6.4 Variable Annuities
Key Takeaways
- Variable annuities invest in separate account subaccounts; the owner bears the investment risk and there is no guaranteed principal or rate.
- They are dual-regulated (state insurance + SEC/FINRA), so selling requires both a life license and a securities registration plus prospectus delivery.
- Accumulation units vary in number during pay-in; at annuitization the number of annuity units is fixed but each unit's value fluctuates, so payments vary.
- Compare actual separate-account return to the AIR: above AIR raises the payment, equal keeps it level, below AIR lowers it; the AIR is not guaranteed.
- Variable annuities are unsuitable for buyers needing guaranteed principal; placing one inside an already-tax-deferred IRA solely for tax deferral is a violation.
A variable annuity invests premiums in separate account subaccounts (mutual-fund-like portfolios chosen by the owner). The owner bears the investment risk — there is no guaranteed principal or interest rate, and the contract value rises and falls with market performance.
Dual Regulation and Licensing
Because it is both an insurance product and a security, a variable annuity is dual-regulated:
| Regulator | Authority |
|---|---|
| State insurance department | Insurance license required |
| SEC / FINRA | Securities registration (Series 6 or 7 + Series 63) and a registered prospectus |
To sell variable annuities a producer must hold both a life insurance license and a securities registration, and must deliver a prospectus before or at the time of solicitation.
Accumulation Units vs. Annuity Units
The measuring units change at annuitization:
| Phase | Unit | Behavior |
|---|---|---|
| Accumulation | Accumulation units | Number of units grows as premiums are added; value per unit varies with the market |
| Payout | Annuity units | Number of units is fixed at annuitization; value per unit varies, so the payment amount fluctuates |
During payout the number of annuity units is locked, but each unit's value moves with the separate account — so the income check changes monthly. This is why a variable annuity does not protect against running out of money the way a fixed annuity does.
The AIR (Assumed Interest Rate)
The AIR is a benchmark used to calculate variable payments after annuitization. Compare actual separate-account performance to the AIR:
| Actual return vs. AIR | Next payment |
|---|---|
| Actual > AIR | Payment increases |
| Actual = AIR | Payment stays the same |
| Actual < AIR | Payment decreases |
Worked Example
The AIR is 4%. If the separate account earns 6%, the next payment rises (6% > 4%). If it earns 2%, the payment falls (2% < 4%). The AIR is not a guaranteed rate — it is only the assumption against which performance is measured.
Charges and Riders
- Mortality & expense (M&E) charge — pays for the death-benefit guarantee and insurer risk
- Administrative / management fees — separate account operating costs
- Surrender charges — declining schedule like other deferred annuities
- GMIB / GMWB riders — guaranteed minimum income or withdrawal benefits for extra cost
Suitability Traps
Variable annuities are generally unsuitable for buyers who need guaranteed principal, have a short time horizon, or want simple low-cost investing. Selling a variable annuity inside an IRA solely "for the tax deferral" is a classic violation — the IRA is already tax-deferred, so the owner pays extra M&E fees for a benefit they already have.
To sell variable annuities, a producer must hold:
A variable annuity has an assumed interest rate (AIR) of 5%. If the separate account earns 3% in a period, the next annuity payment will:
Separate Account and Investor Protections
The separate account holding variable subaccounts is not part of the insurer's general assets, so it is shielded from the insurer's creditors. Because the owner bears investment risk, federal securities law adds protections a fixed annuity never has: a prospectus must be delivered, sales must follow FINRA suitability rules, and the contract carries a free-look during which the owner can cancel and recover account value (sometimes premium, depending on state).
| Feature | Fixed annuity | Variable annuity |
|---|---|---|
| Who bears investment risk | Insurer | Owner |
| Account | General | Separate |
| Producer must hold | Life license | Life license + securities reg. |
| Disclosure | Contract summary | Prospectus |
Worked Example: Annuity-Unit Income Swing
At annuitization the owner is credited 1,000 annuity units valued at $10.00 each, producing a first payment of $10,000 (illustrative). The number of units is now fixed. If unit value rises to $10.50, the next payment is 1,000 x $10.50 = $10,500; if it falls to $9.60, the payment is $9,600.
The income check moves because the unit value floats while the unit count is locked. This is the opposite of a fixed annuity, where the dollar payment is constant. Tie the swing back to the AIR: payment direction depends on actual return vs. the assumed interest rate.
Living-Benefit Riders in Depth
Because the owner bears market risk, insurers sell living-benefit riders for an extra fee to add guarantees:
| Rider | Guarantees |
|---|---|
| GMIB (income benefit) | A minimum future annuitization income regardless of account value |
| GMWB (withdrawal benefit) | A minimum annual withdrawal amount for life, account stays invested |
| GMAB (accumulation benefit) | A minimum account value at the end of a holding period |
These riders carry their own charges that stack on top of the M&E fee, so total annual cost can exceed 3%. The exam tests that the riders solve the variable annuity's core weakness — no principal guarantee — but at a cost that makes the product unsuitable for fee-sensitive buyers.
Death Benefit and Replacement Cautions
A variable annuity's standard death benefit returns the greater of the account value or total premiums paid (less withdrawals); enhanced riders may lock in a high-water-mark value. Replacing an existing annuity with a new variable contract restarts surrender charges and may forfeit accrued living-benefit guarantees — a 1035 exchange must be justified by a documented benefit to the client, or it is a twisting violation.
Quick Recap: Variable Annuity Decision Points
When a question describes a buyer, run this checklist: (1) Can they tolerate market loss to principal? If not, a variable annuity is wrong. (2) Do they have a long time horizon and other liquid savings? Required, given surrender charges. (3) Are they buying inside an IRA? If the only stated reason is tax deferral, the recommendation fails — the IRA already defers tax. (4) Does the producer hold a securities registration and deliver a prospectus? If not, the sale is unlawful. Memorizing this four-point filter answers most variable-annuity suitability items quickly and correctly.