FINRA test prep – variable annuity contracts

In this article we are going to review what you need to know about variable annuities to pass your FINRA exam.

An annuity is a contract between an individual and an insurance company. Once the contract is entered into, the individual becomes known as the annuitant. There are several different types of annuity contracts that you need to be familiar with for your exam. This article will walk you through the subtle differences of each type of contract. 

A fixed annuity or a fixed contract guarantees the individual a fixed payment life, or for a set period of time. Because the amount of the payment is guaranteed by the insurance company, the fixed annuity contract is not a security, it is an insurance product.The investment risk associated with a fixed annuity contract is borne by the annuity company. Perhaps the company guarantees the individual a rate of return of 2% or 3%, if the investments  made by the insurance company cannot meet that minimum guaranteed return, the insurance company, in that scenario, would be required to provide that level of return to the individual. Because the fixed annuity contract guarantees an individual a minimum rate of return, a fixed annuity is an insurance product and not a security. The risk associated with a fixed annuity contract which is assumed by the annuitant is inflation risk or purchasing power risk. If inflation starts to increase, the guaranteed rate provided by the fixed annuity contract may not be sufficient to keep up with the Increased cost of living. As a result of the increased costs and the decrease in the purchasing power of the dollar, an investor who purchases a  fixed annuity contract end up worse off as a result. 

A variable annuity or a variable contract is designed to provide the investor with the opportunity to keep up with inflation. The variable annuity contract has a rate of return, as the name implies, that may vary with the investments in the portfolio. With a variable annuity contract, the investment risk is borne by the individual, or the annuitant. The variable annuity is both a security and an insurance product, and a representative who markets these products to their customers must both have a full securities license as well as a state insurance license.

The variable annuity contract holder assumes the investment risk. Meaning the investor may lose a significant portion of their investment if the securities contained in the contract fall substantially.  This is very different than the risk assumed by the owner of a fixed annuity contract, those investors assume purchasing power risk, the risk that the return that has been guaranteed by the insurance company will not be enough to keep up with inflation.

Now because a fixed annuity may be too conservative for some and a variable annuity may be too risky for others, Another type of annuity contract is a hybrid of the fixed annuity and a variable annuity. A combination annuity, will have a fixed portion of the contract which guarantees a minimum rate of return, and a variable portion, which has a rate of return that will vary in the hopes that the growth in the account will be enough to help the individual keep up with inflation.

Equity-indexed annuities

A very popular type of annuity contract is an equity indexed annuity. An equity indexed annuity is designed to provide a rate of return that is tied to a market index. Most likely the rate of return will be tied to the S&P 500. Equity-indexed annuities have certain terms and features that you need to be familiar with to pass your exam. Most of these contracts have a minimum guaranteed rate. This guaranteed rate will be provided to the investor regardless of the return of the market. For example, perhaps the minimum guaranteed rate for a contract is 4%. So no matter what happens with the market,  the investor in the contract is guaranteed to earn 4%.

Equity-indexed annuities also have a maximum rate. This is the most that the investor could  realize as a return in any given year. For example, maybe the maximum rate of return for a contract is 12%. So regardless of what the market does, the most The investor could expect to have credited to their account would be that maximum rate of 12%.

Another important feature of equity-indexed annuities you need to be familiar with for your exam, is the fact that investors in most contracts do not receive 100% of the return of the market. Certain annuity contracts will have participation rates and others will have spread rates. These rates dictate what the investor can expect to be credited to their account given any particular rate of return in the market. 

We’ll start with the participation rate. The participation rate tells an investor how much of the return of the S&P 500 the investor is going to receive into their account. The investor is not going to get everything.  the investor will get some of it. For example, perhaps the participation rate is 70%. So the contract would be credited with 70% of the return of the S&P 500.

Let’s take a look at a little bit of an example. If the S&P 500 was up 10% for this particular year, the investor would expect to realize a rate of return that would be equal to 70% of that 10%, or 7%. So investors  do not receive 100% of the return of the market. The participation rate tells investors what portion of the Market’s return They will receive.. Now, going back to our minimum guaranteed rate of return, if the S&P 500 was down 2 % for the year,  and the contract had guaranteed a minimum return of 4%, in this scenario, the minimum guaranteed rate would kick in, and the investor would then expect to earn a rate of return equal to the minimum guaranteed rate of 4%.

The maximum rate only really comes into play if the stock market just goes gangbusters during any given period of time. Let’s say the S&P 500 was up 20% for that particular year. Well if we were going to receive 70% of 20%, that would mean our contract would be credited 14%. However, The contract had a maximum rate of 12% the investor would receive the agreed maximum rate of 12%. So the minimum rate only comes in when the stock market performs poorly, and the maximum rate only kicks in when the stock market has performed exceptionally well.  The investor has basically given up some of this upside participation in exchange for a minimum guaranteed rate. This is how an equity index annuity works.

