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.

Before liquidation begins, the investor can look backward and lock in the highest anniversary value (which is either quarterly or annually) or opt for the “default” guaranteed annual rate of 5%-7%. If the owner selects a guarantee (highest anniversary value or default), the contract must be liquidated over a 10- to 20-year period (longer or shorter if the VA is annuitized). With no guarantee, the investor can liquidate 100% of the VA, request a 1035 exchange or make withdrawals as desired.

If one of the two guarantees is used and if distributions commence, the investor must accept the insurer’s distribution schedule. During distribution, any undistributed balances earn either 0% or 1%. (Some contracts allow the investor to continue participating in the stock and/or bond markets, thereby providing the chance of a return even higher than the 5%-7% annual guarantee or highest anniversary value.)

Many advisors and clients want to know, What is the proper use of the living benefit?

Because of the nature of the guarantee, advisors and investors need to understand that only equity-type investments should be used. If downside risk is assured, either through a minimum guarantee or return of principal, there is no reason to use a fixed-income subaccount (high yield or emerging markets bonds being the two possible exceptions).

For the accumulation-type rider, only use equity subaccounts for two reasons: 1) historically it has been relatively rare to see bonds outperforming stocks, assuming the required minimum holding period of 7-10 years; and 2) assuming the minimum annual guarantee is in the 5%-7% range, it will be almost impossible to find fixed-income subaccounts that have similar returns net of expenses (note: the 5%-7% guaranteed annual return is a net figure).

Distribution-oriented living benefit riders should also be largely equity-oriented, again because of the guarantees.

That said, it would be appropriate to at least consider a “balanced” approach if the income-oriented investor were looking to extend the distribution period past 14.2 years with some kind of peace of mind (which is what the bond portion would provide).

Still, for most investors, only equity-type subaccounts should be considered since return of principal is assured. And, just as with the accumulation-type living benefit, the time frame is long enough where it will be very unlikely that bonds will outperform stocks.

Clients need to know there are two major benefits to using a living benefit rider. First, the guarantees can give the investor peace of mind. Second, the guarantees allow the contract owner to participate more heavily in the equities markets than what would otherwise be prudent, because of age or risk level. Compared to a VA without a living benefit, the additional cost of roughly 0.75% a year is a bargain. The client has all of the same upside potential of the markets (minus the 0.75% a year) but none of the downside risk of a VA without such a rider.

Some living benefit clients are initially not happy with a lengthy distribution schedule; they want all the benefits without any strings attached.

These same clients view the living benefit more positively when they understand that a VA with a living benefit is to be used as part of an overall financial plan. Marketability or liquidity concerns can be fulfilled with other investment vehicles.