Variable Annuity Practice Questions for the SIE

Answer: In a fixed annuity, the insurance company bears the investment risk and guarantees a stated rate of return; a variable annuity's payments fluctuate with a separate account's performance, so it is registered as a security.

A fixed annuity places the investment risk on the insurance company: premiums go into the insurer's general account, and the insurer contractually guarantees a stated minimum rate of return regardless of how its own investments perform. Because the contract owner's return doesn't depend on market performance of a specific pool of securities, a fixed annuity is not a security and is sold with only an insurance license. A variable annuity works the opposite way: premiums are invested through a separate account in sub-accounts the owner selects, so the owner's payments rise and fall with that account's performance — the owner bears the investment risk. Because the return depends on securities performance, the variable annuity is registered as a security and requires a prospectus and dual (securities plus insurance) licensing for the representative. Option A flips the risk-bearer; option B wrongly assumes every annuity is a security; option D wrongly attaches the separate-account/registration feature to the fixed product instead of the variable one.

The Trap: Reversing who bears investment risk between fixed and variable annuities, and assuming all annuities are securities.

• In a variable annuity, the insurance company guarantees a fixed rate of return, so the contract owner bears no investment risk.: Reverses the risk-bearer: in a variable annuity the contract owner bears the investment risk because payments depend on the separate account's performance; the insurer makes no rate guarantee. This describes a fixed annuity, not a variable one.
• In a fixed annuity, payments are funded from a separate account registered under the Investment Company Act of 1940.: Confuses the insurer's general account (which funds fixed annuity guarantees) with the registered separate account that is unique to variable products.
• Both fixed and variable annuities must be sold with a prospectus because all annuities are securities.: Embodies the 'all annuities are securities' misconception. A fixed annuity is a general-account insurance product, not a security, and requires no prospectus; only the variable annuity is registered and requires one.

Verified against: Securities Act of 1933 and Investment Company Act of 1940 (separate account registration); state insurance law (fixed annuity general account)

Answer: A fixed-indexed annuity credits interest using a formula tied to a market index (subject to caps or participation rates and a guaranteed minimum), and it is generally not treated as a security, unlike a variable annuity.

A fixed-indexed annuity sits between a fixed and a variable annuity: like a fixed annuity, the insurer's general account backs a guaranteed minimum (a floor, often at or near zero), so the contract owner can't lose principal from market declines. Unlike a plain fixed annuity, however, the interest credited each period is tied to the performance of a market index (such as a stock index) through a formula that typically includes a cap, participation rate, or spread — meaning the owner gets only a portion of the index's gain, never the full return, and never below the guaranteed floor. Because premiums are not invested directly in securities through a registered separate account, indexed annuities are generally not treated as securities under federal law and are typically sold with only an insurance license. Option B incorrectly describes direct market investment (a variable annuity feature); option C ignores the caps/participation rates that limit the credited return; option D reverses which product needs which license.

The Trap: Believing indexed annuities invest directly in the market like a variable annuity, or that they are always securities requiring a securities license.

• Because its return depends on an index, a representative needs only a securities license — not an insurance license — to sell a fixed-indexed annuity.: Reverses the licensing requirement. Because indexed annuities are generally not securities, they are typically sold under an insurance license; it is the variable annuity that requires securities licensing (in addition to an insurance license).
• A fixed-indexed annuity guarantees the contract owner will receive the full percentage gain of the referenced index each year, with no cap.: Ignores the caps, participation rates, or spreads that limit how much index gain is actually credited — a foundational feature of how these products are priced and a frequent point of investor confusion.
• A fixed-indexed annuity invests premiums directly in the referenced index within a registered separate account.: Describes a variable annuity's structure. An indexed annuity does not directly invest owner premiums in the market through a registered separate account — the insurer's general account backs the guarantee, and an index-linked formula determines credited interest.

Verified against: State insurance regulation of indexed annuities; contrast with Securities Act of 1933 registration of variable annuities

Answer: A pool of contract-owner assets invested in securities sub-accounts, held apart from the insurer's general account, and registered under both the Securities Act of 1933 and the Investment Company Act of 1940.

