Optional Variable Annuity Riders (con’d)
Enhanced Living Benefits
Many of the latest enhancements to variable annuities expand the range of possibilities available during the annuitant's lifetime. For this reason, they are sometimes called "living benefits". All deferred variable annuities offer a number of living benefits as part of their basic contract: availability of various investment sub-accounts, cost free transfers between the sub-accounts, dollar cost averaging and automatic rebalancing tools, as well as guaranteed minimum annuity payout factors. All of these are included in the underlying contract, at no additional cost. In addition, most companies offer three optional enhancements, for an additional premium:
¨ guaranteed minimum income benefit (GMIB),
¨ guaranteed minimum accumulation benefit (GMAB), and
¨ guaranteed minimum withdrawal benefit (GMWB).
Some companies require the prospect to elect the enhancement only upon the contract's issue; others permit them to be added later. Some companies will allow only one enhancement; other will permit more than one. After electing the enhancement, some companies allow the contractholder to discontinue it later (and eliminate the additional premium cost); others require the enhancement to remain in force for the life of the contract. Each contract is different, so it is important to read the fine print carefully.
Guaranteed Minimum Income Benefit
As its name implies, the guaranteed minimum income benefit guarantees a minimum income to the annuitant regardless of adverse investment performance in the contract's separate account(s). The contract will create a "benefit base" (also known as the "income base" or "protected value") from which the minimum income payments will be calculated. The benefit base usually represents the initial investment in the contract compounding at a guaranteed rate of growth (typically 5-7%). Some contracts adjust the benefit base using a "step up" provision. In step-up contracts, the company adjusts the benefit base upwards if cash values exceed the existing benefit base at stated intervals, usually the contract's anniversary dates,. Some contracts will use both methods -- annual guaranteed growth plus a possible bonus of the step-up. Some of these contracts may apply the guaranteed rate of interest to only the initial investment in the contract, while others will apply the annual growth rate to the stepped-up values too. Regardless of how it is calculated, this benefit base does not apply to lump sum withdrawals; it is simply a value from which future minimum income payments (annuity payments) will be calculated.
The GWIB rider comes with many restrictions. Most variable annuity contracts with a GWIB provision impose a waiting period (7 to 10 years is common) before the provisions becomes effective. After that waiting period, the contractholder may chose to apply for the guaranteed income payments. Usually the contractowner will be required to annuitize the account under a lifetime payout method, and most contracts give the owner a short window to exercise the GWIB provision (usually 30-60 days following each anniversary date). So, the minimum guaranteed income payments will not be available for the first years of the contract; they will be available only if the contract is annuitized, and only if the contractholder elects this option during the window of opportunity. Remember that when the contract is annuitized, the contractholder loses control of the contract, and hence a lot of flexibility.
Normally, if a variable annuity contract is annuitized, the payments will be based on the current value of the underlying separate accounts. The company will apply the regular annuity payout schedules, based on the method selected by the contractholder, to determine the value of the first payment. Future payments will be based on a fixed number of annuity units whose values vary based on changes in the value of the underlying separate account.
By contrast, payments under the GMIB are typically based on a less-favorable annuity payout schedule (due to lower interest assumptions, an age setback, or both) and the company will apply that schedule to the benefit base (not the account's current cash value). For example, the company's regular monthly payout under a straight life annuity for a 65-year old man is $5.60 per $1,000 of account value. If the holder annuitizes using the GMIB option, however, the company imposes a five-year age setback. This setback assumes that the 65-year annuitant is five years younger than his real age. This adjustment spreads the payments over a longer period. Based on the company's payout schedule, the monthly payment for a 60-year old will be only $4.98 -- and that is applied per $1,000 of the benefit base (which may exceed the current cash value).
A traditional variable annuity payout will be based on the varying value of a fixed number of annuity units created at the time of annuitization. Some GMIB riders may allow for variable annuitization, while others require that the minimum guaranteed payments be fixed in amount.
