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Question

Difficulty: HardAnnuities and Insurance-Based Products

A registered representative is explaining the structural, risk, and tax characteristics of fixed and variable annuities to a client. Which of the following statements regarding fixed and variable annuities are CORRECT? (Select all that apply.)

  1. The contract owner bears the investment risk in a variable annuity because returns depend directly on the performance of subaccounts within the separate account.Answer
  2. B
    Surrender charges assessed by the issuing insurance company for early withdrawal count toward satisfying the 10% IRS penalty tax on premature distributions.
  3. Fixed annuity contract holders face purchasing power risk, whereas the issuing insurance company assumes the investment risk on the underlying general account.Answer
  4. D
    Variable annuity subaccounts are held within the insurance company's general account to guarantee a fixed minimum rate of return.

Answer

The correct statements are that the contract owner bears investment risk in a variable annuity's separate account subaccounts, and that fixed annuity contract holders bear purchasing power risk while the insurer bears investment risk.
The statement regarding variable annuity investment risk is correct because separate account subaccounts pass market risk directly to the contract owner. The statement regarding fixed annuities is also correct because guaranteed fixed payouts transfer market risk to the insurer's general account while leaving the contract owner exposed to purchasing power (inflation) risk.

Step-by-Step Solution

1
Analyze the account structure and investment risk allocation of variable annuities versus fixed annuities.
Variable annuity premiums fund separate account subaccounts where return fluctuates based on market performance, placing investment risk on the investor. Fixed annuity premiums fund the insurer's general account with guaranteed returns, placing investment risk on the insurer.
Separate vs. general account classification dictates which party assumes market performance risk.
2
Evaluate long-term purchasing power risk and early withdrawal penalty mechanics.
Fixed payouts from a general account expose the purchaser to inflation risk over time. Additionally, contractual contingent deferred surrender charges (CDSCs) assessed by the insurer are completely distinct from the federal 10% IRS tax penalty assessed on taxable earnings withdrawn before age 59 1/2.
Insurance company surrender charges do not substitute for or reduce federal tax penalties.

Key Concept

Fixed vs. Variable Annuity Account Risk Allocation and Surrender Penalty Mechanics
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Topics

Annuities and Insurance-Based Products

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