The separate account holds the assets backing variable annuity (and variable life) contracts and is legally separated from the insurer's general account, which shields it from claims by the insurer's general creditors. Because the separate account is invested in securities sub-accounts whose performance determines the contract owner's return, it must be registered under both the Securities Act of 1933 and the Investment Company Act of 1940, and the contract itself is sold with a prospectus. Option A wrongly places this feature in the general account, which actually backs fixed-annuity guarantees. Option C invokes SIPC, which covers custody/insolvency risk at a broker-dealer — never market losses. Option D is wrong because contract owners typically can move money among sub-accounts within the separate account, which is central to how variable annuities let owners manage their own investment risk.

The Trap: Confusing the separate account with the insurer's general account, and assuming SIPC insures against market losses in the separate account.

• A trust account maintained by SIPC to reimburse contract owners for losses in the underlying sub-accounts.: SIPC does not insure against investment/market losses in any account, separate account included. SIPC protects customers of a failed broker-dealer, not investment performance.
• A reserve within the insurer's general account used to guarantee minimum returns on fixed annuities.: Confuses the general account (which backs fixed annuity guarantees) with the separate account (which backs variable annuity sub-accounts). The two are legally and functionally distinct.
• An account whose assets, once invested, cannot be reallocated among sub-accounts by the contract owner.: Contract owners can generally transfer or reallocate among the available sub-accounts within a variable annuity; the separate account structure is designed to accommodate owner-directed investment choices, not to lock them in.

Verified against: Securities Act of 1933 and Investment Company Act of 1940 (separate account registration); SIPC coverage scope

Answer: A varying number of accumulation units, each unit's value fluctuating with the separate account's investment performance.

During the accumulation phase, each purchase payment buys accumulation units at whatever the current unit value happens to be — much like buying mutual fund shares at NAV — so both the number of units owned and the value of each unit vary over time with the separate account's performance. When the contract is annuitized, those accumulation units are converted into a fixed number of annuity units; that number is locked in at annuitization, but each annuity unit's value keeps varying with performance, which is what actually makes the periodic payment amount go up or down. Options A and C incorrectly apply the 'annuity unit' label to the accumulation phase, and option B misuses the AIR as if it were a unit purchase price rather than the payout-phase benchmark it actually is.

The Trap: Confusing accumulation units (varying number, varying value) with annuity units (fixed number, varying value), and misapplying the AIR as a unit price.

• A fixed number of annuity units established at the start of the contract, whose value is guaranteed by the insurer.: Wrongly imports 'annuity units' (which exist only after annuitization) into the accumulation phase, and wrongly claims a guaranteed value — accumulation-phase unit values fluctuate with performance and are not guaranteed.
• A varying number of annuity units, since annuitization has not yet occurred.: Mislabels the units. Before annuitization, the owner holds accumulation units, not annuity units; annuity units don't exist until the contract annuitizes.
• A fixed number of accumulation units purchased at the assumed interest rate (AIR).: The AIR is a payout-phase benchmark used to determine whether the annuitized payment rises or falls; it is not a unit price, and the number of accumulation units purchased varies with each payment and the unit's price at that time.

Verified against: Variable annuity contract structure — accumulation phase vs. annuitization phase

Answer: Increase, because this month's 5% return exceeds the 4% AIR — the relevant comparison is actual return versus the AIR, not versus the prior month's return.

The assumed interest rate (AIR) is the benchmark growth rate built into a variable annuity's payout formula. Each period, the payment is recalculated by comparing that period's actual net investment return to the AIR: if the actual return exceeds the AIR, the payment increases from the prior payment; if it falls short of the AIR, the payment decreases. Here, this month's 5% return exceeds the 4% AIR, so the payment rises again — even though 5% is a slower return than last month's 6%. The trap is comparing this month's return to last month's return instead of to the AIR; the two most recent periods each only need to be checked against the AIR independently, not against each other.

