Often overlooked by advisors and boomer clients who are deciding whether to purchase an optional rider for a deferred variable annuity is the enhanced death benefit the add-on can provide to beneficiaries. Those concerned about the financial well-being of the next generation, experts tell National Underwriter, would do well to take notice.

Consider, for example, a guaranteed living benefit rider that locks the contract value to a “high water mark,” or the highest cash value achieved by a certain policy anniversary. If an annuity in which the client has invested $100,000 later rises in value to $150,000, then dips to $125,000 two years later when the client passes away, the death benefit will be fixed at $150,000.

Clients might also opt for a return of principal rider. If the client deposits $200,000 and the stock market drops to $100,000, the benefit going to the beneficiary will be the original investment, minus withdrawals. Also available at added cost is a rider that increases the account value by a given percentage annually, such as a 5%, subject to a 200% cap.

Ethan Young, manager of annuity research at Commonwealth Financial Network, Waltham, Mass., says this “step-up” option may appeal to many boomers nearing retirement, but may not be suitable for younger boomers who are likely to experience more than a 200% market gain in their account value. He notes also that GLB riders, while boosting potential payouts for heirs, are more often than not purchased for the benefit of the annuity investor.

“With guaranteed living benefits, clients are more willing to use an annuity for what it was originally intended, which is to provide an income stream you can’t outlive,” says Young. “Because they’re paying for the rider, clients are more likely to spend down the annuity’s assets, leaving little or nothing for heirs. Also, some contracts will eliminate the death benefit because of their design.”

To illustrate, Young points to contracts wherein withdrawals reduce the death benefit proportionally (i.e., by the percentage the withdrawal represents of the cash value). When the death benefit exceeds the current cash value, as is typical in a down market, the proportional reduction methods yields a lower death benefit than does the dollar-for-dollar reduction method, which simply reduces the death benefit by the amount of the withdrawal.

Assuming an initial investment of $300,000 in a contract subject to the proportional method, if the client withdraws $50,000 annually for 4 years and then dies, the contract could actually yield a zero death benefit, as opposed to $100,000 under the dollar-for-dollar method. Many contracts that incorporate a GLB rider, notes Young, use the proportional reduction technique to help fund the optional living benefit.

“The difference between the dollar-for-dollar and proportional methods is not often explained to clients,” says Young. “And I doubt whether many advisors even know about the two techniques.”

How else can advisors secure an enhanced death benefit for heirs?

One option, say experts, is to do a 1035 exchange of one variable annuity for another during a bull market, thereby locking in a step-up in basis, or a higher account value not subject to ordinary income tax. Assuming the transaction entails no surrender charge on the original contract, the exchange–and the gain–cost the client nothing.

Also available to boomers is an estate protection rider. This add-on can boost a final account value at the death of a client, often by as much as 150%, to cover ordinary income tax paid by estate beneficiaries, albeit at a potentially steep cost. The rider, according Herb Daroff, a partner at Baystate Financial Services, Boston, Mass., can add an extra 50 to 80 basis points in premium.

He notes also that, unless clients are uninsurable or would pay prohibitively much in premium because of advanced age or ill health, they could more cost effectively transfer wealth to heirs by purchasing a life insurance policy. Unlike the annuity, life insurance proceeds are distributed free of ordinary income tax. In cases where the rider does make sense and the client opts for a laddering strategy–purchasing annuities in increments–then the rider should be supplemented with other optional living benefits.

“If I have $1 million in retirement assets, and I did five $200,000 buckets, then we’ll only put the estate protection rider on the last one,” says Daroff. “But for buckets to be spent down prior to death, I’ll add a guaranteed minimum income or withdrawal benefit. The magic of the annuities is all in the riders.”

Riders aside, observers caution advisors to be mindful of the annuity’s structure. If the contract is “owner-driven,” then it will only pay a death benefit upon the death of the policy owner. An “annuitant-driven” policy, by contrast, will only pay upon the death of the annuitant. The contract structure isn’t an issue where both policy owner and annuitant are the same individual, as is usually the case. But when two individuals are involved, then advisors need to ensure the policy is designed to achieve the desired outcome.

“If you want funds to go to children upon mom’s death, and the contract is owner-driven, then mom better be designated the owner,” says Young. “One way to achieve this is by getting a joint owner-joint annuitant policy, but some contracts will only pay out at second death. What’s important here is that advisors understand the contract structure.”