Variable annuities aren’t something you’re likely to encounter on Wall Street, even if you’re a wealth manager. There are many reasons for this, but the primary one is that these assets were initially designed to provide both reliable income and long-term market exposure for retirement, but often at very high fees. Cheaper alternatives and tighter regulation have made variable annuities less profitable, and thus less promoted.
Their lucrativeness and somewhat dubious position in the history of finance means that they are heavily tested on the Series 7, surprisingly for an asset class that isn’t exactly exploding in popularity. Thus, even if you never touch one, you’ll need to know how to analyze one.
First, let’s start of with what variable annuities are. Like fixed annuities, these promise a cash stream to the annuitant for a fixed period of time, which can mean a set number of years or until the annuitant dies. Fixed annuities are typically backed by an insurance company, who will use a mix of investments to ensure the risk of them losing money on their annuity promise is nil. Insurance companies are extremely robust at identifying pretty much all of the risks they can face, which also means that the fixed income of an annuity becomes very unlucrative, typically being less than the return on low-risk assets like Treasuries and municipal bonds. Again, why they’ve been dwindling.
Variable annuities somewhat fix this, by having a future cash flow dictated by the performance of a separate investment account, which in the future becomes the basis for the annuitant’s cash flow. Again, this sounds pretty complicated, but the idea is simple: you give an insurance company a fixed amount monthly over a certain period, they invest it and give you back your investment plus profits minus fees.
This is not suitable for all investors, which is why FINRA is very harsh on variable annuities. For instance, FINRA has cracked down on registered representatives encouraging clients to get home equity and use that for a variable annuity—any question on this on the Series 7 will be looking to see that you know annuities shouldn’t be invested in from home equity, because the official perspective is that variable annuities will underperform residential real estate long term. FINRA does not condone any kind of investment, but sometimes the regulations imply some condoning; this is a good example.
FINRA will also look to see if you know that variable annuities should not be funded by selling another annuity—again expect this question on the exam.
Other aspects of these investment vehicles will likely be tested, so make to read up on insurance before getting into the exam. This is one spot where students like to cut corners, but it is ill advised.
Similarly, DPPs are more tested than one might expect, and so if you’re studying for the exam, it’s important not to skip the DPP parts or the variable annuity parts. Pay particular attention to risks and suitability—the Series 7 is particularly focused on suitability for clients, so if you focus your attention on what parts of these investments make them bad for whom and why, you’ll probably be in a very strong position to pass these questions without too much thought or energy.
This is particularly interesting because the Series 7 tests on other investments that are arguably even more unsuitable for retail investors, like selling uncovered calls. And, in fact, the exam is very disinterested in that issue despite the fact that uncovered calls are riskier than the average variable annuity.
Of course, the reason for that is simple: your average investor can easily be hoodwinked into a bad deal with the promise of income for life, which is immediately and instantly compelling. Hoodwinking someone into a bad options trade is much harder—you’ll have to begin by explaining what an option is, for instance.
And that shouldn’t be surprising. These regulations exist to protect consumers, so the regulations will focus much more on the promises of a thing and how accessible it might appear rather than the fundamental risks of the thing itself. Not all theories of regulation operate this way, but in looking at how the exam tackles annuities, we can see that it is very much FINRA’s focus.