Understanding Annuities On The Series 6 Exam
and become an Investment Company Representative

One of the keys to passing the Series 6 exam is to make sure that you have a complete understanding of how annuities will be tested on the Series 6 Exam. This article which was produced from material contained in our Series 6 textbook and will help you master the material so that you pass the Series 6 exam.


Annuities

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 three basic types of annuities that are designed to meet different objectives. They are:

  • Fixed annuity
  • Variable annuity
  • Combination annuity

While all three types allow the investor’s money to grow tax deferred, the type of investments made and how the money is invested varies according to the type of annuity.

Fixed Annuity

A fixed annuity offers investors a guaranteed rate of return regardless of whether or not the investment portfolio can produce the guaranteed rate. If the performance of the portfolio falls below the rate that was guaranteed, the insurance company owes investors the difference. Because the purchaser of a fixed annuity does not have any investment risk, a fixed annuity is considered an insurance product not a security. Representatives who sell fixed annuity contracts must have an insurance license. Since fixed annuities offer investors a guaranteed return, the money invested by the insurance company will be used to purchase conservative investments like mortgages and real estate. The insurance company will purchase investments whose historical performance is predictable enough so that a guaranteed rate can be offered to investors. All of the money invested into fixed annuity contracts is held in the insurance company’s general account. Since the rate that the insurance guarantees is not very high, the annuitant may suffer a loss of purchasing power due to inflation risk.

Variable Annuity

An investor seeking to achieve a higher rate of return may elect to purchase a variable annuity. Variable annuities seek to obtain a higher rate of return by investing in stocks, bonds, or mutual fund shares. These securities traditionally offer higher rates of return than more conservative investments. A variable annuity does not offer the investor a guaranteed rate of return and the investor may lose all or part of their principal. Because the annuitant bears the investment risk associated with a variable annuity, the contract is considered both a security and an insurance product. Representatives who sell variable annuities must have both their securities license and their insurance license. The money and securities contained in a variable annuity contract are held in the insurance company’s separate account. The separate account is named as such because the variable annuity’s portfolio must be kept “separate” from the insurance company’s general funds. The insurance company must have a net worth of $1,000,000 or the separate account must have a net worth of $1,000,000 in order for the separate account to begin operating. Once the separate account begins operations, it may invest in one of two ways.

  • Directly
  • Indirectly

Direct Investment

If the money in the separate account is invested directly into individual stocks and bonds, the separate account must have an investment adviser to actively manage the portfolio. If the money in the separate account is actively managed and invested directly, then the separate account is considered an open-end investment company under the Investment Company Act of 1940 and must register as such.

Indirect Investment

If the separate account uses the money in the portfolio to purchase mutual fund shares, it is investing in the equity and debt markets indirectly and no investment adviser is required to actively manage the portfolio. If the separate account purchases mutual fund shares then the separate account is considered a unit investment trust (UIT) under the Investment Company Act of 1940 and must register as such.

Combination Annuity

For investors who feel that a fixed annuity is too conservative and that a variable annuity is too risky, a combination annuity offers the annuitant features of both a fixed and variable contract. A combination annuity has a fixed portion that offers a guaranteed rate and a variable portion that tries to achieve a higher rate of return. Most combination annuities will allow the investor to move money between the fixed and variable portions of the contract. The money invested in the fixed portion of the contract is invested in the insurance company’s general account and used to purchase conservative investments such as mortgages and real estate. The money invested in the variable side of the contract is invested in the insurance company’s separate account and used to purchase stocks, bonds, or mutual fund shares. Representatives who sell combination annuities must have both their securities license and their insurance license.

Equity Indexed Annuities

Equity indexed annuities offer investors a return that varies according to the performance of a set index such as the S & P 500. Equity indexed annuities will credited additional interest to the investor’s account based on the contract’s participation rate. If a contract sets the participation rate at 70% of the return for the S & P 500 index, and the index returns 5%, the investor’s account will be credited for 70% of the return, or 3.5%.

Equity index annuities may also set a floor rate and a cap rate for the contract. The floor rate is the minimum interest rate that will be credited to the investor’s account. The floor rate may be zero or it may be a positive number depending on the specific contract. The contract’s cap rate is the maximum rate that will be credited to the contract. If the return of the index exceeds the cap rate the investor’s account will only be credited up to the cap rate. If the S & P 500 index returns 11% and the cap rate set in the contract is 9%, the investor’s account will only be credited 9%.