A variable annuity payment can shrink in a month when its subaccounts made money. Once you see why, the rest of variable contracts falls into place: who carries the market risk, what the guarantees cost and when the tax bill arrives.
A variable annuity starts from the same basics as any annuity: an insurance contract that pays money back in installments, often for life. A deferred annuity builds value for years before payments begin, so it works as a savings vehicle first. An immediate annuity turns a lump sum into income right away. Under Internal Revenue Code (IRC) Section 72(u)(4), it is bought with a single premium, starts paying within one year and makes substantially equal payments at least annually.
Where the money sits decides who carries the market risk. The insurer's general account is the pool of assets backing all of its guaranteed promises. A fixed annuity is funded there: the insurer credits a guaranteed rate and owes the promised payments even if its own investments do badly.
Common mistakes
- Fixed accumulation units: Each new purchase payment buys more accumulation units. Only annuity units are fixed, and only from annuitization on.
- Zero as the benchmark: A 1% return against a 4% AIR lowers the payment, as Example 1 shows. The hurdle is the AIR.
- The 8.5% cap: That maximum sales charge belongs to mutual funds under Rule 2341. Rule 2320 sets none for variable contracts.
Bottom line
- A variable annuity is a security because its value follows a separate account, so the owner bears investment risk while the insurer keeps mortality and expense risk.
- Purchase payments keep buying accumulation units; annuitization converts the account into a fixed number of annuity units whose value changes each period.
- Returns above the AIR raise the payment, returns equal to it hold the payment, and returns below it lower the payment.
- Life only pays the most and joint and last survivor the least.
Exam shortcut
Find the AIR before you read the answer choices. A return above it raises the payment, equal holds it and below lowers it, whether the return is positive or negative. For payout rankings, the more lives or guaranteed payments the insurer covers, the smaller the check: life only on top, joint and last survivor at the bottom. On a tax stem, ask three questions in order. Is there basis?
The full lesson (about 4,642 words, 31 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C16
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