Annuities
Annuities are contracts between an individual and an insurance company designed to provide income, either immediately or at a future date. The critical exam distinction is whether the annuity is a security or purely an insurance product, and that comes down to one question: who bears the investment risk?
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.
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
- Subaccounts are registered under the Investment Company Act of 1940
Tax Treatment
- Tax-deferred growth during the accumulation phase
- Withdrawals taxed as ordinary income (not capital gains)
- Withdrawals follow LIFO (last in, first out): earnings come out first, so early withdrawals are fully taxable
- 10% IRS penalty on withdrawals before age 59 1/2, in addition to ordinary income tax
Exam Tip: Gotchas
- The 10% early withdrawal penalty is in addition to ordinary income tax. A pre-59 1/2 withdrawal gets hit twice: income tax on the earnings plus the 10% penalty.
- LIFO means earnings come out first. Early withdrawals are fully taxable 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; 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
- 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.
Death Benefit
- Guarantees beneficiaries receive at least the amount invested (minus withdrawals) if the annuitant dies during the accumulation phase
- This is the "insurance" component of a variable annuity; even if subaccounts lose value, beneficiaries get back 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 |
Equity-Indexed Annuities (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) under SEC Rule 151A exemption
- 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.
Annuity Payout Options
When an annuity enters the payout phase (annuitization), the owner selects how payments will be distributed. The core trade-off: more protection for beneficiaries means smaller periodic payments.
| 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: 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.
Exam Tip: Gotchas
- 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.