Characteristics and Insurance Features
Variable annuities are hybrid products: part security, part insurance contract. Understanding this dual nature is the foundation for everything else in this unit.
What Is a Variable Annuity?
- A variable annuity is an insurance contract that combines tax-deferred growth with investment choices in subaccounts (similar to mutual funds) held in a separate account
- Variable annuities are securities registered under the Securities Act of 1933 and the Investment Company Act of 1940, AND they are insurance products
- To sell variable annuities, a representative must hold:
- A securities license (Series 6 or Series 7)
- A state insurance license
- Association with a broker-dealer
- The contract owner bears the investment risk - unlike fixed annuities, the value fluctuates based on separate account performance
Two Phases of a Variable Annuity
| Phase | What Happens | Key Unit |
|---|---|---|
| Accumulation phase (pay-in) | Owner makes purchase payments; money is invested in subaccounts; value grows tax-deferred | Accumulation units |
| Annuity phase (payout) | Contract is annuitized; owner receives periodic income payments that vary with investment performance | Annuity units |
Insurance Features - Minimum Guarantees
Variable annuities include insurance guarantees that pure investment products do not offer. These guarantees are backed by the insurance company's general account, not the separate account.
Guaranteed Minimum Death Benefit (GMDB)
- If the contract owner dies during the accumulation phase, the beneficiary receives at least the total premiums paid (minus withdrawals), even if the account value has declined
- Some contracts offer stepped-up death benefits that lock in periodic high-water marks (e.g., highest anniversary value)
- The guarantee depends on the claims-paying ability of the issuing insurance company
Living Benefit Riders
Living benefit riders provide guarantees the owner can use while alive. Each carries an additional annual charge.
| Rider | What It Guarantees | Typical Details |
|---|---|---|
| GMIB (Guaranteed Minimum Income Benefit) | A minimum annuitization amount | Must wait a specified period (e.g., 10 years) before exercising |
| GMWB (Guaranteed Minimum Withdrawal Benefit) | A guaranteed annual withdrawal percentage (typically 4-6%) for life | Payments continue even if account value drops to zero |
| GMAB (Guaranteed Minimum Accumulation Benefit) | Account value will equal at least premiums paid after a holding period | Protects against market loss over a specified time frame |
- Riders are issued by the insurance company and backed by the general account
- Rider charges typically range from 0.50-1.50% of the benefit base annually
- Riders may have waiting periods before the guarantee can be exercised
Exam Tip: Gotchas
- Variable annuity guarantees (death benefits, living benefits) are backed by the general account of the insurance company, not the separate account. If the insurance company becomes insolvent, these guarantees may not be honored.
Death Benefits in Detail
- The standard death benefit pays the greater of:
- (a) Current account value at death, or
- (b) Total purchase payments minus prior withdrawals
- Enhanced death benefit riders may provide a stepped-up or ratcheted benefit (highest anniversary value) for an additional fee
- Death benefits are paid to the named beneficiary and bypass probate
- The earnings portion of the death benefit is taxable as ordinary income to the beneficiary
- No step-up in cost basis for annuities (unlike most other inherited assets)
Exam Tip: Gotchas
- Annuities do not receive a step-up in cost basis at death, unlike inherited stocks or mutual funds. The beneficiary pays ordinary income tax on the earnings portion of the death benefit.