The age adjustment or lower interest rate assumptions are indirect costs of utilizing the GMIB rider. In order for this rider to be worthwhile, the benefit base must exceed the current cash value of the separate account(s) when the account is annuitized. Put another way, this rider is of value only if the investment growth in the separate account lags behind the minimum guaranteed rate in the GMIB rider. This is the primary benefit of the rider: to be able to annuitize the account on a higher benefit base if market performance turns out to be unfavorable. This guarantees a certain income stream in the future regardless of the market's performance. If variable annuitization is allowed, the GWIB will provide a "floor", but still provide the investor an opportunity to participate in the upside potential of the separate account(s). These advantages come at a cost: there is the premium to buy the rider, and possibly less-favorable payout rates or an age setback.
Partial withdrawals from the variable annuity during the accumulation phase will impact the benefit base and consequently any future guaranteed minimum income payments. Companies may adjust the benefit base using a dollar-for-dollar method or the proportional method. These are the same two methods used to adjust the death benefits discussed above. The proportional method provides a lower reduction (more favorable to the client) if withdrawals are taken when the contract's cash value exceeds the benefit base. If the benefit base exceeds the cash value, the dollar-for-dollar method is best for the client.
Obviously, there are many interdependent factors to consider when analyzing a GMIB rider. Depending on the specifics of a particular contract, the specific GMIB may or may not be worth the price.
Guaranteed Minimum Accumulation Benefit
The guaranteed minimum accumulation benefit (GMAB) promises that the cash value of the contract will be at least a minimum amount at the end of the guarantee period, sometimes called the waiting or vesting period. In most contracts this period is usually 7-10 years. The basic guaranteed amount in most GWABs is the initial investment (in the case of single premium contracts) or the total premiums paid during the guarantee period (in the case of flexible premium contracts). In some ways, this is similar to the death benefit guaranteed to beneficiaries discussed above. The difference is that the benefit is not triggered at an unpredictable date by death, instead it is guaranteed at a specific date during the annuitant's lifetime. In addition to this base guarantee, the GMAB rider will offer a "step up" provision. (This is a different concept than the step-up in a GMIB discussed above.) In a GMAB, the step-up provision allows the contractholder to increase the guaranteed value on stated dates, such as the contract's anniversary date. If the contractholder decides to exercise this right, a new guarantee period begins, and the stepped-up value becomes guaranteed as of the end of that new period. For example, an investor places $100,000 in a deferred variable annuity with a 7-year GMAB rider. This guarantees the investor that at least $100,000 will be available to him at the end of seven years. Suppose that in year 5, the cash value of the separate account is $145,000 and the contractowner exercises the step up provision. The new minimum guaranteed value is now $145,000, which is guaranteed at the end of year 12 (seven years after the step up provision was exercised).
Since this is an accumulation (not income) provision, annuitization of the contract is not a required at the end of the guarantee period or to exercise the step up provision. The guarantee puts the annuity company at risk, and many companies will restrict the types of separate accounts available for investment. Often highly volatile accounts are not available when a GMAB rider is selected, or the company may require the contractholder to select a defined model portfolio; sometimes the company will reserve the right to rebalance the investment funds or move funds from subaccounts into a contract's fixed account. A GWAB rider may prohibit withdrawals from the contract, but more often withdrawals will be permitted. The guaranteed accumulation amount will be reduced when a withdrawal is taken. The contract may use either the dollar-for-dollar or proportional methods discussed above. Or the contract may use a combination of the two, e.g., dollar-for-dollar for withdrawals not exceeding 5% of the guarantee amount, and proportional for any excess.
