit but usually carries a longer surrender schedule — a suitability flag. A combination annuity blends a fixed account with variable subaccounts.
The unifying exam idea: the more of the return that depends on a separate account, the more it looks like a security and the more investment risk shifts to the client.
Suitability Snapshot
Before recommending any annuity, document the customer's time horizon, liquidity needs, tax bracket, existing retirement coverage, and risk tolerance. Annuities are long-term vehicles; recommending one to a client who needs the money within the surrender period, or who has not funded available qualified plans, invites a suitability violation. A variable annuity suits a client who wants tax-deferred, market-linked growth and a lifetime-income option and accepts investment risk; a fixed annuity suits a conservative client prioritizing principal protection over inflation defense.
A 70-year-old retiree with no dependents wants the largest possible monthly income from a $250,000 lump sum and does not care about leaving a residual to heirs. Which settlement option best fits?