Annuities are issued by insurance companies and offer two special benefits: tax-deferral of earnings and guaranteed income for life. A fixed annuity offers a guaranteed rate of return to the investor, and the investment risk is assumed by the insurance company. Thus, it is not considered a security and is regulated by insurance laws, not securities regulations.

Variable annuities do not offer a set rate of return but instead fluctuate in value in tandem with their underlying investments. The investor may choose from one or more accounts with different investment objectives, similar to mutual funds, but known as "separate accounts." Variable annuities are regulated under both the Securities Act of 1933 and the Investment Company Act of 1940.

While a fixed annuity offers a high degree of certainty, a variable annuity does not. As a result, variable annuities are not appropriate for investors with a low risk tolerance.

The following two articles on variable annuities contain valuable advice and information, such as their benefits, consequences and possible hidden costs:

Annuity Structure
There are two distinct phases of an annuity: accumulation and withdrawal.

  • Accumulation: During the accumulation stage,the investor receives accumulation units, rather than shares in the separate accounts. These units have an NAV that is calculated each day, just like mutual fund shares.

  • Withdrawal (Annuity): When the investor wants to withdraw from a variable annuity, one of their options is to exchange accumulation units for annuity units.

    • The number of annuity units remains unchanged, but the value of the units varies based on the performance of the underlying investments.

    • As a result, the monthly income from the annuity may rise or fall over time.

    • While an investor can choose an annuity period of a set amount of years, a lifetime option is more typically chosen. That way, an investor need not worry about running out of money if he or she lives longer than planned.

Exam Tips and Tricks
Typical variable annuity questions may ask whether the price and amount of accumulation units and annuity units are fixed or variable. The correct answers would be:
  • the number of accumulation units and their value are variable
  • the number of annuity units is fixed, while the value of annuity units is variable.

Annuity Taxation
Both fixed and variable annuities offer tax-deferral of earnings. Withdrawals made are taxed as follows:

  • Annuity withdrawals are treated as LIFO (last in, first out), meaning that withdrawals are considered to be from earnings first.

  • Earnings are taxed at the investor's ordinary income rate.

  • Earnings withdrawn prior to age 59 and a half are subject to a 10% penalty tax, unless an exception applies (such as death or disability).

  • No tax or penalty is applied to the investor's principal, since this amount was taxed prior to the investment.

Note that the value of the tax-deferred earnings may not outweigh the cost of subjecting those earnings to ordinary income tax. A similar investment in mutual funds would have the potential benefit of long-term capital gains rates and/or special dividend rates.

Look Out!
This differential (and possible disadvantage) of income tax rates is essential to understand. The question may come in the form of "an investor who is now in a low-income tax bracket but expects to be in a higher tax bracket at retirement" - in this scenario, a variable annuity would not be a suitable investment

Exam Tips and Tricks
Consider this sample exam question:

  1. Investment income earned within a variable annuity is:
    1. Tax-exempt
    2. Tax-free
    3. Tax-deferred
    4. Tax-deductible

The correct answer is "c", since the earnings will be taxable when withdrawn.

Derivative Securities

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