Who Carries the Investment Risk

A fixed annuity pays a guaranteed rate of interest set by the insurance company, and the insurer carries the investment risk. A variable annuity invests the contract owner’s money in subaccounts that hold stocks, bonds and other assets, so the value rises and falls with the markets and the contract owner carries the investment risk.

That single difference drives the rest. A fixed annuity is an insurance product regulated by state insurance departments, while a variable annuity is also a security, registered with the SEC, sold with a prospectus and subject to FINRA rules. Fixed annuities protect principal but face inflation risk, while variable annuities offer growth potential but can lose value.

Both grow tax-deferred, both can be turned into a lifetime income stream, and both appear regularly in exam questions on investment vehicles and retirement planning. For the full route from the exam to a career in advice, our complete guide to how to become an investment adviser representative covers every step.

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How Every Annuity Works

An annuity is a contract between an individual and an insurance company. The contract owner pays premiums, either as a single lump sum or over time, and the insurer promises future payments in return. Payments can begin almost immediately, in an immediate annuity, or years later, in a deferred annuity.

Every deferred annuity has two phases. In the accumulation phase, premiums are invested and grow tax-deferred. In the payout phase, the owner can annuitize, converting the value into a stream of payments that can last for a set period or for life.

Annuities are often used for retirement income because of that lifetime option, which protects against the risk of outliving savings. The Series 65 Exam Preparation course at FRC covers fixed, variable and indexed annuities alongside the retirement planning and suitability topics the exam tests.

What Makes an Annuity Fixed

A fixed annuity credits interest at a rate declared by the insurer, usually with a guaranteed minimum rate for the life of the contract. The premiums are held in the insurer’s general account, and the insurer invests them as it chooses.

Because the insurer promises the rate, it carries the investment risk. If its investments perform poorly, it must still pay the guaranteed interest. The contract owner’s main risks are the insurer’s ability to meet its obligations and inflation eroding the purchasing power of fixed payments, known as inflation risk.

Fixed annuities are not securities. The Securities Act of 1933 exempts insurance and fixed annuity contracts issued by regulated insurers, and the Uniform Securities Act excludes them from its definition of a security, so selling them requires an insurance licence but not a securities registration.

What Makes an Annuity Variable

A variable annuity places premiums in a separate account, divided into subaccounts that work much like mutual funds. The contract owner chooses how to allocate money among them, and the account value moves with their performance.

Because the owner bears the investment risk, a variable annuity is a security. It is registered under the Securities Act of 1933, sold with a prospectus, and its separate account is registered as an investment company under the Investment Company Act of 1940.

Selling variable annuities therefore requires both an insurance licence and a securities registration. During accumulation, the owner’s interest is measured in accumulation units, and on annuitization it is converted into annuity units whose value determines each payment.

Fixed vs Variable Annuity at a Glance

Tax Treatment: Tax-Deferred, Then Ordinary Income

Both types grow tax-deferred, so no tax is paid on earnings while the money stays in the contract. For a non-qualified annuity bought with after-tax money, the premiums form the cost basis and are returned tax-free, while earnings are taxed as ordinary income when withdrawn, never at capital gains rates.

Withdrawals before annuitization are treated as coming from earnings first. Earnings withdrawn before age 59½ generally also face a 10 percent additional tax, with limited exceptions such as death or disability.

Once annuitized, each payment is split between a tax-free return of basis and taxable earnings, using an exclusion ratio. Owners can also move from one annuity to another without tax through a 1035 exchange, though new surrender charges and a fresh review of suitability usually follow.

Worked Example One: An Early Withdrawal

A 55-year-old investor paid a single premium of $100,000 into a non-qualified variable annuity, which has grown to $160,000. She withdraws $20,000 before annuitizing.

Step one: identify what comes out first. Withdrawals before annuitization come from earnings first, and the contract holds $60,000 of earnings, so the full $20,000 is earnings. Step two: tax it as ordinary income. The whole $20,000 is added to her taxable income for the year.

