Table of Contents
SERIES 7 | SERIES 65 | FINANCIAL REGULATION COURSES
A variable annuity is a contract between an individual and an insurance company in which the individual makes either a lump sum payment or a series of purchase payments and the insurance company agrees to make periodic payments to the individual beginning either immediately or at a specified future date — with the value of the contract and the amount of the periodic payments varying based on the investment performance of the underlying sub-accounts in which the purchase payments are invested.
The variable annuity combines elements of two distinct financial product categories — the investment characteristics of a portfolio of mutual fund-like sub-accounts and the insurance characteristics of a traditional annuity including the guarantee of lifetime income payments, death benefit protection, and the tax-deferred growth of investment earnings.
Because variable annuities have a securities component — the sub-accounts — they are regulated as securities under the Securities Act of 1933 and the Investment Company Act of 1940 in addition to being regulated as insurance products by state insurance commissioners, and their sale requires registration with both federal securities regulators and applicable state insurance authorities.
Variable annuities are subject to the specific suitability requirements of FINRA Rule 2330 — Members'
Responsibilities Regarding Deferred Variable Annuities — which establishes enhanced suitability standards for their recommendation and sale, including a principal review requirement not present for most other securities products.
Variable annuities are directly and extensively tested on the Series 7 and Series 65 examinations in the context of insurance products, tax-deferred investment vehicles, FINRA Rule 2330, the cost structure and its impact on suitability analysis, and the specific situations in which variable annuities are and are not appropriate for clients.
Every variable annuity contract operates in two sequential phases — the accumulation phase during which purchase payments are invested and grow on a tax-deferred basis, and the payout or annuitisation phase during which the accumulated value is converted into a stream of periodic income payments.
The accumulation phase begins when the contract is issued and the first purchase payment is made. During the accumulation phase the contract owner directs the purchase payments into a menu of sub-accounts offered by the insurance company — each sub-account is invested in a specific underlying portfolio of securities, typically similar in structure to a mutual fund.
The sub-account options available within a variable annuity typically include domestic equity funds across various market capitalisation and style categories, international equity funds, bond funds of various credit quality and duration, balanced funds, and a fixed account that earns a guaranteed interest rate rather than market-based returns.
The contract owner can typically transfer among sub-accounts without current tax consequences — rebalancing the investment allocation within the annuity does not trigger income recognition because all growth remains tax-deferred within the contract.
The value of the contract during the accumulation phase — called the account value or contract value — fluctuates daily based on the investment performance of the sub-accounts, declining when the sub-account investments lose value and increasing when they gain value.
Unlike a fixed annuity which credits a specified guaranteed interest rate, the variable annuity provides no guarantee of principal preservation or minimum return during the accumulation phase unless the contract includes specific guaranteed benefit riders discussed below.
The investment risk is borne by the contract owner — not the insurance company — making the variable annuity an investment product with insurance wrappers rather than a purely guaranteed insurance instrument.
The payout phase begins when the contract owner elects to annuitise — to convert the accumulated contract value into a stream of periodic income payments.
The election to annuitise is typically irrevocable — once the contract value is converted into an income stream the contract owner surrenders the right to receive a lump sum distribution of the remaining contract value in exchange for the guaranteed income payments.
Annuitisation options include payments for a fixed period — such as ten or twenty years — or lifetime payments that continue regardless of how long the annuitant lives, eliminating the longevity risk — the risk of outliving investment assets — that is the primary insurance benefit provided by the annuity structure.
Variable annuitisation — in which the income payment amount varies with the ongoing investment performance of the sub-accounts — is one distinctive feature of the variable payout phase. A contract owner who annuitises into a variable payout retains investment exposure during the payout phase — payments rise when sub-account performance is strong and fall when it is weak — rather than receiving the fixed predictable payments of a fixed annuity. Many contract owners choose a fixed annuitisation option even within a variable annuity contract, converting the accumulated variable account value into fixed guaranteed income at the time of annuitisation.
The sub-accounts of a variable annuity are the investment vehicles through which the contract owner participates in market returns during the accumulation phase.
Each sub-account is a separate investment portfolio maintained by the insurance company within its separate account — legally segregated from the insurance company's general account assets — and is invested in accordance with a specific investment objective and strategy described in the contract prospectus.
