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An annuity unit is the accounting unit used in the payout phase of a variable annuity to determine how much each periodic payment will be. When a variable annuity contract is annuitized, the accumulated balance expressed in accumulation units is converted into a fixed number of annuity units. That number of annuity units remains constant for the life of the contract. What changes with each payment period is the value assigned to each unit, which fluctuates with the performance of the underlying investment subaccounts. Each payment is calculated as the fixed number of annuity units multiplied by the current annuity unit value.
Think of an annuity unit as a share whose count is locked but whose price moves with the market. A retiree with 500 annuity units who receives $1,000 in the first month holds the same 500 units in the second month; if the subaccounts gained value, the next payment might be $1,050. If subaccounts fell, the next payment might be $960.
During the accumulation phase, contributions buy accumulation units in the variable annuity's separate account, similar to buying shares in a mutual fund. The accumulation unit value rises and falls with the underlying investments. When the contract owner annuitizes, the insurance company calculates the current total value of all accumulation units, then converts that value into a fixed number of annuity units using an annuity purchase rate that incorporates the annuitant's age, life expectancy, selected payout option, and the annuity unit value on the conversion date.
Variable annuity payout calculations use an assumed interest rate (AIR), which is the conservative benchmark growth rate embedded in the annuity unit conversion. If the separate account's actual performance in a given period equals the AIR, the annuity unit value stays the same as the prior period and the payment is unchanged. If performance exceeds the AIR, the annuity unit value increases and the payment rises. If performance falls short of the AIR, the annuity unit value decreases and the payment falls. A higher AIR produces a larger initial payment but requires stronger subaccount performance to maintain or grow that payment over time.
| Accumulation Units | Annuity Units | |
|---|---|---|
| Phase | Accumulation (pre-retirement growth) | Payout (post-annuitization income) |
| Count | Changes as contributions are made or withdrawn | Fixed for life of the contract |
| Value per unit | Varies with subaccount investment performance | Varies with subaccount performance relative to AIR |
| Payment calculation | N/A — reflects account value, not periodic payment | Units × current unit value = periodic payment |
When payments are received from an annuitized variable annuity, each payment is partly a tax-free return of the original investment (cost basis or premium) and partly taxable investment gain. The exclusion ratio determines what fraction of each payment is tax-free. For variable annuities, because each payment amount varies with subaccount performance, the IRS allows an annual exclusion amount to be calculated and applied; the methodology differs slightly from fixed annuities but serves the same purpose of spreading the cost basis recovery over the projected payment period. Payments that represent pure investment gain are taxed at ordinary income rates, not capital gains rates.
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