Traditional annuities grow at a fixed rate and pay out fixed benefits when the annuitant reaches a certain age. Another type of annuity, in which the annuity's rate of growth may vary according to the performance of an underlying investment vehicle, and from which benefit payments can also vary, is called a variable annuity. These annuities provide the opportunity to realize substantial gains; they can, however, also produce a financial loss. Annuity buyers can usually choose from a number of different investment accounts, including the insurance company's general account.

With standard fixed annuities, the insurance company assumes the investment risk. If investment performance is more than what's required to finance the contract's guarantees, the difference is added to the company's profits. If, on the other hand, underlying investment performance lags, the insurance company – not the annuitant (who is generally also the owner of the annuity contract) – suffers the loss.

Conversely, all variable contracts – including variable life insurance as well as variable annuities – place the investment risk squarely with the owner of the contract. Although this allows investment gains to be passed through to the contract owner, it means that he or she will also bear any investment losses that occur.

Because the contract owner bears the investment risk, the Securities and Exchange Commission (SEC) considers variable annuities to be security instruments rather than normal life insurance products. As a result, not only are variable annuities subject to state insurance regulations, they must also be registered with the SEC under the Securities Act of 1933. Generally speaking, the laws and rules that apply to securities also apply to variable annuities. Additionally, the agents who sell variable annuities must have dual licensing. They must be licensed by their state to sell life insurance; they also must be licensed as registered representatives of a member of the National Association of Securities Dealers (NASD). NASD registration requires passing either the Series 6 limited registration exam or the Series 7 general securities exam (some states also require an additional state variable contracts- or variable annuities license).

The money paid into an insurance company as premiums for variable annuities is held in a separate account from all other fixed annuity and insurance products. This separate account is used by the insurance company to buy securities. When paying into the annuity, the contract owner is not buying shares of stock or other securities; he or she is actually buying accumulation units in this separate account. Using accumulation units is simply an accounting measure by the insurance company to determine the contract owner's interest in the separate account during the accumulation (or purchase) period of a deferred variable annuity.

However, not all of the premium payments made by a contract owner go toward the purchase of accumulation units. Before units can are purchased, fees such as sales charges and taxes must be deducted. The remaining 'net' premium is then used to buy accumulation units. The number of units that a net payment will buy depends upon the value of an accumulation unit at that time. This value is determined periodically, usually on a daily basis. Basically, the value of one accumulation unit can be calculated by dividing the total value of the separate account by the total number of outstanding accumulation units.

A contract owner can never end up with fewer accumulation units than he or she has purchased, although the value of each unit may vary up or down. For instance, let's assume that an owner's net premium payment of $100 buys 100 accumulation units. The next week, the value of the portfolio held by the separate account increases so that each accumulation unit is now worth $1.10 each. The contract owner still has only 100 units, but each unit is now worth $1.10 instead of the $1.00 that was paid. Conversely, if the value of the portfolio had decreased, each accumulation unit would be worth less. As the owner continues to buy accumulation units, they're added to those already owned. The dollar value of all the units owned by the contract holder is determined by multiplying the total number of units that the contract holder owns by the value of one accumulation unit. For example, if Jim owns 5,000 accumulation units and the value of one unit is $3, the total dollar value of Jim's accumulation account (his interest in the company's separate account) is $15,000.

When the time arrives for the annuitant to begin collecting payments from his or her annuity, another accounting measure comes into play. Replacing the accumulation unit, the annuity unit is used to determine the amount of each payment that the annuitant will receive during the payout period of the annuity. Unlike accumulation units, which increase with each premium payment into the separate account, the number of annuity units remains fixed and permanent.

The first step in determining the amount of annuity units that an annuitant owns is to find the total dollar value of his or her interest in the insurance company's separate account (refer to Jim's example above). Next, the value of the first monthly payout to the annuitant must be calculated. Insurance company annuity tables – which take into account the annuitant's age, sex, the payout option chosen and other factors – determine the annuity payment amount per $1,000. For example, let's say that an annuitant has a $100,000 accumulation account and the insurance annuity table shows a value of $5 per $1,000. The first monthly payment to the annuitant, then, would be $500.

Now, if the annuity were of the fixed variety, the annuitant would receive that first month's value for every subsequent payment throughout the life of the contract. But with a variable annuity, this figure is converted into annuity units by dividing the first monthly payment by the current value of an annuity unit. If the first monthly payment is $500 and the value of an annuity unit at that time is $5, the annuitant will own 100 annuity units; and as stated, once this number is established, it doesn't change. However, although the number of annuity units remains fixed for the remainder of the contract; the annuity payment itself may vary according to the value of an annuity unit. For example, if the value of a unit rises to $5.10 the following month, the annuitant would receive a payment of $510. And if it fell to $4.85, the annuitant would receive $485.

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