Variable Annuities Structure and Features

4.3.1.1 Structure and Features

Variable annuities are a unique financial product that combines features of both insurance and investment vehicles. They are designed to provide individuals with a way to invest for the future while offering the potential for lifetime income. Understanding the structure and features of variable annuities is crucial for anyone preparing for the Series 6 Exam, as these products are a significant part of the exam content.

What is a Variable Annuity?

A variable annuity is an insurance contract that offers investment options and income payments, with returns that vary based on the performance of the chosen investments. Unlike fixed annuities, which provide guaranteed returns, variable annuities allow investors to select from a range of sub-accounts, which are similar to mutual funds. This choice offers the potential for higher returns but also involves greater risk.

Glossary:

• Variable Annuity: An insurance contract with investment options, providing variable returns and income.
• Sub-Account: An investment option within a variable annuity, similar to a mutual fund.

The Two Phases of Variable Annuities

Variable annuities operate in two distinct phases: the accumulation phase and the annuitization phase. Each phase serves a different purpose in the lifecycle of the annuity.

Accumulation Phase

During the accumulation phase, the investor makes contributions to the annuity. These contributions are allocated among various sub-accounts, which are akin to mutual funds. The performance of these sub-accounts determines the growth of the investment. Investors can typically choose from a wide array of investment options, including equities, bonds, and money market instruments.

• Investment Flexibility: Investors can adjust their portfolio allocations according to their risk tolerance and market conditions.
• Tax-Deferred Growth: One of the key benefits of variable annuities is that earnings grow tax-deferred. This means that investors do not pay taxes on the investment gains until they begin making withdrawals, allowing the investment to compound more effectively over time.

Annuitization Phase

The annuitization phase begins when the investor decides to convert the accumulated assets into periodic income payments. This phase can be initiated at retirement or another chosen time, depending on the terms of the contract.

• Income Options: Investors can choose from various payout options, including lifetime income, joint and survivor income, or period-certain payments. Each option has different implications for the amount and duration of payments.
• Flexibility in Income: Some contracts allow for partial annuitization, enabling investors to withdraw a portion of the funds while leaving the rest to continue growing.

Key Features of Variable Annuities

Variable annuities come with several key features that make them attractive to investors seeking both growth and income potential.

Tax-Deferred Growth

As mentioned earlier, one of the most significant advantages of variable annuities is the tax-deferred growth. This feature allows investors to accumulate wealth more efficiently by deferring taxes on investment gains until withdrawal. This can be particularly beneficial for long-term investors who want to maximize their retirement savings.

Death Benefits

Variable annuities often include a death benefit, which guarantees that a beneficiary will receive a specified amount upon the annuitant’s death. This amount is typically the greater of the total contributions made or the current value of the annuity. Some contracts offer enhanced death benefits for an additional fee, providing even greater security for beneficiaries.

Riders and Options

Variable annuities offer various riders and options that can be added to the contract for additional fees. These riders provide extra guarantees or features that can enhance the annuity’s value.

• Guaranteed Minimum Income Benefit (GMIB): Ensures a minimum level of income regardless of investment performance.
• Guaranteed Minimum Withdrawal Benefit (GMWB): Allows for a specified amount of withdrawals each year without depleting the principal.
• Long-Term Care Riders: Provide additional benefits if the annuitant requires long-term care services.

Variable vs. Fixed Annuities

Understanding the differences between variable and fixed annuities is essential for the Series 6 Exam. While both are insurance products designed to provide income, they differ significantly in terms of investment risk and return potential.

Variable Annuities

• Investment Risk: Returns are not guaranteed and depend on the performance of the chosen sub-accounts.
• Return Potential: Offers the potential for higher returns due to the equity exposure in sub-accounts.
• Flexibility: Greater flexibility in investment choices and income options.

Fixed Annuities

• Investment Risk: Provides guaranteed returns, with the insurance company assuming the investment risk.
• Return Potential: Offers a fixed interest rate, which may be lower than potential returns from variable annuities.
• Predictability: More predictable income due to fixed payments.

Practical Examples and Scenarios

To illustrate the features of variable annuities, consider the following scenarios:

Example 1: Tax-Deferred Growth

John, a 45-year-old investor, contributes $10,000 annually to a variable annuity. Over 20 years, his investment grows to $400,000. Because of the tax-deferred nature of the annuity, John has not paid taxes on his investment gains, allowing his investment to compound more effectively.

Example 2: Death Benefit

Sarah purchases a variable annuity with a $100,000 initial investment. Over time, the value of her annuity decreases to $80,000 due to market fluctuations. Upon her passing, her beneficiary receives the death benefit of $100,000, as guaranteed by the contract.

Example 3: Riders and Options

Michael adds a Guaranteed Minimum Withdrawal Benefit (GMWB) rider to his variable annuity. This rider ensures that he can withdraw 5% of his initial investment annually, regardless of the annuity’s market value, providing him with a stable income stream.

Regulatory Considerations

Understanding the regulatory framework surrounding variable annuities is crucial for compliance and exam preparation. The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) provide guidelines and resources to ensure that investors are informed and protected.

• FINRA’s Guide on Variable Annuities: FINRA Variable Annuities Guide
• SEC Resources on Variable Annuities: SEC Investor Bulletin on Variable Annuities

Best Practices and Common Pitfalls

When dealing with variable annuities, it’s essential to follow best practices and be aware of common pitfalls:

• Suitability: Ensure that the annuity is suitable for the client’s financial goals and risk tolerance. Variable annuities are not ideal for all investors, particularly those with low risk tolerance or short investment horizons.
• Disclosure: Fully disclose all fees, charges, and potential risks associated with the annuity. Transparency is key to maintaining trust and compliance.
• Monitoring: Regularly review the performance of the sub-accounts and make adjustments as necessary to align with the client’s objectives.

Conclusion

Variable annuities offer a unique combination of investment and insurance features, making them a versatile tool for retirement planning. By understanding their structure and features, you can effectively prepare for the Series 6 Exam and provide valuable guidance to clients seeking to enhance their financial future.

Series 6 Exam Practice Questions: Structure and Features