6.4 Variable Annuities

Variable Annuities Defined

A variable annuity (VA) passes investment risk to the owner. Premiums go into the insurer's separate account and are allocated among subaccounts (essentially mutual funds). There is no guaranteed interest rate; values rise and fall with subaccount performance.

Because the owner bears market risk, a variable annuity is a security. To sell one, a producer must hold:

1. A state life insurance license, AND
2. A FINRA registration (Series 6 or 7) with a securities license.

The contract is also a dual-regulated product: it is regulated by the state insurance department AND by the SEC/FINRA, and the buyer must receive a prospectus at or before solicitation.

Licensing and Regulation Recap

Because a variable annuity's value rides on separate-account subaccounts (mutual-fund-like), it is a security: the producer needs both a state insurance license and a FINRA registration (Series 6 or 7), and the buyer must receive a prospectus. Contrast this with fixed and indexed annuities, which are insurance products needing only the state license. The accumulation phase uses accumulation units; the payout phase uses a fixed number of annuity units whose value floats — the single most-tested variable-annuity mechanic.

Accumulation Units vs. Annuity Units

This is the classic VA exam trap:

• During accumulation, premiums buy accumulation units. The number of units grows with each deposit; their value floats with the separate account.
• At annuitization, accumulation units are converted into a fixed number of annuity units. After that, the number of annuity units never changes - but each unit's value still floats, so the monthly check varies.

So in payout, the count is fixed but the dollar amount fluctuates. This is why a variable annuity income hedges inflation but offers no guaranteed payment amount.

Licensing and Suitability

Because variable products are securities, suitability is heavily scrutinized. Producers must have reasonable grounds that the recommendation fits the client's age, income, risk tolerance, liquidity needs, and tax status. A common exam point: selling a long-surrender-charge variable annuity to an elderly client with short time horizon is a textbook unsuitable sale.

VA charges to know:

• Mortality and expense (M&E) risk charge - funds the insurer's guarantee of a death benefit and lifetime income.
• Administrative/management fees - separate-account fund expenses.
• Surrender charges - declining schedule like other deferred annuities.

Many VAs add a guaranteed minimum death benefit (GMDB) so the beneficiary receives at least premiums paid (less withdrawals) even if subaccounts lost value.

The Assumed Interest Rate (AIR) and Why Payments Move

In the payout phase the size of each variable check is benchmarked against the assumed interest rate (AIR) - a conservative return the insurer builds into the first payment. After that:

• If the subaccount's actual return exceeds the AIR, the next payment rises.
• If actual return equals the AIR, the payment stays the same.
• If actual return is below the AIR, the payment falls.

Worked example: A retiree annuitizes into 100 annuity units at a unit value of $10.50, so the first check is 100 x $10.50 = $1,050. If performance lifts the unit value to $10.80, the next check is 100 x $10.80 = $1,080; if it slips to $10.20, the check is $1,020. The number of units never changes - only their value does. This is the most-tested mechanic in the variable-annuity section.

Living-Benefit Riders

To blunt market risk, insurers sell optional living-benefit riders for extra fees:

These riders make a variable annuity behave more like a fixed product, at the cost of higher annual charges that drag on returns. On the exam, a rider that promises income or withdrawals "regardless of market performance" is a living benefit, while a guarantee tied to the annuitant's death is the GMDB. Suitability analysis must weigh whether the rider fees are justified for the specific client - an unjustified high-fee rider sold to a conservative buyer is a classic unsuitable recommendation.

Annuity Taxation and 1035 Exchanges

Non-qualified annuity gains grow tax-deferred. On withdrawal, earnings come out first under the LIFO rule (interest-first) and are taxed as ordinary income - never capital gains. The original after-tax deposits are the cost basis and return tax-free.

At annuitization, the exclusion ratio determines the tax-free portion of each payment:

• Exclusion ratio = investment in contract / expected total return
• Example: $100,000 basis, expected return $200,000 over life. Ratio = 100,000 / 200,000 = 50%. So 50% of each check is tax-free return of basis; 50% is taxable interest - until basis is fully recovered, after which payments are fully taxable.

A Section 1035 exchange lets an owner swap one annuity for another (or life-to-annuity) with no current tax. Permitted: life-to-life, life-to-annuity, annuity-to-annuity. Not permitted: annuity-to-life (you cannot move backward into life insurance tax-free).