The coupling of a living benefit rider with a variable annuity has resulted in a windfall for the insurance industry.
Close to 75% of all VA sales last year included a living benefit. Investors are attracted to the feature’s ability to provide the upside potential of equities markets coupled with either principal protection or principal growing at a 5%-7% annualized rate of return. This article briefly describes these riders, when to use them and whether they really benefit the investor.
All living benefits are designed as either accumulation or distribution vehicles with certain guarantees. Their cost is roughly 0.5%-1% a year, thereby increasing the VA’s annual cost from about 2.5% to roughly 3.25%. In most cases, once the rider is selected, the only way to cancel it is either to liquidate or to annuitize the VA.
Distribution-oriented living benefit riders guarantee that the investor will receive 100% of principal, distributed over a specific period, typically 14.2 years (7% of principal a year for 14.2 years). During distribution, the investor either selects from one or more offered subaccounts, or from asset allocation models derived by the insurer or an affiliate, and can make changes continuously within the VA parameters.
The asset allocation models help to limit the insurer’s possible exposure. Allowing the investor to select one or multiple subaccounts, without restriction, increases upside potential but also increases the chances of possible subpar performance.
With distribution-type benefits, the insurer’s risk level decreases each year, because less principal is subject to risk. The risk is further reduced because of the time value of money, something rarely talked about by the insurer or its marketers. Yet the benefit still can be substantial.
Consider the alternatives for a conservative or older client shown in the box. The problem with all four alternatives is, they offer a poor rate of return with guarantees (option 1), or they provide no guarantees and no tax deferral (options 2-4).
On the other hand, the distribution-type living benefit allows clients to participate in the stock and/or bond markets. If the return, net of all annuity fees, is a positive number, the distribution phase could easily extend from 14.2 years to 15 years or even over 25 years–depending on the projected return.
Obviously if a balanced portfolio is annually returning 5% net of all costs, the investor will be receiving 7% a year for several dozen years. If the net return is in the neighborhood of 2%-3% a year, the payout period is still extended beyond 20 years. And, if returns are flat or negative, the 7% payments remain guaranteed for the full 14.2 years.
The accumulation-type living benefit rider typically requires a holding period of 7-10 years or longer. During this phase, the contract owner can make ongoing investment changes–again, the choices are any and all subaccounts offered to other investors, or one or more asset allocation models. Many of these contracts also offer a minimum guarantee of 5%-7% per year if investment results are disappointing.
Anytime after the minimum holding period (7 to 10-plus years), the contract can be systematically liquidated or annuitized.