Sub-accounts function similarly to mutual funds in their investment mechanics — they hold diversified portfolios of securities, are managed by investment managers according to stated objectives, publish net asset values reflecting the per-unit value of the sub-account at the end of each trading day, and can increase or decrease in value based on the performance of the underlying securities.
Unlike mutual fund shares, sub-account units cannot be held directly outside the annuity contract — they are contractual interests in the insurance company's separate account rather than independently transferable securities.
The separate account structure — the legal framework requiring that variable annuity sub-account assets be held separately from the insurance company's general account — provides protection to contract owners in the event of the insurance company's insolvency. Because the sub-account assets are legally separate from the general account, they are not available to satisfy the claims of the insurance company's general creditors and must be used solely for the benefit of variable annuity contract owners. This protection is the primary structural basis for the regulatory treatment of variable annuities as investment products subject to securities regulation in addition to insurance regulation.
The cost structure of variable annuities is among the most important analytical considerations in any suitability assessment — and is the most common basis for enforcement actions and investor complaints related to variable annuity recommendations. Variable annuities carry multiple layers of fees that collectively create a cost burden substantially higher than comparable mutual fund investments, making the tax-deferred growth benefit the primary economic justification for accepting those higher costs.
The mortality and expense risk charge — the M&E charge — is the foundational insurance cost of the variable annuity, compensating the insurance company for the mortality risk it assumes by guaranteeing lifetime income payments regardless of how long the annuitant lives and for the expense risk it assumes by guaranteeing that the contract's expenses will not exceed those specified in the contract. As noted in the SEC's investor bulletin, the M&E charge is typically in the range of one and one quarter percent of account value annually — deducted continuously from the sub-account assets. For a contract with a one hundred thousand dollar account value the annual M&E charge is approximately one thousand two hundred and fifty dollars — a cost that is charged regardless of the investment performance of the sub-accounts.
The administrative fee is a separate annual charge — typically twenty-five to seventy-five dollars or a small percentage of account value — compensating the insurance company for the administrative costs of maintaining the contract including recordkeeping, statements, and account services.
The underlying fund expenses are the investment management fees and other expenses of the sub-account portfolios — equivalent to the expense ratios of the mutual funds in which the sub-accounts invest. These range from a few basis points for passive index-tracking sub-accounts to more than one percent annually for actively managed sub-accounts. The underlying fund expenses are in addition to the M&E charge and administrative fee — they represent the investment management costs on top of the insurance wrapper costs.
The rider charges are additional optional fees for guaranteed benefit features — guaranteed minimum income benefits, guaranteed minimum withdrawal benefits, guaranteed minimum accumulation benefits, and enhanced death benefits — that provide various forms of insurance protection beyond the basic annuity structure. Rider charges typically add one-half to one percent or more of account value annually, further increasing the total cost of the contract for owners who elect them.
The total annual cost of a variable annuity with riders can easily reach two and one-half to three percent of account value annually — creating a substantial drag on investment returns that the tax deferral benefit must overcome to make the variable annuity superior to a directly held taxable mutual fund portfolio. For investors in lower tax brackets or with shorter time horizons, the cost burden often exceeds the tax deferral benefit — making the variable annuity unsuitable. For investors in higher tax brackets with long investment horizons who have already maximised contributions to all other tax-advantaged vehicles, the tax deferral benefit can exceed the cost burden — making the variable annuity suitable. This analytical comparison is the core suitability question for every variable annuity recommendation.
Variable annuities impose surrender charges — contingent deferred sales charges — during the surrender period that typically extends for seven to ten years after each purchase payment. A surrender charge is a percentage of the amount withdrawn that declines over the surrender period — typically starting at seven or eight percent in the first year and declining by one percentage point per year until reaching zero after the surrender period ends.
A contract owner who purchases a variable annuity and needs to access the full contract value in the first year pays a surrender charge of perhaps seven percent — surrendering seven thousand dollars on a one hundred thousand dollar contract in addition to any applicable income taxes and the ten percent early withdrawal penalty for withdrawals before age fifty-nine and a half. This surrender charge creates a meaningful illiquidity constraint — contract owners who anticipate needing access to their invested capital within the surrender period face potentially significant costs to access those funds.
