An investor who has held a fixed annuity for several years is concerned that fixed monthly payouts during retirement will not keep pace with rising living costs. The investor considers reallocating the funds into a variable annuity with equity subaccounts. Which of the following statements accurately describes the primary risk trade-off and contractual shift resulting from this decision?
- The investor trades purchasing power (inflation) risk for market risk, shifting the investment risk from the insurance company to the contract owner.Answer
- BThe investor eliminates market risk while retaining the insurance company's guaranteed minimum rate of return on the separate account subaccounts.
- CThe investment risk remains with the insurance company because separate account subaccount assets are held within the insurer's general account portfolio.
- DThe investor avoids tax penalties on future withdrawals because variable annuity separate account growth is fully exempt from federal income tax.
Answer
The investor trades purchasing power (inflation) risk for market risk, shifting the investment risk from the insurance company to the contract owner.
Fixed annuities expose contract owners to purchasing power (inflation) risk because payouts are fixed while living costs rise over time. In a fixed annuity, the insurer guarantees the payout and holds the investment risk in its general account. When reallocating to a variable annuity, the investor directs funds into a separate account holding equity subaccounts. This shift provides growth potential to combat inflation, but transfers market performance risk entirely from the insurer to the contract owner.
Step-by-Step Solution
Key Concept
Fixed vs. Variable Annuity Risk Profiles and Separate Account Mechanics
Estimated Time:1m 30s