Step three: apply the early withdrawal penalty. She is under 59½, so a 10 percent additional tax of $2,000 applies. Step four: note what is untouched: her $100,000 cost basis remains in the contract and will come out tax-free later.

Worked Example Two: The Assumed Interest Rate

When a variable annuity is annuitized, the insurer sets an assumed interest rate, often called the AIR, as the benchmark for future payments. If the subaccounts earn more than the AIR, payments rise; if they earn less, payments fall.

Step one: suppose the AIR is 4 percent and the first monthly payment is $1,000. Step two: if the subaccounts return 6 percent over the next period, the next payment rises to about $1,000 × 1.06 ÷ 1.04, or $1,019.23. Step three: if they return 2 percent, it falls to about $1,000 × 1.02 ÷ 1.04, or $980.77.

Step four: if they return exactly 4 percent, the payment stays at $1,000. The rule to remember is simple: payments change only when actual performance differs from the AIR, not whenever returns are positive.

Fees and Surrender Charges

Variable annuities typically cost more than fixed annuities. They charge a mortality and expense risk fee, administrative fees and the expenses of the underlying subaccounts, and optional riders for guaranteed income or enhanced death benefits add further annual charges. Over many years, the gap in annual costs between a simple fixed annuity and a feature-rich variable annuity can meaningfully reduce the variable contract’s net return, which is why clear fee disclosure sits at the centre of every recommendation.

Both types usually carry surrender charges, a form of contingent deferred sales charge that applies if the owner withdraws more than a permitted amount in the early years. A common schedule starts at 7 percent and falls by one point a year to zero after seven years.

Using that schedule, surrendering $50,000 in year three would cost 5 percent, or $2,500, before any tax. Many contracts allow a free withdrawal, often 10 percent of the value each year, without a surrender charge. Our article on rights of accumulation vs letter of intent explains how sales charges work on mutual funds for comparison.

Study Retirement Products With FRC

Annuities connect insurance, securities law, taxation and suitability, which is exactly why they feature across the exam. Our Series 65 course takes you through fixed, variable and indexed contracts, their taxation and the rules that govern their sale, step by step.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

FINRA Rule 2330 and Variable Annuity Sales

Recommendations of deferred variable annuities are covered by FINRA Rule 2330. Before recommending a purchase or exchange, a representative must have a reasonable basis to believe the customer has been told about the product’s main features, such as surrender charges, fees, tax treatment and market risk.

The representative must also believe the customer would benefit from features such as tax deferral, annuitization or a death benefit, and that the recommendation is suitable. For exchanges, the representative must consider whether the customer has had another exchange within the previous 36 months, because frequent switching can generate repeated surrender charges and commissions.

A registered principal must review and approve the application within seven business days after the firm receives it in good order. The rule does not apply to deferred variable annuities purchased through tax-qualified, employer-sponsored retirement plans, unless the recommendation is made to an individual plan participant. Our FINRA rules quick reference on duties and conflicts places Rule 2330 alongside the other conduct rules.

Death Benefits and Indexed Annuities

Most variable annuities include a standard death benefit. If the owner dies during the accumulation phase, the beneficiary typically receives the greater of the account value or the premiums paid, less withdrawals, protecting heirs from a market fall.

Indexed annuities sit between the two main types. They credit interest linked to the performance of a market index, usually subject to a cap and a minimum floor, so the owner shares in some market gains without risking principal through index losses.

Indexed annuities that meet conditions set by federal law are treated as insurance products rather than securities, which places them under state insurance regulation. Exam questions usually test them as a hybrid: more upside than a fixed annuity, less risk than a variable one.

The Memory Aid

Remember this line: fixed means the insurer carries the risk, variable means you do. Every other difference, from regulation to licensing to returns, follows from who bears the investment risk.

For regulation, remember that if the owner bears the risk, it is a security. That is why variable annuities need a prospectus and a securities registration, and fixed annuities do not.

