Variable annuities and the separate account

Two accounts, two very different promises

An annuity is a contract with an insurance company: money goes in, and at some point a stream of payments comes out. What separates the two kinds is where the money is held. A fixed annuity sits in the insurer’s general account alongside its other obligations, and the insurer promises a stated rate and a stated payment. The investment risk is the insurer’s, and the buyer’s risk is that the insurer itself fails.

A variable annuity puts the money in a separate account, kept apart from the general account and invested in subaccounts the owner chooses. Nothing about the value is guaranteed. If the subaccounts fall, the contract value falls, and the eventual payment falls with it. Because the buyer carries investment risk, a variable annuity is a security as well as an insurance contract, sold with a prospectus.

The tax treatment is the reason people buy them. In a nonqualified contract, premiums are paid with money that has already been taxed, and growth inside the contract is not taxed while it stays there. On withdrawal, the growth is taxed as ordinary income rather than at capital gains rates, and a withdrawal taken before age 59 and a half carries a tax penalty on top. Before annuitization, withdrawals from a nonqualified contract come out earnings first: every dollar is taxable until the growth is used up, and only then does the owner get back their own money tax-free. The industry nickname for this order is last in, first out (LIFO). Deferral postpones tax; it never removes it.

Surrender charges are the other feature the exam tests. A surrender charge is generally a percentage of money withdrawn within a certain period after a purchase payment, and it often declines gradually over several years, the surrender period. A surrender charge is a contractual cost paid to the insurer, entirely separate from the tax the same withdrawal may attract. Confusing the two is the classic wrong answer.

Because the product is complex and the charges are heavy, selling one carries its own rule. Before recommending a deferred variable annuity, the representative must have a reasonable basis to believe the customer has been told about the surrender period and charge, the tax penalty before 59 and a half, the mortality and expense and advisory fees, any death or living benefit, and the market risk being taken. A registered principal must then review and approve the application no later than seven business days after a complete package reaches the office of supervisory jurisdiction. The seven days is the number the exam asks for.

What the contract promises, and what it costs to change

A common death benefit pays the beneficiary the greater of the account value or a guaranteed minimum, such as purchase payments minus withdrawals. That guarantee, like living benefits and annuity payments, is only as strong as the insurer that issues the contract. A new owner who changes her mind can cancel during the free look period, a short window stated in the contract, without a surrender charge; the refund is typically her purchase payments, which may be adjusted up or down for how her investments did.

Annuitizing protects against outliving one’s money, but once income payments start, withdrawals are generally not allowed. Inside an IRA or a 401(k), a variable annuity adds no further tax advantage, because the account already defers tax. Exchanging one variable annuity for another may mean a surrender charge on the old contract and a new surrender period on the new one, so compare the two in full and weigh the professional’s incentive to recommend the switch.

Exam terms

General account

The insurer’s own assets, backing the guarantees in a fixed annuity.

Separate account

Assets held apart from the insurer’s own, backing a variable annuity.

Subaccount

One investment option inside the separate account, chosen by the owner.

Principal review

Approval of a deferred variable annuity application within seven business days of a complete package.

Accumulation phase

The period while money is paid in and value builds up.

Annuitization

Converting the contract value into a stream of payments.

Earnings first

Withdrawals before annuitization are taxed as growth until the growth is used up; often nicknamed LIFO.

Surrender charge

A declining contractual charge on money withdrawn in the early years.

Worked example

An owner holds a variable annuity in its fifth year with a value of $60,000 and a surrender schedule that charges 3 percent in year five, and withdraws $10,000.

1. Start with the contractual cost. A 3 percent surrender charge on the $10,000 withdrawn is $300, paid to the insurer under the contract.
2. The tax question is separate. Before annuitization, withdrawals come out earnings first, so if the contract holds at least $10,000 of growth, the whole $10,000 is taxed as ordinary income. Only after the growth is used up does the owner’s own money come back tax-free.
3. If the owner has not reached the qualifying age, that taxable growth also attracts a tax penalty, which is charged by the tax authority rather than by the insurer.
4. None of this touches the rest of the contract. The remaining value stays in the separate account, still allocated to the subaccounts the owner chose and still moving with them.
5. Notice what the surrender charge is not. It is not a tax and it is not deducted by anyone but the insurer, which is why a choice that describes a surrender charge as a penalty paid to the tax authority is wrong however familiar the number looks.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Variable annuity: separate account and guaranteesPractice this
• Variable annuity contract features: death benefit, free look, annuitization and exchangesPractice this