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Difficulty: Very hardAnnuities and Insurance-Based Products

An investor annuitizes a non-qualified variable annuity contract using a straight life payout option with an Assumed Interest Rate (AIR) of 4%4\%. During the first three payout months, the contract's separate account subaccount yields the following net monthly annualized returns: Month 1 yields 4%4\%, Month 2 yields 6%6\%, and Month 3 yields 2%2\%. Assuming no changes in mortality or contract expense charges, how does the investor's payout amount in Month 3 compare to the payout amount received in Month 2?

  1. The Month 3 payout is lower than the Month 2 payout because Month 3 separate account performance fell below the 4%4\% AIR.Answer
  2. B
    The Month 3 payout is higher than the Month 2 payout because Month 3 performance was positive.
  3. C
    The Month 3 payout is equal to the Month 2 payout because the three-month average performance (4%4\%) matches the 4%4\% AIR.
  4. D
    The Month 3 payout is reduced by an additional 10%10\% IRS tax penalty due to underperformance relative to the benchmark AIR.

Answer

The Month 3 payout is lower than the Month 2 payout because the Month 3 separate account return of 2%2\% was below the 4%4\% Assumed Interest Rate (AIR).
In a variable annuity payout phase, monthly payments fluctuate based on separate account performance compared to the Assumed Interest Rate (AIR). If subaccount performance exceeds the AIR, payout increases from the previous month. If performance equals the AIR, payout remains identical to the previous month. If performance is below the AIR (even if positive, such as 2%2\% versus 4%4\% AIR), the payout decreases compared to the previous month's payout.

Step-by-Step Solution

1
Analyze Month 1 performance relative to AIR.
Month 1 return (4%4\%) equals AIR (4%4\%). Therefore, the Month 1 payment equals the baseline payment.
When actual subaccount performance equals the AIR, the monthly payout remains unchanged from the previous month.
2
Analyze Month 2 performance relative to AIR.
Month 2 return (6%6\%) exceeds AIR (4%4\%). Therefore, the Month 2 payment increases compared to the Month 1 payment.
When actual subaccount performance exceeds the AIR, the monthly payout increases over the preceding period.
3
Analyze Month 3 performance relative to AIR.
Month 3 return (2%2\%) is less than AIR (4%4\%). Therefore, the Month 3 payment decreases compared to the Month 2 payment.
When actual subaccount performance is less than the AIR, the monthly payout decreases relative to the preceding period, regardless of whether the return itself is positive.

Key Concept

Variable Annuity Payout Phase Mechanics and Assumed Interest Rate (AIR)
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Topics

Annuities and Insurance-Based Products

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