The Trap: Comparing the current period's return to the prior period's actual return instead of to the AIR.

• Stay exactly the same, because the AIR is merely a disclosure figure with no effect on the payment amount.: The AIR is not just disclosure — it is the actual benchmark used in the formula that recalculates each period's annuity payment based on whether the separate account beat or missed it.
• Decrease, because 5% is lower than last month's 6% return.: This is the classic AIR trap: it compares this month's return to last month's actual return instead of to the AIR. Since 5% still exceeds the 4% AIR, the payment rises again, even though the return itself slowed from 6% to 5%.
• Decrease, because any return below the rate assumed at contract issue always reduces the payment.: Mischaracterizes the mechanic and the numbers in this scenario: 5% is above (not below) the 4% AIR, so this reasoning doesn't even apply here, and it wrongly implies the AIR is a ceiling rather than a benchmark for comparison.

Verified against: Variable annuity payout mechanics — assumed interest rate (AIR) benchmark

Answer: Pay a surrender charge to the insurance company (since only 4 of the 7 scheduled years have elapsed), in addition to any income tax — and possibly a 10% penalty — on the earnings withdrawn.

Surrender charges are contractual fees the insurer imposes when a contract owner withdraws more than any allowed free amount before the surrender-charge period ends; the charge typically declines each year (for example, from a higher percentage in year one down toward zero by the end of the schedule) but doesn't disappear just because a few years have passed. Because only four of the seven scheduled years have elapsed, the surrender-charge schedule has not yet run its course, so a surrender charge would still generally apply. That charge is entirely separate from the federal tax treatment of the withdrawal: earnings withdrawn are taxed as ordinary income, and if the owner is under age 59½, a 10% additional tax generally applies to the taxable portion as well (subject to statutory exceptions such as death, disability, or substantially equal periodic payments). Option B wrongly brings SIPC into a matter it has no role in; option D confuses a withdrawal with a Section 1035 exchange, which requires a direct transfer of contract value into a new contract — if the owner ever actually or constructively receives the funds, the transaction is a taxable withdrawal, not a tax-free exchange.

The Trap: Assuming a withdrawal converts into a 1035 exchange, or that SIPC or the mere passage of time eliminates the surrender charge.

• Owe only a SIPC assessment fee for withdrawing before the surrender period ends.: SIPC does not assess withdrawal fees and has no role in annuity surrender charges; SIPC's function is limited to protecting customers of a failed broker-dealer, not charging fees on annuity transactions.
• Pay no surrender charge, because four years have already passed and that is generally considered 'long term.': Surrender charges apply for the specific period stated in the contract, not a generic notion of 'long term.' With only four of the seven scheduled years elapsed, the surrender-charge period has not yet run out, so a charge (even if reduced from year one) would still typically apply.
• Automatically convert the withdrawal into a tax-free Section 1035 exchange to a new contract.: A withdrawal (taking cash out of the contract) is not the same transaction as a Section 1035 exchange (a direct transfer of contract value into a new annuity or life insurance contract, with no actual or constructive receipt of funds by the owner). Withdrawals are taxable/penalized as applicable; only a proper direct exchange qualifies for Section 1035 tax-free treatment.

Verified against: Annuity contract surrender-charge schedule; Internal Revenue Code Section 72(q) (10% additional tax on early annuity distributions) and Section 1035 (tax-free exchanges)

Answer: The beneficiary will typically receive at least a guaranteed minimum amount — often the greater of total premiums paid or the current contract value — even though the separate account has lost value.

Most variable annuity contracts include a guaranteed minimum death benefit that applies during the accumulation phase: if the contract owner (or annuitant, depending on contract terms) dies before annuitizing, the beneficiary generally receives at least a guaranteed floor — commonly the greater of total premiums paid or the current contract value — even if the separate account has lost money. This feature exists precisely to protect beneficiaries from investment risk in the period before payout begins. Once a contract has been annuitized, this pre-annuitization death benefit typically no longer applies, and what (if anything) passes to a beneficiary instead depends on the payout option chosen (for example, a period-certain option guarantees remaining payments, while a straight life option does not). Options A and D wrongly assume the guarantee doesn't exist or expires with an unrelated feature (the surrender-charge schedule); option C reverses when the death benefit actually applies.

