Quick Answer
Variable annuities are purchased as deferred (accumulation phase first) or immediate (payments start right away) contracts, and they carry layered charges: M&E risk, administrative, subaccount, surrender (CDSC), rider, and 12b-1 fees. The IRC's tax-free-exchange provision lets owners exchange insurance products tax-free, but only toward products with fewer tax advantages, never back toward life insurance.
Every fee and every exchange rule exists to answer one question the exam asks repeatedly: who bears the cost of this feature, and in which direction is this exchange allowed to move?
Immediate vs. Deferred Annuities
| Feature | Deferred Annuity | Immediate Annuity |
|---|---|---|
| Payment type | Lump sum or periodic payments | Single lump-sum payment only |
| Accumulation phase? | Yes | No |
| When payments begin | At a future date chosen by the owner | Within one payment period (e.g., one month) |
| Typical buyer | Someone building retirement savings | Someone at or near retirement converting savings to income |
- Deferred annuities are the most common type and the primary focus of the variable-annuity sales-practice rules
- Immediate annuities skip the accumulation phase entirely
Charges and Fees
Variable annuities carry multiple layers of charges, each described below.
| Charge | Typical Range | What It Covers |
|---|---|---|
| Mortality and Expense (M&E) risk charge | 1.00-1.50% of account value/year | Mortality risk (guaranteeing death benefits and lifetime payments) and expense risk (guaranteeing admin costs won't increase) |
| Administrative fees | Flat annual fee or small % | Recordkeeping and contract administration |
| Subaccount expenses | Varies (like mutual fund expense ratios) | Management fees and operating expenses of each subaccount |
| Surrender charges / Contingent Deferred Sales Charge (CDSC) | 6-8% declining to 0% over 6-8 years | Penalty for early withdrawals exceeding the free withdrawal allowance |
| Rider charges | 0.50-1.50% of benefit base/year | Optional living benefit riders: Guaranteed Minimum Income Benefit (GMIB), Guaranteed Minimum Withdrawal Benefit (GMWB), Guaranteed Minimum Accumulation Benefit (GMAB) |
| 12b-1 fees | Up to 0.25% (no-load); higher for load | Distribution fees charged by underlying subaccounts |
Surrender Charges (CDSC)
- A declining charge assessed on withdrawals exceeding the free withdrawal allowance during the surrender period
- Typical schedule: starts at 6-8% in year 1, declining by approximately 1% per year
- Most contracts allow free withdrawals of up to 10% of account value per year without a surrender charge
Penalties
- 10% federal tax penalty on taxable withdrawals taken before age 59 1/2 (applies to the earnings portion only for non-qualified annuities)
- Exceptions to the 10% penalty include:
- Death
- Disability
- Substantially Equal Periodic Payments (SEPP), a lifetime series of equal withdrawals calculated under IRS-approved methods
- Surrender charges are a contractual penalty imposed by the insurance company
- The 10% tax penalty is a federal tax penalty imposed by the IRS
- Both may apply simultaneously to the same withdrawal
Exam Tip: Gotchas
- Surrender charges and the 10% tax penalty can both apply to the same withdrawal. Surrender charges come from the insurance company; the 10% penalty comes from the IRS. They are independent.
- Free withdrawal allowance (typically 10% of account value per year) avoids surrender charges only, not the 10% tax penalty. If you are under 59 1/2, the tax penalty still applies to the earnings portion.
Try it: Calculate what the customer would owe if they withdraw in year X of the contract with the Variable Annuity Surrender Calculator.
Right of Accumulation (ROA)
- Some variable annuity contracts offer breakpoint discounts on fees or enhanced features based on cumulative purchase payments or account value
- ROA allows the contract owner to count prior purchases toward reaching a breakpoint level
- Similar in concept to mutual fund breakpoints but applied to annuity contract features
Waiver of Premium
- A waiver of premium rider provides that if the contract owner becomes disabled, the insurance company will continue to make premium payments on the owner's behalf
- This rider carries an additional charge
- Typically available on variable life insurance policies rather than variable annuities
Tax-Free Exchanges of Insurance Products
The Internal Revenue Code's tax-free-exchange provision for insurance products permits tax-free exchanges of insurance products, provided the exchange moves toward a product with fewer tax advantages (or the same type). These are commonly called "1035 exchanges" in the industry.
Permitted Exchanges
| From | To (Permitted) |
|---|---|
| Life insurance policy | Another life insurance policy |
| Life insurance policy | Endowment contract |
| Life insurance policy | Annuity contract |
| Endowment contract | Another endowment contract |
| Endowment contract | Annuity contract |
| Annuity contract | Another annuity contract |
NOT Permitted
- Annuity to life insurance: an annuity is the "end of the line." You cannot exchange back to a product with greater tax advantages
Requirements for a Valid Tax-Free Exchange
- Must be a direct transfer between insurance companies (owner cannot take constructive receipt of funds)
- The owner and annuitant/insured must remain the same
- Both full and partial 1035 exchanges are permitted
The 36-Month Lookback
- The variable-annuity sales-practice rules include a 36-month lookback: if a customer has exchanged a deferred variable annuity within the preceding 36 months, the firm must evaluate whether the new exchange is suitable
- Frequent exchanges are a red flag for churning (generating commissions at the customer's expense)
Exam Tip: Gotchas
- A tax-free insurance-product exchange is one-way toward annuities. Life insurance can become an annuity, but an annuity can never become life insurance tax-free. Think of it as a one-way street: Life Insurance → Endowment → Annuity. You can move right but never left.
What Should You Check on Exam Day?
- Distinguish deferred (has an accumulation phase) from immediate (payments start within one payment period) annuities.
- Match each fee to what it covers: M&E to mortality and expense risk, rider charges to living benefits, 12b-1 to subaccount distribution.
- Remember the free withdrawal allowance (typically 10% of account value per year) avoids the surrender charge only, not the 10% tax penalty.
- Confirm the direction of a 1035 exchange: toward annuities is allowed, back toward life insurance is not.
- Flag any exchange of a deferred variable annuity purchased within the preceding 36 months as a suitability red flag.