6.4 Variable Annuities

How a Variable Annuity Differs

A variable annuity shifts the investment risk to the contract owner. Premiums are placed in the insurer's separate account and allocated among subaccounts that invest in stocks, bonds, and money-market funds chosen by the owner. There is no guaranteed interest rate and no guaranteed payout amount; both the accumulation value and the income payments rise and fall with subaccount performance.

Because the owner bears market risk, a variable annuity is a security as well as an insurance product. The producer must hold both a life insurance license and a FINRA securities registration (Series 6 or 7 with Series 63 where required), and the contract is sold with a prospectus. The separate account is registered with the SEC.

Accumulation Units and Annuity Units

During accumulation, each premium buys accumulation units whose value floats with the subaccounts; the owner accumulates a varying number of units as deposits continue. At annuitization, the accumulated value converts into a fixed number of annuity units. From that point the number of annuity units stays constant, but the dollar value of each unit changes with performance, so the monthly check varies.

This is the most-tested distinction: during pay-in the number of units changes; during pay-out the number of units is fixed and only the unit value moves. The first variable income payment is set using an assumed interest rate (AIR), a benchmark used to calculate subsequent payments.

How AIR Drives the Next Payment

The assumed interest rate (AIR) is a conservative benchmark, not a guarantee. Each period the actual subaccount return is compared to the AIR:

• Actual return greater than AIR -> next payment rises.
• Actual return equal to AIR -> next payment stays the same.
• Actual return less than AIR -> next payment falls.

Worked example: AIR is 4%. If the subaccount earns 6%, the next check increases. The following month it earns 4% exactly - the check then stays level (not falls), because the comparison is always against the AIR, not against last month's higher return. Candidates routinely miss that a return equal to the AIR keeps payments flat even after a strong prior month.

Charges, Riders, and Suitability

Variable annuities carry layered costs the exam expects you to recognize:

Living-benefit riders such as a Guaranteed Minimum Income Benefit (GMIB) or Guaranteed Minimum Withdrawal Benefit (GMWB) add a floor of income or withdrawals for an extra fee. Because of cost and market risk, suitability rules are strict: replacing a fixed annuity or selling a long-surrender VA to an elderly client with short time horizons draws regulatory scrutiny.

Comparison and Taxation Recap

Taxation is identical across types: tax-deferred growth, gains taxed as ordinary income (never capital gains) under the exclusion ratio at payout, and a 10% penalty on earnings withdrawn before 59 1/2. Trap: even though a VA invests in equities, its gains are still ordinary income - the equity character is lost inside the annuity wrapper.