It’s no secret that persistently low interest rates have had variable annuity carriers scrambling to develop ways to remain competitive—carriers have initiated buyback offers and limited VAs’ investments to conservative options in order to limit risk exposure while continuing to offer these products. However, a new trend has recently emerged to allow these carriers to offer increased flexibility in variable annuity products while simultaneously managing the associated market risks.
The ability to alter key terms (including roll-up rates and rider fees) of in-force variable annuity contracts can provide both carriers and clients with a degree of flexibility—but for advisors, the key consideration becomes whether these adjustable term annuities are a smart choice for each individual client’s portfolio.
The New Variable Annuity Landscape
As early as 2012, insurance carriers began issuing buyback offers for existing variable annuity contracts in order to manage risk. Others began requiring existing contract holders to move the majority of their investments to conservative bond funds in order to avoid losing guarantee features.
A recent study by the Insured Retirement Institute indicates that the potential need to modify variable annuity contracts has continued through 2015—except that now, carriers are introducing contracts with adjustable terms so that clients are aware of potential modifications at the time of purchase. These contracts can allow the insurance carrier to reduce income payouts, change rider fees and alter roll-up rates on guaranteed benefits.
For example, some carriers have introduced products that allow carriers to reduce payout rates if the client’s account value is ever depleted (whether because of the client’s withdrawal rates, overall market performance or fees). A product that initially guarantees a payout rate of 6% could reduce the payout rate to 4% if the account value is depleted.
Some contracts allow the carrier to alter roll-up rates on guaranteed living withdrawal benefits (GLWBs) based on the 10-year Treasury or the CBOE Volatility Index. Similarly, some contracts will now tie fees to market volatility, reflecting the fact that low interest rates and higher volatility increase hedging costs.
Pros and Cons of Increased Variability
For some clients, increased flexibility in variable annuity contracts can be a positive—these contracts may provide clients with the opportunity to take higher withdrawals earlier in retirement (reducing the payouts once the account value is depleted) in order to manage sequence of return risk associated with traditional retirement accounts and investments.
Sequence of return risk is a market volatility risk surrounding the order in which returns on a client’s investments occur. Essentially, if a greater proportion of low or negative returns occur during the early years of retirement, the client’s overall returns are going to be lower than if those negative or low returns occurred at a later point in the client’s (and the investment’s) lifetime. If the client has the ability to allow those investments to continue growing because he or she can take higher withdrawals from a variable annuity contract, the risk is mitigated.
For other clients, however, an annuity carrier’s ability to change product terms based on market performance can actually make the products less valuable. Many clients purchase variable annuities (rather than investing directly in the equity markets) in order to mitigate the risk of market downturns. For these clients, reductions in value of the contract guarantees (or increases in fees) based on market performance may eliminate the appeal of the variable annuity strategy.
Additionally, clients who purchase variable annuities to protect against the risk of outliving other assets may find these products less attractive, because their value is more likely to be reduced later in life if the annuity account value is depleted—at the same time that traditional retirement assets may also be dwindling.
Many clients have become accustomed to changes in the variable annuity industry in recent years—but in the case of products that can alter the value of guarantees over time, it becomes more important than ever for advisors to evaluate the client’s overall goals and financial position when recommending these new variable annuities.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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