Given the success that the variable annuity industry has had with offering living benefits as riders on their products, we shouldn't be surprised that the index annuity companies are copying the strategy. But does it make any sense? Living benefits provide valuable income protection on variable annuities because, as we have learned all too well, the value of a variable annuity can fall significantly. However, this is not the case with an indexed annuity. The entire point of an indexed annuity is to get a long-term rate of return that is 1.5 - 3.0 percent above prevailing CD rates without putting principal at risk. Therefore, for the vast majority of cases, clients will receive no incremental value by adding a living benefit on an indexed annuity. In the limited number of situations where an indexed client may benefit from adding a living benefit, all of the following must be true:
- The client must have a very high degree of certainty that he or she will utilize the index annuity for lifetime income
- The client must want to have a near 0 percent probability that he or she will outlive that income
- The expected return must be more than 2.5 percent below the guaranteed growth in the income benefit base (the amount used to calculate the lifetime income amount). Remember that income via a living benefit is first deducted from the client's account value. Therefore, until that account value goes to $0, withdrawals via the living benefit are simply a return of the client's money. During the accumulation phase, unless the income benefit base grows on average at least 2.5 percent faster than the account value, the odds of the client liquidating the account at the allowable withdrawal rate prior to his or her 90th birthday is highly unlikely.
When does a living benefit on an indexed annuity make sense?
In order to analyze the true value of a living benefit on an indexed annuity, I ran through some possible scenarios. The first scenario had the following assumptions:
- A 60-year-old client that begins income at age 75 and makes no withdrawals prior to 75.
- The income base grows at 8 percent per year for the full 15-year deferral period.
- The account value earns 5.5 percent each year, net of any fees for the living benefit (which can cost up to 0.75 percent per year).
- The index annuity credits a 10 percent bonus to both the account value and the income base only at the time of purchase.
- The withdrawal rate at age 75 is 6.5 percent of the income-benefit base.
The income benefit base, represented by the blue bar in the graph above, compounds at 8 percent each year until it reaches $348,939 on the 15th policy anniversary. Since the only purpose of the income benefit base is to calculate the amount of available lifetime income, it ceases to exist at age 75. The account value, represented by the red bars, grows at 5.5 percent each year until it reaches $245,572 on the 15th policy anniversary. At that time, the client begins to withdraw $22,681 per year, 6.5 percent of the income benefit base. Because this amount is greater than the 5.5 percent earned each year on the account value, the account value declines in value each time a withdrawal is made.
Under this scenario, the withdrawals will exhaust the client's account value at age 92. Since all withdrawals are first deducted from the client's account value, it is not until the 33rd policy year that the annuity in this example would provide money that couldn't have been received without ever purchasing the living benefit.
If the account value averages a 5 percent return rather than 5.5 percent, the account value would be liquidated at age 90. On the other hand, if the account value averaged 6 percent, the account value would reach $0 at age 96.
This example assumes the same return every year -- something that obviously is unlikely to happen. In the accumulation phase, the sequence of returns doesn't matter. The investment will grow to the same sum no matter if it earns 5.5 percent every year or averages 5.5 percent over the accumulation period (assuming no withdrawals).
Since the sequence of returns does matter during the payout years, I reran the numbers assuming that the annuity earned 0 percent for each of the first 3 years after the income payments begin and then 6 percent for income years 4-10 and 5.5 percent thereafter. Under these assumptions the account value reaches $0 four years earlier at age 88. Of course, the opposite effect will occur if the client experiences higher than expected returns early in the income phase and lower than expected returns late in the income phase.
Should anyone pay extra for a living benefit on an indexed annuity?
I believe that a competitively priced indexed annuity may be an appropriate option for the CD buyer that is a) willing to give up a portion of the guaranteed return for an opportunity to earn on average 1.5 percent - 2.5 percent more per year, and b) is willing to tie money up for five to 10 years. An indexed annuity is not a proper alternative to a mutual fund or variable annuity. For most of these clients, it will make little sense to add a living benefit for additional income protection. The principal of an indexed annuity is already guaranteed. The only thing that is in question is the actual rate of return each year. Why pay extra to insure something that is already guaranteed?
Adding the living benefit will only make sense if a) its cost is minimal, b) the client has a high degree of certainty that not only is he or she going to eventually begin receiving lifetime income payments, but will receive the payments from that particular annuity, and c) the client wishes to protect against the worst possible market scenario. In the vast majority of cases, the client will either surrender the annuity or die prior to the account value going to $0. If this occurs, the client has paid for a benefit that was never received.
Of course, the insurance companies understand this all too well. That's precisely why they are willing to add a living benefit on an indexed annuity with such seemingly aggressive pricing relative to similar features on variable annuities.
Does the Deferral Period Matter?
Yes, but perhaps not in the way you might think. One might suppose that the sooner the client starts the income, the likelier the account value would run out of money. However, that is not necessarily the case. First, insurance companies compensate for longer life expectancies by paying a lower income percentage off of the income base at younger ages. Second, a shorter deferral period prior means that the income benefit base will not be as great relative to the account value. Both of these factors work to reduce the probability that the account value will be liquidated prior to the client's death.
Scott Stolz is president of Raymond James Financial's insurance group.