The Trap: Assuming the variable annuity death benefit offers no protection against a market decline in the separate account.

• The death-benefit guarantee lapses once the contract's surrender-charge period has expired.: Conflates two unrelated contract features. The surrender-charge schedule governs withdrawal fees; it has no bearing on whether the death benefit guarantee remains in force.
• The beneficiary receives only the current (declined) separate account value, since variable annuities offer no protection against investment losses.: Ignores the standard minimum death benefit guarantee built into most variable annuity contracts, which is specifically designed to protect beneficiaries against exactly this kind of market decline.
• No death benefit is payable unless the contract has already been annuitized.: Reverses the actual pattern: the death benefit guarantee generally applies during the accumulation phase (before annuitization); once a contract has annuitized, whether anything passes to a beneficiary instead depends on the specific payout option selected.

Verified against: Variable annuity death-benefit guarantee (standard contract feature, accumulation phase)

Answer: The entire $15,000 is treated as earnings under LIFO, taxed as ordinary income, and — because the client is under age 59½ — also subject to a 10% early-withdrawal penalty.

Non-qualified annuity withdrawals are taxed under a last-in-first-out (LIFO) rule: any earnings above the owner's basis (total premiums paid) are deemed withdrawn first, and only after all earnings have been withdrawn does the owner start receiving a tax-free return of basis. Here the contract holds $25,000 of earnings ($65,000 current value minus $40,000 basis), and the $15,000 withdrawal is entirely within that earnings layer — so 100% of it is taxable as ordinary income (never capital gains, regardless of how long the contract has grown). Because the client is 50 (under 59½), the taxable portion is also subject to a 10% additional tax, absent an exception such as death or disability. Option A wrongly applies FIFO, which is the opposite ordering rule associated with life insurance cash-value withdrawals; option B mischaracterizes annuity earnings as capital gains; option C confuses deferral (tax delayed until withdrawal) with a permanent exemption that doesn't exist.

The Trap: Applying FIFO, capital-gains, or permanent-tax-exemption treatment instead of the LIFO ordinary-income rule that governs non-qualified annuity withdrawals.

• The $15,000 is taxed as a long-term capital gain, because the contract value has appreciated over time.: Annuity earnings are never treated as capital gains, no matter how long the contract has been held; they are always taxed as ordinary income.
• The $15,000 is entirely tax-free, because growth inside a non-qualified annuity is permanently tax-exempt.: Confuses tax deferral (no tax while growth accrues inside the contract) with permanent tax exemption. Tax is due — as ordinary income — once earnings are actually withdrawn.
• The entire $15,000 is a tax-free return of the client's basis, since annuity withdrawals are treated on a FIFO basis.: Reverses the ordering rule. Non-qualified annuity withdrawals follow LIFO (earnings out first), not FIFO — FIFO-style basis-first recovery is more characteristic of life insurance cash-value withdrawals, not annuities.

Verified against: Internal Revenue Code Section 72 — LIFO ordering for non-qualified annuity withdrawals; 10% additional tax before age 59½

Answer: Variable life insurance is primarily designed to provide a death benefit funded through insurance (with cash value invested in a separate account), while a variable annuity is primarily designed to accumulate and later distribute retirement income.

Variable life insurance and variable annuities are both securities that invest contract/policy value through a registered separate account and both require a prospectus and dual securities/insurance licensing to sell — but their core purposes differ. Variable life insurance exists primarily to provide a death benefit to a beneficiary, with cash value that fluctuates with the separate account's performance; a variable annuity exists primarily to accumulate assets during a person's working years and then distribute income, often for retirement. Cash value in a variable life policy is not guaranteed and can fall with poor performance (it's typically the death benefit, not the cash value, that carries a guaranteed minimum). The two products also differ in how withdrawals are taxed: annuities use LIFO (earnings out first), while life insurance cash-value withdrawals are generally treated as basis recovery first under IRC Section 72(e), up to the premiums paid — the reverse ordering. Option B wrongly claims variable life insurance escapes securities registration; option C wrongly guarantees cash value instead of the death benefit; option D wrongly equates the two products' tax-ordering rules.

