Variable Annuities
Variable annuities offer investment options with the potential for higher returns, but the owner bears the investment risk. These products are considered securities and require additional licensing.
How Variable Annuities Work
In a variable annuity, the owner selects from investment options (subaccounts), and the contract value fluctuates based on investment performance.
Key Characteristics
| Feature | Description |
|---|---|
| Investment options | Owner chooses from subaccounts |
| Investment risk | Borne by the contract owner |
| Account value | Fluctuates with market performance |
| Separate account | Funds held separately from insurer's general account |
| Growth potential | Higher than fixed annuities |
The Separate Account
Variable annuity funds are held in a separate account, which is legally distinct from the insurer's general account.
Separate Account Features
| Feature | Description |
|---|---|
| Legal protection | Assets not available to insurer's creditors |
| Investment options | Contains multiple subaccounts |
| Valuation | Value calculated daily based on subaccount performance |
| SEC regulation | Considered a security; regulated by SEC |
Subaccounts
Subaccounts are investment options within the separate account, similar to mutual funds:
| Subaccount Type | Investment Focus |
|---|---|
| Equity (stock) | Growth stocks, value stocks, international |
| Bond | Government, corporate, high-yield |
| Balanced | Mix of stocks and bonds |
| Money market | Short-term, stable value |
| Specialty | Real estate, sector funds |
Securities Registration Requirements
Because variable annuities are securities, they have unique regulatory requirements.
Federal Regulation
| Requirement | Description |
|---|---|
| SEC registration | Variable annuities must be registered with SEC |
| Prospectus | Must be provided before or at sale |
| FINRA oversight | Registered representatives must follow FINRA rules |
Agent Licensing Requirements
| License Required | Purpose |
|---|---|
| State insurance license | Required to sell any annuity |
| Securities license (Series 6 or 7) | Required for variable products |
| FINRA registration | Must be registered with a broker-dealer |
Exam Tip: Variable annuities require BOTH an insurance license AND a securities license. Fixed annuities require only an insurance license.
Prospectus Delivery
The prospectus is a legal disclosure document that must be provided to potential buyers.
Prospectus Requirements
| Requirement | Description |
|---|---|
| Timing | Before or at the time of sale |
| Content | Fees, expenses, investment options, risks |
| Updates | Updated prospectus must be provided periodically |
| Purpose | Enable informed investment decisions |
What the Prospectus Contains
| Section | Information |
|---|---|
| Fee table | All fees and expenses clearly disclosed |
| Investment options | Description of each subaccount |
| Risk factors | Investment risks, including possible loss of principal |
| Death benefit | How death benefit is calculated |
| Surrender charges | Schedule of charges for early withdrawal |
| Tax information | Tax treatment of distributions |
Variable Annuity Fees and Expenses
Variable annuities have multiple layers of fees:
Common Fees
| Fee Type | Typical Range | Description |
|---|---|---|
| Mortality and expense (M&E) | 0.50% - 1.50% | Covers insurance guarantees |
| Administrative fees | 0.10% - 0.30% | Contract administration |
| Subaccount expenses | 0.50% - 1.50% | Investment management fees |
| Surrender charges | 5% - 8% (declining) | Early withdrawal penalty |
| Rider charges | 0.50% - 1.50% | Optional benefits (GMIB, GMWB) |
Total Annual Costs
| Category | Example |
|---|---|
| M&E + Administrative | 1.25% |
| Subaccount expenses | 0.75% |
| Total (without riders) | 2.00% |
| With optional riders | 2.50% - 3.00%+ |
Guarantees and Riders
Many variable annuities offer optional living benefit riders for additional fees.
Common Riders
| Rider | Benefit |
|---|---|
| Guaranteed Minimum Income Benefit (GMIB) | Guarantees minimum income at annuitization |
| Guaranteed Minimum Withdrawal Benefit (GMWB) | Guarantees minimum withdrawal amount |
| Guaranteed Minimum Accumulation Benefit (GMAB) | Guarantees account value after specified period |
| Enhanced death benefit | Higher death benefit than account value |
Death Benefit
Variable annuities typically include a death benefit:
| Type | Description |
|---|---|
| Return of premium | Pays greater of account value or premiums paid |
| Stepped-up | Locks in gains periodically (e.g., annually) |
| Roll-up | Increases at guaranteed rate (e.g., 5% per year) |
Variable Annuity Considerations
Advantages
| Advantage | Description |
|---|---|
| Growth potential | Can participate in market gains |
| Tax deferral | Earnings grow tax-deferred |
| Death benefit | Protection for beneficiaries |
| Investment flexibility | Can reallocate among subaccounts |
| Optional guarantees | Riders provide income/withdrawal guarantees |
Disadvantages
| Disadvantage | Description |
|---|---|
| Investment risk | Can lose money |
| High fees | Often 2-3%+ annually |
| Complexity | Many features to understand |
| Surrender charges | Limited liquidity early on |
| Tax treatment | Gains taxed as ordinary income, not capital gains |
Suitability Considerations
Variable Annuities May Be Suitable For:
| Profile | Why Variable Annuities May Fit |
|---|---|
| Long time horizon | Time to recover from market downturns |
| Moderate to high risk tolerance | Comfortable with investment fluctuation |
| Seeking growth with tax deferral | Wants higher return potential |
| Needs death benefit protection | Beneficiary protection important |
Variable Annuities May NOT Be Suitable For:
| Profile | Why Variable Annuities May Not Fit |
|---|---|
| Risk-averse investors | Cannot tolerate investment losses |
| Short time horizon | Insufficient time to recover losses |
| Cost-sensitive | High fees reduce returns |
| Already maximizing tax-advantaged accounts | Other accounts may be more efficient |
Key Takeaways
- Variable annuities offer investment options with growth potential
- The owner bears the investment risk—account value can decrease
- Funds are held in separate accounts with subaccounts similar to mutual funds
- Variable annuities are securities requiring SEC registration and a prospectus
- Agents must hold both insurance and securities licenses
- Fees are higher than fixed annuities (often 2-3% annually)
- Optional riders can provide income and withdrawal guarantees for additional cost
- Suitable for investors with longer time horizons and higher risk tolerance
To sell a variable annuity, an agent must hold:
Variable annuity funds are held in a:
A prospectus for a variable annuity must be provided:
Which of the following is a potential disadvantage of variable annuities?
15.4 Indexed Annuities
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