Optional Variable Annuity Riders
Many commentators liken the marketplace for annuities to an "arms race", in which each company tries to gain an advantage on their competitors. Annuity companies compete vigorously for business and a significant part of that competition has been in the area of product design. As we saw in the case of EIAs, companies mix-and-match various "moving parts" and indexing methods to differentiate their products from the competition. Companies selling variable annuities use optional riders to enhance their products. Once one company designs a new rider, others respond by introducing new options of their own. All of this creative effort to one-up each other does widen the range of financial planning tools available to consumers. But these optional riders come at a cost -- the investor pays an additional premium, of which the sales agent collects a commission. Whether the benefits offered by these riders outweigh their cost, whether customers and agents fully understand these options, and whether the additional commission encourage sales agents to make unsuitable recommendations are questions that are uppermost in regulators minds. The optional provisions available on variable annuities can be categorized as enhanced death benefits or enhanced living benefits.
Enhanced death benefits
Traditionally, variable annuities have provided a basic death benefit equal to the greater of the current value of the subaccount or return of the initial principal. Most variable annuity contracts available today offer more liberal death benefit guarantees, though these enhanced death benefits are available only at an extra cost either by charging an additional premium or by building the cost into the base contract's underlying fees. While each contract's terms will be different, the enhanced death benefits in most variable annuity contracts pay the survivors the highest of:
¨ total contributions (less any withdrawals)
¨ the current cash value of the subaccount(s)
¨ the highest cash value as of stated prior dates (such as "prior policy anniversary dates", or the values on specific anniversary dates such as 5th, 10th, 15th, etc.) up to a maximum age (usually 85) this is sometimes called a ratcheted death benefit.
¨ total contributions (less withdrawals) plus accumulated interest at a minimum guaranteed rate, up to a maximum age.
The first two items on this list are the standard death benefits available under the basic deferred variable annuity -- at no additional cost. The last two are the enhancements. A prospective purchaser must ask herself whether these two enhanced protections for her beneficiaries are worth the extra cost. Please note that all of these benefits, including the ratcheting benefit and the minimum guaranteed rate, apply only in the event of death.
As you can see from the list, withdrawals taken by the contractholder during the accumulation phase will have an impact on any minimum death benefits payable to beneficiaries. How will the contract adjust the enhanced death benefit for withdrawals? Some contracts adjust the value dollar-for-dollar, i.e., a dollar withdrawn will reduce the death benefit by a dollar. Other contracts will adjust benefits based on proportional formula. The method used by a contract will impact the ultimate value of this optional rider.
For example, assume that an investor originally invested $100,000 in a deferred variable annuity seven years ago. Based on a ratcheting feature that looks at every 5th anniversary's value, the minimum death benefit is now $125,000. Meanwhile the current value of the subaccounts has grown to $150,000 today (year 7). What is the effect of a $15,000 withdrawal on the contract's minimum death benefit? If the contract used dollar-for-dollar adjustments, the death benefit would drop $15,000, from $125,000 to $110,000. If the contract used a proportionate reduction instead, the death benefit would drop by only $12,500 to $112,500 ($15,000 withdrawal represents 10% of the current cash value [$15,000 / $150,000], a 10% reduction of the $125,000 death benefit amounts to $12,500).
In this example, the proportional method of adjustment leaves a higher remaining death benefit -- and that is true whenever the current cash value exceeds the minimum death benefit. A dollar-for-dollar adjustment will result in a higher death benefit if the death benefit exceeds the cash value. Using the above example, assume that the withdrawal takes place next year, when the cash value is only $120,000 (the death benefit remains ratcheted at $125,000). A $15,000 withdrawal on a dollar-for-dollar basis reduces the death benefit by $15,000. On a proportional basis, the death benefit would be reduced by 12.5% [$15,000 / $120,000] or $15,625 [12.5% of $125,000]. When the death benefit exceeds the cash value, the dollar-for-dollar methods results in a lesser reduction, or put another way, a higher remaining death benefit. These reductions also apply when a client chooses to make a partial exchange of this contract for a new one. The amount exchanged is treated as a withdrawal, and the death benefit adjusted accordingly.
One other important question to ask when contemplating an enhanced death benefit rider: Whose death triggers the death benefit? Most contracts are "annuitant-driven", that is, the benefits are payable upon the death of the annuitant. Others are "owner-driven", meaning the death benefits are paid if the owner dies. In most cases, this is a distinction without a difference; as in most contracts the owner (investor) is also the annuitant (measuring life). But when the two are not the same, it is important that the client and the advisor know whose death will trigger the minimum death benefit under that particular contract.