The Trap: Assuming variable life insurance is not a security, that its cash value is guaranteed, or that it shares the annuity's LIFO tax ordering.

• Withdrawals of variable annuity earnings and withdrawals of variable life insurance cash value follow the identical LIFO ordering rule for tax purposes.: The two products use different ordering rules: non-qualified annuity withdrawals follow LIFO (earnings first), while life insurance cash-value withdrawals are generally treated as a return of basis first under IRC Section 72(e) (a FIFO-like approach) up to the amount of premiums paid.
• Variable life insurance guarantees that cash value will never fall below total premiums paid, regardless of separate-account performance.: Cash value in a variable life policy is not guaranteed and can decline with poor separate-account performance; it is the death benefit (not the cash value) that policies commonly guarantee a minimum floor for.
• Unlike a variable annuity, variable life insurance is not considered a security and requires no prospectus.: Both products are securities. Variable life insurance's cash value is invested through a registered separate account just like a variable annuity's, so it too must be sold with a prospectus by a dually licensed representative.

Verified against: Securities Act of 1933 / Investment Company Act of 1940 (separate account registration for variable life insurance); IRC Section 72(e) (tax ordering: LIFO for non-qualified annuity withdrawals vs. FIFO-style basis recovery for non-MEC life insurance cash-value withdrawals)

Answer: Compare the costs, benefits, and new surrender period of the proposed contract against the client's needs and document why the exchange is suitable — a 1035 exchange that mainly benefits the representative through new commissions while resetting the surrender-charge period is a classic red flag for churning.

A Section 1035 exchange lets a contract owner move value from one annuity (or certain life insurance) contract into another without triggering current income tax on the gain — but that tax-free status is a separate question from whether the exchange is suitable for the client. Because the new contract resets a fresh surrender-charge schedule and carries higher ongoing fees, the representative must weigh the client's actual needs against the real costs and features of both contracts and document why the recommendation is appropriate; an exchange whose main effect is a new surrender period and a new commission for the representative — with only a modestly richer death benefit to show for it — is a textbook churning concern regulators watch for closely. Option A wrongly treats tax-free status as proof of suitability; option B wrongly claims the new contract must be identical to qualify, when Section 1035 permits exchanges between different insurers and different contract features; option D wrongly denies that variable annuities can use Section 1035 at all, when annuity-to-annuity exchanges are one of its most common applications.

The Trap: Believing a 1035 exchange's tax-free status alone establishes suitability, and ignoring the churning red flag of a reset surrender-charge period.

• Have the client fully surrender the existing contract, pay any taxes due, and then purchase the new annuity, since Section 1035 exchanges do not apply to variable annuities.: Section 1035 exchanges do apply to variable annuities — annuity-to-annuity exchanges are one of the most common uses of the provision. Forcing a taxable surrender instead of a proper exchange would needlessly cost the client tax-deferred growth.
• Proceed with the exchange without further analysis, since Section 1035 exchanges are always income-tax-free and therefore always suitable for the client.: Confuses tax treatment with suitability. That an exchange qualifies for tax-free treatment under Section 1035 says nothing about whether it is suitable given the new surrender period, higher fees, and the client's actual needs.
• Tell the client a Section 1035 exchange is unavailable here because the new contract is not identical to the existing one.: A Section 1035 exchange does not require the new contract to be identical to the old one — it permits exchanging one annuity contract for another annuity contract (or certain life insurance exchanges) without a taxable event, even across different insurers and features.

Verified against: Internal Revenue Code Section 1035 (tax-free exchanges); FINRA rules on suitability review of deferred variable annuity exchanges (e.g., FINRA Rule 2330)