Most variable annuity contracts include a free withdrawal provision — allowing the contract owner to withdraw a specified percentage of the account value — typically ten percent annually — without incurring a surrender charge. This provision allows some liquidity within the surrender period for routine needs, but material withdrawals above the free withdrawal amount remain subject to the declining surrender charge schedule.
The surrender charge is a critically important suitability consideration under FINRA Rule 2330 — a contract owner who replaces an existing variable annuity with a new one resets the surrender period, potentially costing the owner the surrender charge on the old contract plus initiating a new multi-year surrender period on the new contract. FINRA Rule 2330 specifically requires that any recommended exchange be evaluated for suitability considering whether the owner would incur a surrender charge, be subject to a new surrender period, lose existing benefits, or be subject to increased fees — making the exchange suitability analysis more demanding than the initial purchase suitability analysis.
FINRA Rule 2330 — Members' Responsibilities Regarding Deferred Variable Annuities — establishes suitability requirements for variable annuity recommendations that go beyond the general suitability requirements of FINRA Rule 2111 in several important respects, reflecting FINRA's recognition that variable annuities are complex, expensive, and illiquid products with significant potential for unsuitable recommendations.
The recommended purchase or exchange suitability determination under Rule 2330(b)(1) requires the registered representative to have a reasonable basis to believe that the customer has been informed in general terms of the variable annuity's features including the potential surrender period and charges, the potential ten percent tax penalty for withdrawals before age fifty-nine and a half, the M&E fees, investment advisory fees, potential rider charges, and the insurance and investment components. The representative must also have a reasonable basis to believe the customer would benefit from the specific features of variable annuities — tax-deferred growth, annuitisation, or a death or living benefit — and that the specific annuity and its sub-accounts are suitable for the particular customer.
The specific investment profile factors that must be obtained and considered for variable annuity suitability under Rule 2330(b)(2) are the customer's age, annual income, investment experience, investment objectives, investment time horizon, existing assets, and risk tolerance — a more specifically enumerated list than the general Rule 2111 investment profile but consistent with its underlying framework.
The principal review requirement is the most distinctive supervisory feature of Rule 2330 — before a variable annuity application is sent to the issuing insurance company, a registered principal of the member firm must review and determine whether to approve the transaction. This principal approval must occur no later than seven business days after the office of supervisory jurisdiction receives a complete and correct application. This pre-submission principal review is not required for most other securities products — it reflects FINRA's heightened concern about variable annuity suitability given the complexity and cost of the product and the history of unsuitable recommendations in this product category.
Every variable annuity includes a death benefit — a guaranteed minimum payment to the contract's designated beneficiary upon the death of the annuitant before annuitisation. The most basic death benefit guarantees that the beneficiary will receive at least the total purchase payments made into the contract — even if the sub-account investments have declined in value below the amount invested. If the contract owner has paid one hundred thousand dollars in purchase payments and the account value at death is eighty thousand dollars due to investment losses, the insurance company pays the beneficiary one hundred thousand dollars — the purchase payment amount — rather than the lower account value.
Enhanced death benefit riders available for additional charges provide more generous guarantees — for example, the greatest of the current account value, the total purchase payments, or the account value on a specified prior anniversary date — providing a ratchet mechanism that locks in investment gains for death benefit purposes even if the account subsequently declines.
The tax treatment of variable annuities is simultaneously their primary economic benefit and a source of significant complexity that investment advisers must understand thoroughly under the fiduciary duty of the Investment Advisers Act of 1940.
All earnings within a variable annuity accumulate on a tax-deferred basis under IRC Section 72 — dividends, interest, and capital gains realised within the sub-accounts are not taxed in the year earned. The deferral continues until distributions are made from the contract — and when distributions are made, all earnings are taxed as ordinary income at the recipient's marginal income tax rate regardless of how the underlying sub-accounts generated those earnings. This is the critical tax disadvantage relative to taxable mutual fund investing for long-term investors — a sub-account invested in equities that generates primarily long-term capital gains and qualified dividends would in a taxable account benefit from the fifteen or twenty percent preferential capital gains rate, but when those gains are distributed from a variable annuity they are taxed at ordinary income rates of up to thirty-seven percent plus the net investment income tax. For investors in high tax brackets with long time horizons in tax-efficient equity sub-accounts, this conversion of preferential-rate income to ordinary income can substantially offset the benefit of deferral.