For payouts, remember to beat the AIR to raise the payment. Variable annuity payments rise only when subaccount returns exceed the assumed interest rate.

Exam Traps to Avoid

The first trap is calling a fixed annuity a security. Fixed annuities are insurance products exempt from securities registration, and selling them requires only an insurance licence.

The second trap is assuming annuity earnings receive capital gains treatment. All earnings are taxed as ordinary income when withdrawn, even if the subaccounts held stocks.

The third trap is misreading the AIR. A positive return does not raise the payment; only a return above the AIR does. The fourth trap is overlooking the exception in Rule 2330, which does not apply to deferred variable annuities in tax-qualified, employer-sponsored plans unless the recommendation is made to an individual participant.

A Client Scenario

A 62-year-old client plans to retire in three years and wants to turn part of her savings into income she cannot outlive. She has a low tolerance for market losses but worries about inflation over a long retirement.

The adviser compares the options. A fixed annuity would guarantee her principal and a set rate, matching her low risk tolerance, but its fixed payments would lose purchasing power as prices rise. A variable annuity could grow faster and keep pace with inflation, but its value and future payments could fall in a market downturn, and its fees are higher.

Given her priorities, the adviser suggests placing most of the allocation in a fixed annuity for dependable income, while keeping a separate diversified portfolio for growth. The adviser documents her objectives, time horizon and risk tolerance, explains surrender charges in full and confirms the recommendation meets the standard of suitability.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Open a rule and the same depth is there, from the variable annuity requirements of FINRA Rule 2330 to the securities laws that separate fixed from variable products. Use the FRC dictionary to open every term in this article, from the Investment Company Act of 1940 to inflation risk, as its own explanation, video and quiz.

Practice Questions to Test Yourself

Question one: In a fixed annuity, who bears the investment risk? The insurance company, because it guarantees a minimum rate of interest regardless of how its investments perform.

Question two: Why is a variable annuity considered a security? Because the contract owner bears the investment risk, with value depending on subaccount performance. It is registered under the Securities Act of 1933 and sold with a prospectus.

Question three: A variable annuity has an AIR of 5 percent, and the subaccounts return 3 percent. What happens to the next payment? It falls, because the actual return is below the assumed interest rate.

Question four: How are earnings withdrawn from a non-qualified annuity taxed? As ordinary income, with withdrawals before annuitization treated as earnings first, plus a 10 percent additional tax on earnings withdrawn before age 59½ unless an exception applies.

Question five: Does FINRA Rule 2330 apply to a deferred variable annuity held in a tax-qualified, employer-sponsored retirement plan? Generally no, unless the recommendation is made to an individual plan participant.

Turn Product Knowledge Into Career Evidence

Annuity knowledge is valued in wealth management, retirement planning and insurance-based advisory roles. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining clearly who carries the risk in each type of annuity shows the client-first clarity advisory firms look for.

Candidates returning to the exam should note that the wait after a third failure drops from 180 days to 60 days for exam windows opened on or after January 4, 2027, as explained in our article on the Series 65 retake rule change.

Related Questions

Continue with Call Option vs Put Option for the call options insurers commonly use to fund the index-linked credits on indexed annuities, and Rights of Accumulation vs Letter of Intent for fund sales charges.

For income-focused fixed income topics, read Agency Bonds vs Treasury Bonds and Investment Grade vs High Yield Bonds.

Key Points to Retain

In a fixed annuity, the insurer guarantees a minimum rate and bears the investment risk, and the product is regulated as insurance rather than as a security. In a variable annuity, premiums go into subaccounts, the owner bears the risk, and the contract is a security sold with a prospectus.

Both grow tax-deferred, with earnings taxed as ordinary income and a 10 percent additional tax on most earnings withdrawn before 59½. Variable annuity payments rise only when returns beat the AIR, and FINRA Rule 2330 governs deferred variable annuity recommendations, with principal review within seven business days.

For the exam’s structure and requirements, see the Series 65 dictionary entry, and for the role the exam leads to, read our guide to what an investment advisor representative is.