We have detailed how the participation rate works, and that tells you how much of the return of the index the  investor will receive. Another way the contract can be established is with a spread rate. Some contracts have a spread rate in lieu of a participation rate. So if they showed you a spread rate of, say, 3%, well we know that we are giving up 3% of the total return. Which means that if the stock market returned 10% that year, the investor would give up 3%, and  would get credited that 7%. So on a test point basis here, you want to keep in mind that the participation rate is what the investor does get, and the spread rate is what the investor does not get. These are some of the more testable concepts surrounding equity index annuities. Your minimum guaranteed rate, only important when the market performs poorly. Max rate, only when it goes gangbusters.

There are significant suitability factors surrounding the use of variable annuity contracts as investments for clients. It’s very important to know that variable annuities are only used to generate income now or income later. So either someone has just retired and is looking to supplement or augment their social security, and pension, and other retirement assets by using a variable annuity, or they are some years from retirement, and they want to prepare for retirement and establish a variable annuity contract in hopes that it will provide enough income for them later on down the road. So it’s very important to keep this in mind on your exam and the only reason a variable annuity should be recommended to an investor is for income now or income later.

A variable annuity is not for growth, and it’s not to save for a big purchase like a home, a second home, or a child’s college education. These are not suitable uses of variable annuities.  variable annuity should only be recommended for Income now or income later. Certain red flags are drawing the attention of regulators. You want to be on the lookout for some of these on your exam. Switching annuity contracts is a big red flag. The practice of switching annuity contracts   consists of taking an investor from annuity contract A and moving them into annuity contract B, otherwise known as a 1035 exchange, this practice is indeed a red flag to regulators for churning. Because most likely what you’re doing is you’re moving the annuity money from one annuity company to another to increase your commissions on that client’s account. In addition to generating additional commission dollars, 1035 exchanges subject investors to another surrender period.  During the surrender period, should the investor need to access their money, the investor will pay a significant penalty to the annuity company for withdrawing their money early.

Another red flag may be the sale of L share annuities. An L share annuity is one that has higher sales charges and lower lockup terms or surrender periods. Sales of L share annuities can also be red flags for regulators for abusive sales practices. 

Now that we’ve reviewed why an investor would purchase an annuity contract we need to take a look at the ways an investor may purchase the annuity contract. There are three methods available for an investor to buy an annuity contract. they are:

  1.  single payment deferred annuity
  2.  single payment immediate annuity
  3.  periodic payment deferred annuity

Single payment deferred annuity

With a single payment deferred annuity, an investor would make one large contribution into the contract, and then leave it there to grow, to generate a revenue stream later down the road when they reach retirement.

Let’s take a look at a little bit of an example of how that may take place. Perhaps a manager at a tech company brings a project in way ahead of schedule, and they’re due for a nice $50,000 bonus. And as a result of the bonus, the investor has a couple of options. They could keep the money and spend it, or perhaps they’d like to be a little bit more prudent, and use the money to put away for their retirement years. So in our example here, the mid-level manager receives a bonus, and he funds the annuity contract completely by placing that $50,000 bonus into the annuity contract and the investor will leave that money there to accumulate value over the years until they’re ready to use it to generate an income stream. 

Single payment immediate annuity

Another way someone could purchase an annuity contract using a single payment would be with a single payment immediate annuity. Let’s review an example of when someone may purchase an annuity through a single payment immediate annuity. Perhaps someone up in the Northeast, in the New York/New Jersey area is getting close to retirement. And they elect to sell the home in the Northeast, as many do, and move down to Florida, where it’s a warmer climate and housing is less expensive. Perhaps when they sell the home in the New York/New Jersey area and move down to Florida, they have $250,000 left over from the purchase price of the new residence in Florida.

Now in their retirement years, they would like to use this to the $250,000 nest egg to generate some income while they enjoy their golden years down in Florida. So this is the kind of scenario where someone may wish to purchase an immediate annuity using a single payment. So our investor here– or our retiree, in this case– would fund the contract completely with one payment, and they would begin to receive payments from that annuity contract immediately within 60 days.

Periodic payment deferred annuity

Now this last way that an investor may purchase an annuity contract is probably the most likely that you will see throughout your careers, and it’s a periodic payment deferred annuity. With a periodic payment deferred annuity, the investor makes regular contributions in the account– perhaps $500 or $1,000 per month. And they can make regular contributions over a long period of time so that as they are approaching retirement, the value of the account is building. And once they enter into the retirement years, they’ll have a nice nest egg that they can use to generate income.

We hope that this article has helped you understand the  reasons why an investor would purchase a variable annuity as well as some of the purchase options available.

Stay tuned in our next article we will continue our review of annuities and take a look at annuity payout options.

Pass your exam  or your money back with our Greenlight pass guarantee.

 Good luck on your exam!

 The Securities Institute of America

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