Distributions from variable annuities before age fifty-nine and a half are subject to the ten percent early withdrawal penalty under IRC Section 72(q) in addition to ordinary income tax — the same penalty applying to early distributions from traditional IRAs and 401(k) plans. The substantially equal periodic payments exception under IRC Section 72(t) — which allows penalty-free early distributions from retirement accounts under a systematic payment schedule — also applies to variable annuities, providing a mechanism for penalty-free access in certain circumstances.
The suitability question for variable annuities is among the most practically important in the entire Series 65 examination curriculum — because variable annuities are appropriate for a narrow set of client situations and inappropriate for the majority of retail investors for whom they are sometimes recommended.
Variable annuities are generally most appropriate when three conditions are simultaneously satisfied. First, the investor has already maximised contributions to all other available tax-advantaged vehicles — traditional and Roth IRAs, employer-sponsored 401(k) or 403(b) plans — and is seeking additional tax-deferred accumulation space beyond those limits. The tax deferral benefit of the variable annuity is most valuable for investors who cannot access lower-cost tax deferral through qualified plans. Second, the investor has a long investment horizon — typically ten or more years — that allows the tax deferral benefit sufficient time to compound and overcome the high cost burden of the M&E charge, administrative fees, and underlying fund expenses. Short time horizons make it mathematically unlikely that the tax benefit will exceed the additional costs. Third, the investor is in a sufficiently high marginal tax bracket that the annual tax drag on a comparable taxable investment is meaningful enough to justify the additional costs. Investors in lower tax brackets experience less tax drag on taxable investments and derive less benefit from deferral.
Variable annuities are generally not appropriate for investors who need liquidity within the surrender period, who are already in lower tax brackets where the deferral benefit is minimal, who have not yet maximised other available tax-advantaged options, who are purchasing a variable annuity inside an already tax-advantaged retirement account where the deferral benefit is redundant, or who are elderly and lack sufficient time horizon for the costs to be overcome by the deferral benefit.
Variable annuities are tested on the Series 7 and Series 65 examinations in the context of insurance products, tax-deferred investment vehicles, FINRA Rule 2330 suitability requirements, the cost structure, and appropriate suitability analysis.
The key points to retain are these.
A variable annuity is a contract between an individual and an insurance company in which purchase payments are invested in sub-accounts — investment portfolios within the insurance company's separate account — with earnings growing tax-deferred under IRC Section 72. The two phases are the accumulation phase — during which payments are invested in sub-accounts and grow tax-deferred — and the payout or annuitisation phase — during which the accumulated value is converted into a stream of periodic income payments including lifetime payment options that eliminate longevity risk.
The cost structure includes the mortality and expense risk charge — typically one and one quarter percent annually — the administrative fee, the underlying fund expenses of the sub-accounts, and optional rider charges — with total annual costs commonly reaching two and one-half to three percent for fully-loaded contracts with riders. Surrender charges — contingent deferred sales charges — apply during the surrender period of typically seven to ten years, declining annually from approximately seven or eight percent to zero. Distributions are taxed as ordinary income regardless of how sub-account earnings were generated — eliminating the preferential capital gains and qualified dividend rates available in taxable accounts. The ten percent early withdrawal penalty under IRC Section 72(q) applies to distributions before age fifty-nine and a half.
FINRA Rule 2330 establishes enhanced suitability requirements for deferred variable annuity recommendations — requiring the registered representative to have a reasonable basis to believe the customer has been informed of key features, would benefit from the variable annuity's specific features, and that the specific product and sub-accounts are suitable. The principal review requirement — mandatory before the application is submitted to the insurance company, within seven business days of receipt at the OSJ — is the most distinctive supervisory feature distinguishing Rule 2330 from general suitability requirements. Exchange suitability under Rule 2330 requires specific consideration of surrender charges on the existing contract, new surrender period on the replacement contract, loss of existing benefits, and increased fees. Variable annuities are most appropriate for investors who have maximised all other tax-advantaged options, have long investment horizons of ten or more years, are in high marginal tax brackets, and do not need liquidity within the surrender period — placing variable annuities inside an already tax-advantaged retirement account produces no additional tax benefit while adding the cost burden, making such placement generally unsuitable.
