Variable Contracts / Variable Annuities

Variable annuities combine investment features with insurance benefits, making them unique hybrid products with their own set of rules.

What Are Variable Annuities?

• Insurance products with investment features
• Considered securities (regulated by both the SEC and state insurance regulators)
• Must be sold by prospectus
• Invested in separate accounts (sub-accounts) that function like mutual funds
• Returns are not guaranteed - they vary with sub-account performance
• Require both a securities license (Series 6 or Series 7) and an insurance license to sell

Exam Tip: Gotchas

• Variable annuities are both insurance products and securities. This dual nature means they require dual licensing (securities + insurance) and dual regulation (SEC + state insurance).
• Fixed annuities are not securities - only variable annuities are securities.

Think of it this way: A variable annuity is like a mutual fund wrapped inside an insurance contract. You get market exposure through sub-accounts (similar to mutual funds), but the insurance wrapper adds tax deferral, a death benefit, and a future income stream.

The Two Phases

Variable annuities have two distinct phases:

Accumulation Phase (Building the Account)

• Investor makes contributions (can be lump sum or periodic)
• Funds grow tax-deferred - no current taxation on gains while they remain in the account
• Investor selects sub-accounts (stock, bond, money market options)
• No contribution limits (unlike IRAs or 401(k)s)
• Withdrawals before age 59 1/2 subject to a 10% IRS early withdrawal penalty plus ordinary income tax

Annuitization Phase (Receiving Payments)

• Investor converts the account into a stream of periodic payments
• Payments taxed as ordinary income (not capital gains rates)
• Once annuitized, the decision is generally irrevocable

Exam Tip: Gotchas

• Variable annuity withdrawals are taxed as ordinary income, not capital gains, even if the underlying sub-accounts hold stocks.
• The 10% early withdrawal penalty applies before age 59 1/2 (same as IRAs).

Payout options:

Surrender Charges

• Contingent deferred sales charge (CDSC)-like fees charged for early withdrawals during the surrender period
• Typically decline over 5-10 years (similar to Class B mutual fund CDSCs)
• Designed to discourage short-term investing in a long-term product

Key Features

• Death benefit: If the annuitant dies during the accumulation phase, the beneficiary receives at least the amount invested (or the current account value, whichever is higher)
• Tax-deferred growth: No taxes on gains until withdrawal
• No contribution limits: Unlike qualified retirement plans
• 1035 exchange: Tax-free exchange of one annuity for another (or a life insurance policy for an annuity) under Internal Revenue Code (IRC) Section 1035

Exam Tip: Gotchas

• A 1035 exchange is tax-free, but surrender charges on the old contract may still apply.
• Surrender charges and CDSC are similar concepts but apply to different products (annuities vs. mutual funds).

FINRA Rule 2330

FINRA Rule 2330 specifically governs suitability for deferred variable annuities:

• Requires the representative to make reasonable efforts to determine the customer's age, income, investment experience, objectives, time horizon, existing assets, and risk tolerance
• A registered principal must review and approve the customer's application before it is sent to the insurance company
• Principal review must occur within 7 business days of receiving a complete application
• FINRA scrutinizes exchanges of one variable annuity for another (especially within 36 months) because surrender charges on the old contract may apply

Exam Tip: Gotchas

• FINRA Rule 2330 specifically targets deferred variable annuities for enhanced suitability requirements; it does not apply to fixed annuities.
• A registered principal must review and approve the application within 7 business days.
• Exchanges within 36 months of a prior purchase receive extra scrutiny because of surrender charges on the old contract.