Variable Annuities

What Is a Variable Annuity?

A variable annuity is both an insurance product and a securities product. It is a contract between an investor (the contract owner or annuitant) and an insurance company in which the insurance company agrees to make periodic payments to the investor, either immediately or at a future date. The "variable" aspect means that the value of the contract and the amount of the payments depend on the performance of underlying investment options chosen by the contract owner.

Variable annuities are one of the most important products tested on the Series 6 exam because they combine insurance features (death benefits, guaranteed income options) with securities features (investment risk, subaccount selection). Because they are securities, variable annuities must be sold with a prospectus, and the representative must hold both a securities license (Series 6 or Series 7) and a state insurance license.

Dual Regulation

Variable annuities are subject to regulation by multiple authorities:

SEC: Because the investment return is variable and depends on the performance of underlying securities, variable annuities are considered securities and must be registered with the SEC.
FINRA: Broker-dealers selling variable annuities must comply with FINRA rules, including suitability requirements and supervision.
State Insurance Commissioners: Because variable annuities are issued by insurance companies and include insurance features (death benefits, annuitization options), they are also regulated by state insurance departments.

Variable Annuity: A contract between an investor and an insurance company where the investor makes contributions that are invested in subaccounts (similar to mutual funds). The contract value and eventual annuity payments vary based on investment performance. Variable annuities offer tax-deferred growth, a death benefit, and various payout options at annuitization.

The Two Phases: Accumulation and Annuitization

Every variable annuity has two distinct phases that represent different stages of the contract. Understanding these phases and the transition between them is essential for the Series 6 exam.

Accumulation Phase (Pay-In Phase)

During the accumulation phase, the contract owner makes contributions to the annuity. These contributions are invested in one or more subaccounts chosen by the contract owner. The value of the contract fluctuates based on the performance of the underlying subaccounts. Key points about the accumulation phase:

Contributions: The owner can make a single lump-sum payment or periodic payments. Variable annuities accept both qualified (IRA, 401(k)) and non-qualified (after-tax) money.
Accumulation units: During this phase, the contract owner's interest is measured in accumulation units, which are similar to mutual fund shares. The value of each accumulation unit changes daily based on the performance of the selected subaccounts.
Tax deferral: Earnings on the investment grow tax-deferred during the accumulation phase. No income tax is owed on investment gains until money is withdrawn or annuitized.
Flexibility: The contract owner can transfer funds between subaccounts without triggering a taxable event (unlike mutual fund exchanges, which are taxable).
Withdrawals: The owner can make withdrawals during the accumulation phase, but withdrawals may be subject to surrender charges and, if the owner is under age 59 1/2, a 10% IRS early withdrawal penalty.

Annuitization Phase (Pay-Out Phase)

When the contract owner decides to begin receiving income from the annuity, the contract is annuitized. The insurance company converts the accumulated value into a stream of periodic payments. At annuitization, accumulation units are converted into annuity units. The number of annuity units is fixed at annuitization and does not change, but the value of each annuity unit fluctuates based on the performance of the subaccounts relative to an assumed interest rate (AIR).

Annuity Payout Options

The contract owner selects a payout option at annuitization. Common options include:

Life Only (Straight Life): Payments continue for the annuitant's lifetime. When the annuitant dies, payments stop. No beneficiary receives anything. This option provides the highest monthly payment because the insurance company's obligation ends at death.
Life with Period Certain: Payments continue for the annuitant's lifetime, but if the annuitant dies before a specified period (e.g., 10 or 20 years), payments continue to a beneficiary for the remainder of that period. This provides lower monthly payments than life only.
Joint and Survivor: Payments continue for the lifetime of two annuitants (typically spouses). When the first annuitant dies, payments continue to the surviving annuitant for their lifetime. This provides the lowest monthly payments.
Fixed Period (Period Certain Only): Payments are made for a specified period regardless of whether the annuitant is alive. If the annuitant dies during the period, the beneficiary receives the remaining payments.

The exam will ask which payout option provides the highest and lowest monthly payments. Life Only provides the highest payments (greatest risk to the insurance company because payments could last a very long time, but end at death). Joint and Survivor provides the lowest payments (covers two lifetimes). Remember: the more guarantees the annuitant receives, the lower each payment will be.

The Separate Account and Subaccounts

One of the most important structural features of a variable annuity is the separate account. Understanding the difference between the separate account and the insurance company's general account is critical for the Series 6 exam.

