Quick Answer
An annuity is a security only when the contract owner bears the investment risk. Fixed annuities and equity-indexed annuities guarantee a return, so the insurance company bears the risk and they are not securities. Variable annuities let the owner choose subaccounts, so the owner bears the risk and they must be registered with the SEC.
Annuities are contracts between an individual and an insurance company designed to provide income, either immediately or at a future date. Everything below builds on that one question: who bears the investment risk?
What Are Fixed Annuities?
- Guaranteed fixed rate of return for a specified period
- The insurance company bears the investment risk; the company promises a set return regardless of market conditions
- Provide predictable, stable income
- Not considered securities; regulated by state insurance departments, not the SEC or FINRA
- Surrender charges apply for early withdrawal (typically declining over 5-7 years)
Key takeaway: Because the insurance company guarantees the return, the contract owner takes no investment risk. No investment risk to the owner means it is not a security.
Exam Tip: Gotchas
- Fixed annuities are NOT securities. The insurance company bears all investment risk, so they are regulated by state insurance departments, not the SEC.
What Are Variable Annuities?
Variable annuities are the most frequently tested insurance product on the Series 66. Unlike fixed annuities, the contract owner bears the investment risk.
- Return depends on the performance of underlying subaccounts (similar to mutual funds)
- Subaccount options typically include equity, bond, and money market portfolios
- Are securities: Must be registered with the SEC and sold with a prospectus
- Sold by individuals who hold both securities and insurance licenses
- The insurer's separate account is generally registered under the Investment Company Act of 1940; the subaccounts within it invest in underlying fund portfolios
Tax Treatment
- Tax-deferred growth during the accumulation phase
- For a nonqualified annuity, the taxable portion of withdrawals before annuitization is taxed as ordinary income (not capital gains)
- Withdrawals generally follow LIFO (last in, first out): earnings come out first, so early withdrawals are taxable until the earnings are exhausted
- 10% additional IRS tax generally applies to the taxable portion of withdrawals before age 59 1/2, on top of ordinary income tax, unless a statutory exception applies
Exam Tip: Gotchas
- The 10% early withdrawal tax applies on top of ordinary income tax. A pre-59 1/2 withdrawal generally gets hit twice: income tax on the taxable earnings plus the 10% additional tax, absent an exception.
- LIFO means earnings come out first. Early withdrawals are taxable until the earnings are used up, because the IRS treats the last money in (earnings) as the first money out.
Fees and Charges
| Fee | Description |
|---|---|
| Mortality and expense (M&E) risk charge | Covers the insurance company's risk of guaranteeing annuity payments; typically 1.25%-1.50% per year; among annuity types, unique to variable annuities |
| Surrender charges | Penalty for early withdrawal, typically declining over 5-7 years (e.g., 7% in year 1, 6% in year 2, down to 0%) |
| Administrative fees | Annual contract maintenance charges |
| Subaccount management fees | Similar to mutual fund expense ratios |
Exam Tip: Gotchas
- Among annuity types, mortality and expense (M&E) charges are unique to variable annuities. Fixed annuities do not have M&E charges because the insurance company is not guaranteeing a death benefit tied to fluctuating subaccount values. (Variable life insurance contracts can also carry M&E charges.)
Death Benefit
- Typically guarantees beneficiaries receive at least the amount invested (minus withdrawals) if the annuitant dies during the accumulation phase, though the exact guarantee is contract-specific
- This is the "insurance" component of a variable annuity; even if subaccounts lose value, beneficiaries generally get back at least the original investment
Exam Tip: Gotchas
- The death benefit guarantee applies only during the accumulation phase. Once the contract is annuitized (payout phase begins), the death benefit depends on the payout option selected.
Two Phases of a Variable Annuity
| Phase | What Happens | Key Feature |
|---|---|---|
| Accumulation | Owner makes purchase payments; subaccounts grow tax-deferred | Death benefit guarantee applies |
| Annuitization (Payout) | Contract converts to a stream of income payments | Payment amount depends on payout option chosen |
What Are Equity-Indexed Annuities?
Also called fixed indexed annuities.
Equity-indexed annuities sit between fixed and variable annuities. They link returns to a stock market index while providing downside protection.
- Returns linked to a stock market index (e.g., S&P 500) with a guaranteed minimum return
- More complex than fixed annuities; often have long surrender periods
How Returns Are Calculated
| Mechanism | Definition | Example |
|---|---|---|
| Participation rate | Percentage of the index's gain credited to the contract | 80% participation rate: if the index gains 10%, you get 8% |
| Cap rate | Maximum return credited regardless of index performance | 7% cap: if the index gains 12%, you get only 7% |
| Floor | Minimum guaranteed return, protecting against losses | 0-3% floor: if the index loses 15%, you lose nothing (or gain the floor amount) |
Regulatory Status
- Has been debated, but generally regulated as insurance products (not securities) because the insurer bears the downside investment risk
- The insurance company (not the contract owner) bears the downside risk because of the floor
- The owner does not directly select subaccounts
Exam Tip: Gotchas
- Equity-indexed annuities are NOT securities, even though they are linked to a market index. The owner does not select subaccounts or bear the full investment risk. The guaranteed floor means the insurance company absorbs losses.
What Are the Annuity Payout Options?
When an annuity enters the payout phase (annuitization), the owner selects how payments will be distributed. Among the life-contingent options, the core trade-off is: more protection for beneficiaries means smaller periodic payments. Fixed period sits outside that trade-off since its payment size depends on the chosen term.
| Option | How It Works | Payment Size | Beneficiary Receives |
|---|---|---|---|
| Life only | Payments for the annuitant's lifetime only | Highest | Nothing at death |
| Life with period certain | Payments for life or a minimum period (e.g., 10 years), whichever is longer | Lower than life only | Remaining payments if annuitant dies within the guaranteed period |
| Joint and survivor | Payments continue for the lifetime of two annuitants | Lowest | Surviving annuitant receives continued payments (100%, 75%, or 50%) |
| Fixed period | Payments for a set number of years regardless of survival | Varies by period length | Remaining payments if annuitant dies before the period ends |
Think of it this way: Among the life-contingent payout options, life only provides the highest periodic payment because the insurance company keeps any remaining value at death. Every additional guarantee (period certain, joint survivor) reduces the payment amount because the insurer takes on more risk. Fixed period sits outside this comparison since its payment size depends on the term chosen, not survivorship.
Exam Tip: Gotchas
- Among the life-contingent options, life only = highest payment. Students often assume joint and survivor pays more because it covers two people, but it actually pays the least per period because the insurer's obligation lasts longer.
What Should You Check on Exam Day?
- Fixed and equity-indexed annuities are not securities; the insurance company bears the investment risk, and they are regulated by state insurance departments.
- Variable annuities are securities; the contract owner bears the risk through subaccounts, and the product requires SEC registration and a prospectus.
- Nonqualified variable annuity withdrawals are generally taxed LIFO as ordinary income, plus a 10% additional tax on the taxable portion before age 59 1/2 (absent an exception).
- Among annuity types, the M&E risk charge is unique to variable annuities.
- Among the life-contingent payout options, payment size trades off against beneficiary protection: life only pays the most, joint and survivor pays the least. Fixed period pays according to the chosen term instead.