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Difficulty: MediumAnnuities and Insurance-Based Products

An investor annuitizes a non-qualified variable annuity contract and selects an Assumed Interest Rate (AIR) of 4%. In the first month following the start of payouts, the subaccounts in the separate account generate a net return of 3%. Which of the following statements best describes the effect on the annuitant's next monthly payment?

  1. The monthly payment will decrease compared to the previous month because actual performance was below the AIR.Answer
  2. B
    The monthly payment will increase compared to the previous month because the separate account experienced a positive net return.
  3. C
    The monthly payment will remain identical to the previous month because the payout amount is fixed upon annuitization.
  4. D
    The monthly payment will be reduced by an IRS 10% tax penalty for failing to meet the minimum contract return rate.

Answer

The monthly payment will decrease compared to the previous month because actual performance was below the AIR.
During the payout phase of a variable annuity, monthly payments are recalculated by comparing the actual net performance of the separate account against the contract's Assumed Interest Rate (AIR). If actual performance is less than the AIR (in this case, 3% performance vs. 4% AIR), the subsequent monthly payment decreases.

Step-by-Step Solution

1
Identify the annuity type and phase.
The investor has annuitized a variable annuity, entering the payout phase where payments depend on separate account performance relative to the Assumed Interest Rate (AIR).
Variable annuity payout amounts fluctuate monthly based on subaccount performance compared to AIR.
2
Compare actual subaccount performance to the contract's AIR.
Actual net return = 3%; AIR = 4%. Actual performance (3%) is lower than AIR (4%).
AIR acts as the performance benchmark for determining whether monthly payments increase, stay the same, or decrease.
3
Determine the direction of the next monthly payment.
Because 3%<4%3\% < 4\%, the next payment decreases relative to the previous month's payout.
If actual return > AIR, payout increases; if actual return = AIR, payout stays the same; if actual return < AIR, payout decreases.

Key Concept

Assumed Interest Rate (AIR) Mechanics in Variable Annuity Payouts
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Topics

Annuities and Insurance-Based Products

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