Guaranteed Minimum Withdrawal Benefit
The newest of the enhanced living benefits is the guaranteed minimum withdrawal benefit (GMWB) rider, sometimes called the guaranteed partial withdrawal benefit. This rider guarantees return of principal though a series of partial withdrawals, regardless of the separate account's investment performance. The guaranteed amount is typically the greater of investor's total contributions to the contract or the cash value at the time of the first withdrawal. Most contracts will allow for annual withdrawals of up to 5-7% of the guarantee amount. For example, an investor pays a single premium of $100,000 into a deferred variable annuity with a GMWB allowing a 5% withdrawal. The contractholder will be able to withdraw $5,000 per year, for 20 years (at which point he will have withdrawn his entire investment), regardless of the current cash value of the separate account. If the rider allowed a 7% withdrawal, he could take $7,000 annually for a little more than 14 years (100% / 7% per year = 14.3 years), even if the cash value falls to zero. In other words, the contractholder may withdraw more than the contract is currently worth — which is what makes the GMWB valuable to the contractholder. If on the other hand, the cash value increases over the contract's life, the contractholder would be able to take withdrawals from that growing value, so the GMWB rider would provide no additional benefit to the owner. After each withdrawal, the remaining guaranteed value is reduced dollar-for-dollar. In the example above, if the contractholder withdrew $5,000 per year, the guaranteed value would drop to $95,000 after the first withdrawal, $90,000 after the second withdrawal, then $85,000, $80,000, etc., until it reached 0 after the 20th withdrawal.
At first blush, this rider seems to duplicate the annuity phase of the basic contract — the company pays out a series of payments over time. The difference is that under the GMWB the contractholder retains control over the cash value (can change investment subaccounts, exchange the annuity, etc.), if the contract is annuitized, the contractholder loses that control and flexibility. This is a key difference between the guaranteed minimum income benefit rider, which requires annuitization, and the guaranteed minimum withdrawal benefit rider, which does not. (Another difference: the GMIB guarantees growth in the benefit base, the standard GMWB only guarantees the initial investment.)
Most GMWB riders do not impose a waiting period, withdrawals can be taken in the first year (although some contracts require a waiting period before withdrawal may begin). Some companies offer a "bonus" for contractholders who do not take withdrawals in the early years of the contract. The bonus is an extra amount added to the guaranteed funds that are available under the GMWB.
Like the guaranteed minimum accumulation benefit riders, the annuity company may restrict the range of investment alternatives available to the contractholder. Usually highly volatile subaccounts will not be available if the contract purchases a GMWB, or the company may require the contractholder to invest in a diversified "model portfolio". This is similar to the restrictions on GWAB riders, and is designed to protect the annuity company from excessive investment risk
One important feature available in some GMWB riders is the reset. A reset provision allows the contractholder to adjust the guaranteed amount upwards. If the cash value in the separate account grows, the contractholder can elect to reset the guaranteed value to that new, higher level, thus locking in the gains. This is similar to the step up provision allowed in the GMIB rider. After resetting the guaranteed base, the amount available for periodic withdrawal will increase, as the GMWB withdrawal percentage will now apply to this higher base. Most contracts will allow for upward resets only on certain dates (e.g., each anniversary date, every fifth anniversary date, etc.) although some contracts may allow for resets whenever the cash value has increased by some stated amount. There is a downside to "reset" provisions. Most contracts will automatically reset the guaranteed base amount if the contractholder makes a withdrawal exceeding the percentage set forth in the GMWB rider. For example, if the rider permits a guaranteed 5% withdrawal each year, and the contractholder withdraws 6% this year, the guaranteed base will automatically reset. If the cash value in the separate accounts has dropped since the contract's inception, the guaranteed base amount will be reduced too, as a result of the automatic reset. Excess withdrawals in a declining market can be a real risk. In some contracts, the automatic reset may occur even if the excess withdrawal is as little as one dollar.
Partial withdrawals under the GMWB (which is, after all, what this rider encourages) will adjust the guaranteed base amount after each withdrawal. In the earlier example, the contract used a dollar-for-dollar reduction; other contracts may use the proportional method or some combination of the two.