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A Primer on Living Benefits
Baby boomers, as
they move toward retirement, are beginning to question how they will
maintain their standard of living during their golden years. For many, the
need to create lifetime income will require the use and integration of
many investment products, perhaps including variable annuities.
For those of whom
variable annuities are a suitable solution, the big question to answer is
"which one?" Variable annuities today come with a variety of
riders, all of which are designed to address specific investment
objectives and risk profiles, but especially principal risk and longevity
risk. Most of those features come in the form of guarantees, chief among
them the guaranteed death benefit and the guaranteed living benefit. What
are some of those guarantees and what are the risks and benefits
associated with those guarantees?
Variable annuities
with a guaranteed death benefit are suitable for individuals who would
like to be heavily invested in the market, yet would like to have
guarantees about the amount of money that their heirs will receive even if
the market declines, and who want at least some access to the cash value
in the meantime. In other words, they do not plan to or need to "annuitize"
their variable annuity. Often, the basic death benefit is equal to the
greater of (1) the contract value, and (2) purchase payments less
withdrawals (or what is also called a "return of premiums"
guarantee) and is made to the beneficiary upon the death of the owner
and/or annuitant, according to RetireOnYourTerms. Nearly all contracts
sold these days have additional death benefit features, including
guaranteed accruals on premiums and/or so-called "high water
marks" that pay the highest value on any previous contract
anniversary date, according to "The Annuity Advisor" by John
Olsen and Michael Kitces, MSFS, CFP®, CLU, ChFC.
Some variable
annuities also have guaranteed living benefits, which are designed for
investors who desire current protection of principal, income, or the
ability to take withdrawals, while they are still alive. In some cases,
obtaining the protection features may require them to "annuitize"
their investment. In other cases, principal may be recovered through
guaranteed withdrawals over a specified period, and annuitization is not
required. Other forms of living benefits guarantee a floor of principal
that will be restored if the annuity has experienced losses over a set
time period. With a guaranteed living benefit, the owner or annuitant is
purchasing protection against investment risk or the risk of not being
able to generate an adequate amount of income, and the variable annuity
contract will either guarantee the level of account values which may be
accessed through current withdrawals or the amount of annuitized payments
that can be received in the future.
Typically, these
guarantees come with some restrictions of one form or another depending on
the guarantee. What’s more, variable annuities with guarantees may be
confusing. Contracts, for instance,
may make a distinction between the payout base of a variable annuity that
can be used to generate guaranteed income (but not available for
withdrawal) and the actual contract cash value that can be surrendered at
any time.
The most popular
forms of guaranteed living benefits features are guaranteed minimum income
benefit (GMIB) riders, guaranteed minimum accumulation (or account)
benefit (GMAB) riders, and guaranteed minimum withdrawal benefit (GMWB)
riders. Immediate annuities with for-life guarantees can be nice
retirement income tools, but may not always be the best fit for your
client.
The variable annuity
with a GMIB rider ensures that under certain conditions the owner may
annuitize the contract based on the greater of (1) actual account value or
(2) an adjusted 'payout base' equal to premiums credited with a specified
minimum interest rate or a step-up in value based upon the maximum annual
anniversary value of the account value prior to annuitization. In essence,
these products are designed to provide a steadily growing base for
generating annuitized income, even in the face of a large or extended bear
market. Most GMIBs provide an annuitization value based on the greater of
premiums accumulated at a 5 or 6 percent return, or an annual step-up of
the contract value. Some contracts require a waiting period of as much as
10 years prior to the implementation of the guaranteed payments.
These annuities have
several restrictions. An annuity owner must annuitize in order to exercise
the guarantee; there may be a minimum exercise age; and the guaranteed
annuity payout rates are typically much lower than current rates on new
immediate annuity contracts. What’s more, the annuity owner, after
annuitizing their investment under the guarantee, may not participate in
any stock market gains (if a fixed annuitization is required or selected).
And, the annuity owner who dies after annuitizing the contract may not be
able to pass any money to beneficiaries, depending on the form of benefit
selected or required under the guarantee Also of note, the contract for
these products should always be read carefully since it contains language
that defines exactly how the GMIB payout base is determined, as well as
disclosure of additional fees resulting from the GMIB benefit. These fees
directly reduce the performance of the contract and may range from 25 to
65 basis points.
The variable annuity
with a GMAB rider promises that, at specified periods, the account value
will not be less than purchase payments, sometimes with an additional
minimum rate of interest.
After a specified
waiting period the annuity owner’s losses are immediately restored to
the guaranteed minimum account value, without any annuitization
requirements. Thus, even if investment losses are otherwise incurred, the
annuity owner will at least get back their original investment. A drawback
is that investors who purchase a GMAB cannot take current income from the
product during the waiting period without a potential reduction in the
guarantee. Companies offering GMABs typically reserve the right to
reallocate unilaterally the annuity owner’s investments. As with the
other benefits, the fees incurred in exchange for the GMAB should be
carefully considered.
The variable annuity
with the GMWB rider allows contract holders to take a set percentage of
the original investment, usually from 5 to 7 percent, as distributions per
year, regardless of investment performance. Thus, even in a period of
declining stock prices where the account value goes to $0, an annuity
owner will eventually get back their entire principal a bit at a time. In
addition, in a bull market, some riders allow the annuity owner to step up
their guaranteed amount to the highest contract value, usually every three
to five years, but sometimes annually. As with the other benefits
outlined, the cost of the benefit may be "wasted" if the
guarantee isn’t actually utilized. On the other hand, the psychic
support provided by the guarantee may allow a particular investor to
subject long-term assets to market risk (and the prospect of higher
returns) when otherwise she would not do so. Withdrawals in excess of the
guaranteed amount reduce the amount of principal protected or may forfeit
the guarantee. Of note, the annuity owner doesn’t have to annuitize as
they do with the GMIB and they may have to wait to withdraw money as they
do with the GMAB.
With a GMWB, there
are specific restrictions. This form of guaranteed benefit does not
provide permanent income and it will take a specified time period, usually
14 or more years (at 7 percent withdrawals per year), to get the initial
investment back. In some cases, there may be a waiting period of up to
five years before withdrawals can be exercised. Typically, taking out any
withdrawal in excess of the GMWB allowable amount can substantially reduce
or completely lose the underlying guarantee.
Regardless of the
rider, an investor must understand what costs are incurred in order to
manage the risk negated. Generally, the insurance companies who provide
these benefits do so in order to support investors that want to take on
market risk when they otherwise might not do so, and expect few contract
holders to exercise the benefit. And since some companies were hurt by
mistakenly priced products during the last bear market, few benefits are
now likely to be offered without corresponding, fully priced costs. Fully
informed investors will select benefits carefully based upon their
priorities and after a full consideration of the cost and associated
risks.
September 2005— This column is
produced by the Financial Planning Association, the membership
organization for the financial planning community, and is provided by
McGuire & Co., LLC, a local member of the FPA.
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