Variable Contracts

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.

Separate Account vs. General Account

An insurance company keeps two kinds of accounts, and they carry different risks.

Exam Tip: Gotchas

• A guaranteed return belongs to a fixed annuity and its general account. A variable annuity's separate account guarantees nothing about performance.
• The separate account is why a variable annuity is a security: the owner, not the insurer, takes the market risk.

Variable Life Insurance

Variable life insurance is the other variable contract. It is a life insurance policy whose cash value is invested through a separate account, the same way a variable annuity's money is.

• It is both a security and an insurance product, so it is sold by prospectus, and selling it takes a securities license and an insurance license
• Premiums, after the policy's fees come out, go into separate-account sub-accounts that the policyowner picks
• Cash value is not guaranteed: it rises and falls with the sub-accounts, and the owner can lose money
• The insurer may guarantee a minimum death benefit; any amount above that minimum varies with the sub-accounts. No guarantee covers the separate account's investment return or principal value
• The policyowner bears the investment risk, just as a variable annuity owner does

Exam Tip: Gotchas

• The greatest risk in a variable life policy or a variable annuity is market risk, because the policyowner bears the separate account's investment risk. Interest rate risk is the signature risk of a fixed-rate bond.
• FINRA's deferred variable annuity rule lists market risk among the features a customer must be told about.
• A guaranteed minimum death benefit does not guarantee the cash value.

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)
• A withdrawal before annuitization is taxed LIFO (last in, first out): earnings come out first and are fully taxable as ordinary income; only after all earnings are withdrawn does the owner reach the tax-free cost basis
• Withdrawals before age 59 1/2 generally face a 10% IRS early withdrawal penalty on the taxable (earnings) portion unless an exception applies, plus ordinary income tax on that same portion

Annuitization Phase (Receiving Payments)

• Investor converts the account into a stream of periodic payments
• The earnings part of each payment is taxed as ordinary income (not capital gains rates)
• In a nonqualified contract, part of each payment is a tax-free return of the owner's after-tax investment. The exclusion ratio (investment in the contract divided by the expected return) sets that part, and once the investment is fully recovered, later payments are fully taxable
• Once annuitized, the decision is generally irrevocable
• Qualifying substantially equal periodic payments, made at least annually over life or life expectancy, are exempt from the 10% IRS penalty even before age 59 1/2. Annuitization alone does not automatically remove the penalty

Exam Tip: Gotchas

• Variable annuity withdrawals are taxed as ordinary income, not capital gains, even if the underlying sub-accounts hold stocks.
• Age 59 1/2 removes the 10% IRS penalty based on age alone. Earlier exceptions have their own requirements. Ordinary income tax and any contractual surrender charge are separate.
• LIFO means earnings come out first. A common mistake is expecting FIFO (basis returned first). Example: you invested $50,000 and the contract is now worth $70,000, so it holds $20,000 in earnings. A $20,000 withdrawal comes entirely from those earnings under LIFO, so the whole amount is taxable (plus the 10% penalty if you are under 59 1/2 without an exception).

Payout options:

What Sets the Size of Each Payment?

• The payout option: the time period the payments must cover changes each payment. For the same account value, adding a guaranteed period or a second life generally lowers each payment
• Age and sex: a life payout depends on the annuitant's life expectancy. An older annuitant is expected to receive fewer payments, so the same account value buys a larger payment
• Sub-account performance (variable payout only): payments rise and fall with the owner's separate-account sub-accounts, measured against an assumed interest rate (AIR) set in the contract. They do not follow the insurance company's own investment returns

Exam Tip: Gotchas

• The kind of annuity payout chosen partly decides how large each payment is.
• A variable payout follows the owner's sub-accounts, not the insurer's general-account investments.
• Age and sex do affect a life annuity payment, because they set life expectancy.
• A nonqualified payout is not all tax-free: only the part that returns the owner's after-tax investment escapes tax.

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

Try it: Calculate what you would owe if you withdraw in year X of the contract with the Variable Annuity Surrender Calculator.

Costs and Fees

A variable annuity charges more than one fee, and each fee comes out of the owner's return.

Exam Tip: Gotchas

• The M&E charge is ongoing. The owner pays it whether or not they ever withdraw. A surrender charge applies only when money leaves early.
• The variable-annuity sales-practice rule lists M&E fees, investment advisory fees, and rider charges, along with the surrender charge, among the features a representative must make sure the customer has been told about.
• Swapping one variable annuity for another can raise these fees, which is one reason FINRA looks closely at exchanges.

Key Features

• Death benefit: If the owner 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 the Internal Revenue Code's tax-free-exchange provision for insurance products

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).

Variable-Annuity Sales-Practice Requirements

The variable-annuity sales-practice rule 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

• The variable-annuity sales-practice rule 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.

What Should You Check on Exam Day?

• Can you explain why variable annuities and variable life policies need both a securities license and an insurance license, while fixed annuities are not securities?
• Can you say who bears the separate account's investment risk, why that makes market risk the greatest risk in a variable life policy or variable annuity, and which account backs a fixed annuity's guarantee?
• Can you state the age before which a withdrawal triggers a 10% IRS early withdrawal penalty, why a partial withdrawal is often fully taxable (LIFO: earnings come out before basis), and how the exclusion ratio splits a nonqualified annuity payment?
• Can you list what sets the size of an annuity payment: the payout option, age and sex, and, for a variable payout, sub-account performance?
• Can you tell the ongoing variable annuity fees apart from the surrender charge, and state how many business days a principal has to review a deferred variable annuity application?