The Separate Account

When a contract owner invests in a variable annuity, their money is placed into the insurance company's separate account. This is an investment account that is legally separate from the insurance company's general account and other business assets. The separate account is registered as an investment company under the Investment Company Act of 1940.

The key significance of the separate account is that the assets are protected from the insurance company's creditors. If the insurance company were to go bankrupt, the assets in the separate account belong to the contract owners, not to the insurance company's creditors. This is a major distinction from fixed annuities, where the investor's money goes into the general account and IS subject to the claims of the insurance company's creditors.

Subaccounts

Within the separate account, the contract owner can allocate their investment among various subaccounts. Subaccounts function very similarly to mutual funds. Each subaccount has its own investment objective (growth, income, balanced, etc.) and is managed by a professional investment adviser. Common subaccount types include:

Equity (stock) subaccounts
Bond (fixed-income) subaccounts
Money market subaccounts
Balanced or asset allocation subaccounts
International or global subaccounts
Sector-specific subaccounts

The contract owner bears all of the investment risk for money in the separate account. The insurance company does not guarantee the investment performance of the subaccounts. The value of the annuity can increase or decrease based on market conditions.

Feature	Separate Account	General Account
Used By	Variable annuities, variable life	Fixed annuities, whole life, term life
Investment Risk	Borne by the contract owner	Borne by the insurance company
Creditor Protection	Protected from insurer's creditors	Subject to insurer's creditors
Securities Registration	Registered as investment company	Not a security
Return	Variable; depends on market	Fixed; guaranteed by insurer

Assumed Interest Rate (AIR)

The Assumed Interest Rate (AIR) is a critical concept for understanding how variable annuity payments change over time during the annuitization phase. The AIR is a benchmark rate set by the insurance company that is used to determine the initial annuity payment and to compare against actual investment performance to determine subsequent payments.

Here is how the AIR works during annuitization:

If the actual investment return of the subaccounts equals the AIR, the next payment stays the same.
If the actual investment return exceeds the AIR, the next payment increases.
If the actual investment return is less than the AIR, the next payment decreases.

Note that the comparison is between the actual return and the AIR, not between the actual return and zero. Even if the subaccounts have a positive return, payments will decrease if that return is less than the AIR. For example, if the AIR is 5% and the subaccounts return 3%, the annuity payments will decrease even though there was a positive return.

Think of the AIR as the "hurdle rate" for annuity payments. The subaccounts must beat the AIR for payments to rise. If performance matches the AIR, payments stay level. If performance falls short, payments decline. The higher the AIR set by the insurer, the higher the initial payment, but the harder it is for subsequent payments to increase.

Surrender Charges and Fees

Variable annuities are known for having multiple layers of fees and charges. Understanding these costs is essential for both the exam and for making suitable recommendations to clients.

Surrender Charges (CDSC)

Most variable annuities impose a surrender charge (also called a contingent deferred sales charge) if the contract owner withdraws money or surrenders the contract within a specified period, typically 6-8 years. The surrender charge schedule is declining, meaning the charge decreases each year the contract is held. A typical schedule might be:

Year 1: 7%
Year 2: 6%
Year 3: 5%
Year 4: 4%
Year 5: 3%
Year 6: 2%
Year 7: 1%
Year 8 and beyond: 0%

Many contracts allow the owner to withdraw up to 10% of the contract value annually without incurring a surrender charge (the "free withdrawal" provision). Surrender charges are applied to the amount withdrawn that exceeds the free withdrawal allowance.

Other Fees and Expenses

Mortality and Expense (M&E) Risk Charge: This is the largest ongoing fee in most variable annuities, typically ranging from 1.00% to 1.50% of account value annually. It compensates the insurance company for the mortality risk (guaranteeing the death benefit) and the expense risk (guaranteeing that administrative costs will not increase).
Administrative fees: Annual fees charged to cover record-keeping and other administrative costs, often a flat dollar amount (e.g., $30-$50 per year) or a small percentage of assets.
Subaccount management fees: Each subaccount charges its own investment management fee, similar to a mutual fund's management fee. These typically range from 0.25% to 1.50% depending on the subaccount.
Optional rider fees: Additional fees for optional benefits such as guaranteed minimum income benefits (GMIB), guaranteed minimum withdrawal benefits (GMWB), or enhanced death benefits. These can add 0.25% to 1.00% or more to the total annual cost.

