Variable Annuities and Variable Life

The separate account and the two phases

Premiums for a variable contract go into a separate account, kept apart from the insurer's general account so that the contract holder's money is not exposed to the insurer's own investment results or general creditors. The separate account is itself registered under the Investment Company Act, as either a unit investment trust or a management company, and it is divided into subaccounts, each investing in a portfolio with a stated objective — much like a family of mutual funds.

During the accumulation phase, purchase payments buy accumulation units. The number of units the holder owns grows with each payment; the value of each unit moves with the performance of the chosen subaccounts. There is no guaranteed value. The holder may transfer between subaccounts, usually without immediate tax consequence, and may surrender the contract subject to charges.

Annuitization converts the accumulated value into a stream of payments. At that moment the accumulation units are exchanged for a fixed number of annuity units, and that number never changes again. What changes thereafter is the value of each annuity unit, which is why a variable annuity payment varies from month to month.

Annuitization is generally irrevocable. That is the single most important fact to convey to a customer, and it is why the decision deserves more attention than the sale that preceded it.

The assumed interest rate

The size of the first annuity payment is computed using an assumed interest rate — a projected rate of return built into the payout calculation. What happens to subsequent payments depends on how the separate account's actual performance compares with that assumption.

If actual performance exceeds the AIR, the next payment rises. If it equals the AIR, the payment stays the same. If it falls short, the payment falls. This holds regardless of whether the account made money in absolute terms — an account that returned 3 percent against a 5 percent AIR produces a smaller payment even though it gained. The comparison is always against the AIR, never against zero, and that is the exam's question every time.

A higher AIR produces a larger first payment and a greater likelihood of subsequent declines. A lower AIR produces a smaller first payment that is more likely to grow.

Payout options and contract features

The election at annuitization determines who is paid and for how long, and the trade-off is uniform: the more protection the option provides to a beneficiary, the smaller each payment.

Life only, or straight life, pays for the annuitant's lifetime and stops at death. It produces the largest payment and pays nothing to anyone afterwards.

Life with period certain pays for life, but if the annuitant dies within a stated period, payments continue to a beneficiary for the rest of that period.

Unit refund life, or refund life, pays for life and, at death, pays a beneficiary the remaining value of units not yet distributed.

Joint and last survivor pays until the second of two annuitants dies, and produces the smallest payment of the four because the expected payment period is longest.

During accumulation, contracts commonly offer a death benefit guaranteeing at least the amount paid in, riders providing guaranteed living benefits, and a free-look period. All of them are paid for through the contract's charges: a mortality and expense risk charge, an administrative charge, the underlying subaccount expenses, and surrender charges that decline over a stated period. The total is materially higher than a comparable mutual fund's, which is why the recommendation has to rest on the features actually being used.

The outline also names the immediate annuity, purchased with a single premium and annuitized at once, and the right of accumulation applied to purchase payments.

Taxation

Contributions to a non-qualified annuity are made with after-tax dollars, so they establish a cost basis. Growth inside the contract is tax-deferred — no annual tax on gains or income within the separate account, which is the product's core appeal.

Withdrawals during accumulation come out on a last-in, first-out basis: earnings first, and they are taxed as ordinary income, not as capital gains. Only after the earnings are exhausted does the return of basis begin, tax free. That LIFO treatment is the opposite of the intuition customers bring from brokerage accounts and it is worth stating explicitly.

A withdrawal before age fifty-nine and a half generally attracts a 10 percent penalty on the taxable portion, on top of ordinary income tax.

Annuity payments are treated differently. Each payment is part return of basis and part earnings, determined by an exclusion ratio, so only the earnings portion is taxable.

Because the growth is already tax-deferred, placing a variable annuity inside an IRA or another qualified plan buys a tax benefit the account already has, while paying the annuity's costs for it. The exam's position, and the regulators', is that such a recommendation needs a justification beyond tax deferral — such as a guaranteed living benefit the customer actually wants.

Section 1035 of the Internal Revenue Code permits a tax-free exchange of one annuity contract for another, or of a life insurance policy for an annuity. It does not permit an annuity to be exchanged for a life policy. A 1035 exchange preserves the deferral, but it does not preserve the customer from a new surrender charge period, and an exchange that starts a fresh surrender schedule to generate a commission is the classic abuse.

Rule 2330 and the sales obligations

FINRA Rule 2330 applies specifically to purchases and exchanges of deferred variable annuities, and it exists because this product has generated more sales-practice enforcement than almost any other.

Before recommending one, the representative must have a reasonable basis to believe the transaction is suitable under Rule 2111; that the customer has been informed of the material features — surrender period and charges, the tax penalty on withdrawals before age fifty-nine and a half, mortality and expense charges, investment advisory fees, potential charges for riders, market risk, and the restrictions on access to the money; that the customer would benefit from at least one feature of a deferred variable annuity such as tax deferral, annuitization or a death or living benefit; and that the particular contract, its subaccounts and any riders are suitable for that customer.

The firm must make reasonable efforts to obtain the customer's age, income, financial situation and needs, investment experience, objectives, time horizon, existing assets, liquidity needs, risk tolerance and tax status.

A registered principal must review and determine whether to approve the transaction no later than seven business days after an office of supervisory jurisdiction receives a complete and correct application package. Where the recommendation is an exchange, the review must consider whether the customer has had another exchange within the preceding thirty-six months.

FINRA Rule 2320 governs variable contracts more generally, and Rule 2211 governs communications with the public about variable life insurance and variable annuities — a reminder that a variable contract's marketing is regulated separately from an ordinary fund's.

Variable life insurance follows the same structure applied to a policy rather than an annuity: premiums fund a separate account, the cash value fluctuates with performance and is not guaranteed, and the death benefit varies above a guaranteed minimum. Scheduled premium contracts require fixed premiums; flexible premium, or variable universal life, allows the holder to vary them. Policy loans are available against cash value, usually up to a stated percentage, and the general suitability question is whether the customer needs permanent insurance at all before whether they want the investment component.