Lifetime income benefits were introduced as an optional feature on annuities over a decade ago. Today, roughly 75% of all retail variable annuities and 60% of all indexed annuities are purchased with a living benefit. By now, there must be millions of policyholders who have the ability to turn their annuity into a stream of income guaranteed for life without actually annuitizing the contract. Yet, relatively few have elected to do so … thus far. I believe that this is a mistake.
Given today’s low interest rates and ever-increasing life expectancies, activating the lifetime income benefit — even if a policyholder does not need the income — could provide attractive, low-risk rates of return. Alternatively, if a client in their late 70s or early 80s has not yet activated the benefit, you might explore dropping the rider in order to reduce the fees.
This article analyzes these options and provides next steps for you to approach your clients about maximizing the potential of their benefits. I use a racing analogy because the lifetime income benefit is a powerful vehicle — when handled right.
Prepare for the Race
Recently, one of our advisors called us for our advice on what to do with a variable annuity he sold to his client back in December of 2007. Given the timing of the purchase date, and the contract and living benefit fees, we were not surprised to see that the contract value had appreciated very little. By contrast, the income benefit base had compounded at 5% per year.
This particular 70-year-old client had an account value of $315,405 and an income benefit base of 525,045. (Note: for those of you who are wondering if the lack of a dollar sign in front of the income base is an editorial error, it is not. The income base has no monetary value, and therefore, in my opinion, has the potential of misleading clients when it is expressed with a “$” sign.)
The living benefit allows the client to take 5% of the income base, or $26,252, per year. But the proper way to think of this situation is not in terms of the income base, but rather as a percentage of the account value. The allowable lifetime withdrawal amount of $26,252 is 8.32% of the account value. If a 70-year-old client walked into your office and said he wanted to withdraw 8.32% of his portfolio every year, would you give the plan a thumbs-up, or would you advise against it?
Unless you had a reason to believe his particular life expectancy was below the average of 14.1 years for a male his age, my guess is that you would advise against it for fear that a market downturn combined with the withdrawals would cause the client to run out of money before he died. The lifetime benefit eliminates this issue, but only if it’s turned on.
This case is far from unique. We regularly see policies that could generate in excess of 7% of the account value in lifetime income. Amazingly, we came across a policy that allowed a 66-year-old to withdraw almost 9.5% of the account value. Consequent to the last market crash, variable annuities issued between 2004 and 2008 are the most likely candidates, but even policies issued as recently as 2011 could provide surprisingly high lifetime income payout rates. Many of those policies required policyholders to use a volatility managed investment option. Most of these strategies have indeed protected the downside, but in exchange for capturing very little of the upside, thereby allowing the income base to grow well beyond the account value.
Start Your Engines
A lifetime income benefit rider eliminates the possibility of a client outliving his or her assets. In fact, eliminating that possibility is the only benefit the rider provides … but only if the income is actually turned on. If the income is never turned on, then the client has effectively paid for insurance that was never used. And to be honest, that’s exactly what the insurance companies hope will happen. Living benefits are like any other insurance. Insurance companies hope that the premiums (in this case, the living benefit fees) plus the interest earned on the premiums exceed the claims that are paid out. And from the insurance company’s point of view, the very best policies are those that never have claims.
When we ask advisors why they have not turned on the income, we typically hear either the client does not need the income and/or the client will get more income by waiting. Let me take those points one at a time, starting with the benefits of waiting.
It is indeed true that the longer the client waits to take the income, the more guaranteed income the rider will provide. In addition, many living benefit riders sold between 2004 and 2009 automatically double the initial value of the income base on the 10th policy anniversary. The contract I cited above fell into that category. Therefore, since the policy was issued in December of 2007, it would likely make sense to wait another 18 months before turning on the income.
However, this raises yet another consideration: the client’s age and life expectancy. By that point, the client will be 72. The life expectancy of a 72-year-old male drops from 14.1 years to 12.8 years. The odds of the withdrawals causing the account to run out of money prior to the death of the client become increasingly slimmer the older the client gets. In fact, this is one of the reasons the riders are designed to encourage the client to wait to take the income. All of the lifetime income withdrawals are taken first from the account value itself. The insurance company is on the hook for any “claims” only after the account value is depleted. This also implies that there is an age at which one would conclude that the rider is no longer needed. By age 75, the life expectancy is down to 10.9 years, and by 80 it is only 8.1 years.
Of course, I fully understand that life expectancy is simply an average mortality, which means that the client has a 50% chance of living beyond that age. However, I would suggest that if the income on a variable annuity is not turned on somewhere in the 75- to 80-year-old range, you should explore the possibility of dropping the rider and saving the fees. For a living benefit on an indexed annuity, since sequence of returns is not a risk, you should be looking to turn the income on by the time the client is 70 to 72 years old.
Secondly, what if the client really doesn’t need the income? Of course, the first question in this case is when, if at all, do they expect to need the income? If the answer is prior to the age limits I discussed previously, then it certainly makes sense to continue to wait. But if the answer is either never or even well after the previously discussed age limits, then the goal becomes to maximize the return on the annuity. The easiest way to increase the return is to drop the rider, thereby saving on the fees. If the insurance company does not offer that as an option, then you might have a valid reason for a 1035 exchange into an annuity without a rider. But the other option is to turn on the income anyway. Driving the account value to $0 and then getting payments from the insurance company could very well provide the best overall return on the policy. After all, in today’s interest environment, it’s hard to duplicate a 7%–9.5% cash flow for life.
Yellow Flag: Caution
Of course, there are several other issues that must be considered before the income is turned on. First and foremost on the list are potential taxes. Lifetime income withdrawals are exactly that — withdrawals. Therefore, the income from non-qualified policies will be fully taxable to the extent of the deferred income in the policy. In addition, the taxable withdrawals could have other tax impacts such as increasing taxes on Social Security benefits or triggering the 3.8% Medicare surtax. Withdrawals from regular IRAs will of course be fully taxable, but if the client does not actually need the income, the transaction might be able to be done as an IRA transfer. If so, then you can simply reinvest the payments into another investment. In this case, the goal becomes maximizing the possible return of the annuity rather than providing income.
Waving the Checkered Flag
My suggestion is simple. Next month, you will receive copies of your client’s variable annuity statements. These statements will provide the specific annual lifetime income that is available under the policy. Have your assistant calculate the income as a percentage of the account value. If the statement does not provide the age of the client, instruct your assistant to write that on the statement. Next have the statements sorted by the allowable withdrawal percentage — highest to lowest. You now have a prioritized list of potential client appointments.