Variable annuity total annual expenses often exceed 2-3% when all fees are combined. This makes them significantly more expensive than comparable mutual fund investments. Representatives must ensure that the tax-deferral benefits and insurance features justify these higher costs for each individual client. FINRA Rule 2330 specifically addresses suitability obligations for variable annuity transactions.

Death Benefit

One of the key insurance features of a variable annuity is the death benefit. If the contract owner (or annuitant, depending on the contract) dies during the accumulation phase, the beneficiary receives at least the amount of the original investment, minus any withdrawals, regardless of the current market value of the subaccounts. This provides downside protection that mutual funds do not offer.

The standard death benefit guarantees that the beneficiary will receive the greater of (1) the current account value, or (2) the total contributions minus withdrawals. Some contracts offer enhanced death benefits (for an additional fee) that may provide:

Stepped-up death benefit: The death benefit is periodically reset to the higher of the current value or the previous death benefit, often on each contract anniversary.
Ratchet death benefit: The death benefit locks in at the highest account value reached on any anniversary date.
Roll-up death benefit: The death benefit increases at a specified rate (e.g., 5% per year) regardless of market performance.

The death benefit is only available during the accumulation phase. Once the contract is annuitized, the death benefit no longer applies (unless the annuitant selected a payout option with a period certain or joint survivor feature).

Deep Dive Tax Treatment of Variable Annuities

The tax treatment of variable annuities is complex and is frequently tested on the Series 6 exam. Here are the key tax rules:

During the accumulation phase: All earnings grow tax-deferred. No taxes are owed until money is withdrawn. Transfers between subaccounts within the annuity are not taxable events.

Withdrawals during accumulation (non-qualified contracts): The IRS uses a Last-In, First-Out (LIFO) approach. This means that earnings are considered withdrawn first and are taxed as ordinary income. After all earnings have been withdrawn, the remaining withdrawals are considered a return of the investor's cost basis and are not taxed. This is less favorable than the tax treatment of mutual funds, where the investor can choose which shares to sell.

10% early withdrawal penalty: If the contract owner is under age 59 1/2, withdrawals of earnings are subject to a 10% IRS penalty in addition to ordinary income tax. Exceptions include death, disability, and annuitization under a life expectancy method (Section 72(q)).

Annuity payments: Each annuity payment is partially taxable. A portion of each payment represents a return of the investor's cost basis (not taxable) and a portion represents earnings (taxed as ordinary income). The exclusion ratio determines the tax-free portion. For non-qualified annuities: Exclusion Ratio = Investment in Contract / Expected Return.

Death benefit: The death benefit paid to a beneficiary is taxed as ordinary income to the extent it exceeds the contract owner's cost basis. There is no "step-up in basis" at death for annuities, unlike stocks or mutual funds held in taxable accounts.

1035 Exchange: Section 1035 of the Internal Revenue Code allows a tax-free exchange of one annuity contract for another annuity contract, or a life insurance policy for an annuity contract (but not an annuity for life insurance). This allows investors to move to a better product without triggering a taxable event.

FINRA Rule 2330: Variable Annuity Suitability

FINRA Rule 2330 establishes specific suitability requirements for deferred variable annuity transactions. This rule goes beyond general suitability requirements and imposes additional obligations on registered representatives and their firms. Key provisions include:

Reasonable basis to believe the customer has been informed of the product's features, including surrender charges, potential tax penalties, fees, risks, and benefits.
Reasonable basis to believe the customer would benefit from the annuity's tax-deferral features, which is a consideration in light of the customer's tax status and the additional cost of the annuity compared to other investment options.
Suitability factors that must be considered: age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the annuity, existing assets (including other annuities), liquidity needs, liquid net worth, risk tolerance, and tax status.
Principal review and approval: Before transmitting a customer's application for a deferred variable annuity, a registered principal must review and approve the transaction.
Exchange/replacement review: Additional scrutiny is required when a customer proposes to exchange or replace an existing annuity, as new surrender charges may apply.

Variable annuities are complex products with high costs. They are generally NOT suitable for short-term investors, investors who need liquidity, investors already in a low tax bracket (who don't benefit much from tax deferral), or for funding qualified retirement plans that already provide tax deferral (such as IRAs), unless the insurance features provide additional value. Always consider whether a lower-cost alternative would be more appropriate.