Variable Annuities
Variable annuities were designed to help investors keep pace with inflation by tying returns to market performance. Understanding accumulation units, annuity units, and the Assumed Interest Rate (AIR) is critical for the Series 7 exam.
The Separate Account
Variable annuity premiums are invested in a separate account:
- Legally separated from insurer's general account
- Functions like a family of mutual funds
- Offers multiple investment subaccounts (equities, bonds, money market)
- Policyholder chooses allocation
- Policyholder bears investment risk
- Account value fluctuates with market
Accumulation Units
During the accumulation phase, investors purchase accumulation units:
How Accumulation Units Work
- Similar to mutual fund shares
- Represent proportionate ownership in separate account
- Value fluctuates with subaccount performance
- Dividends and capital gains automatically reinvested
- No taxation during accumulation (tax-deferred growth)
Accumulation Unit Value (AUV) Calculation
AUV = Total Separate Account Value ÷ Number of Accumulation Units
Example:
- Premium payment: $10,000
- AUV at purchase: $25
- Accumulation units purchased: 400 units
If the separate account performs well and AUV increases to $30:
- Account value: 400 × $30 = $12,000
Annuity Units
When the contract is annuitized (begins payout phase):
Conversion Process
- Accumulation units are converted to annuity units
- Number of annuity units is fixed at annuitization
- Value of each annuity unit varies with performance
- Monthly payment = Fixed annuity units × Variable unit value
Key Distinction
| Feature | Accumulation Units | Annuity Units |
|---|---|---|
| Phase | Accumulation | Payout |
| Number | Variable (add more with payments) | Fixed at annuitization |
| Value | Variable | Variable |
Assumed Interest Rate (AIR)
The AIR is a benchmark set at contract issuance to determine initial payout amount:
How AIR Works
- Insurance company projects a rate of return (e.g., 4%)
- First payment is based on this assumed rate
- Subsequent payments compared to actual performance
Payment Changes Based on Performance
| Separate Account Performance | Effect on Payment |
|---|---|
| Exceeds AIR | Payment increases |
| Equals AIR | Payment stays the same |
| Below AIR | Payment decreases |
Example:
- AIR: 4%
- If separate account earns 6%: Payments increase
- If separate account earns 4%: Payments stay same
- If separate account earns 2%: Payments decrease
Important AIR Concepts
- AIR affects annuity units only (not accumulation units)
- Higher AIR = Higher initial payment, but harder to maintain/increase
- Lower AIR = Lower initial payment, but easier to maintain/increase
- AIR does NOT guarantee any rate of return
Variable Annuity Fees
| Fee Type | Description |
|---|---|
| Mortality & Expense (M&E) | Covers insurance guarantees, typically 1-1.5% |
| Administrative fees | Covers recordkeeping and administration |
| Subaccount fees | Similar to mutual fund expense ratios |
| Surrender charges | CDSC if withdrawn early (typically 7 years) |
| Contract fees | Annual flat fee (e.g., $25-50) |
Licensing Requirements
To sell variable annuities, representatives must hold:
- Securities license (Series 6 or Series 7)
- State insurance license
- State securities registration (Series 63 or 66)
Both licenses are required because variable annuities are both securities AND insurance products.
Exam Tip: AIR Comparison Remember: If actual performance EXCEEDS AIR, payments go UP. If performance EQUALS AIR, payments stay the SAME. If performance is BELOW AIR, payments go DOWN. The AIR is the "neutral point."
6.3 Annuity Taxation
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