The annuity contracts that were first offered by insurance carriers over a century ago were relatively simple instruments. They were designed to insure the risk of superannuation, or outliving one's income, and provided a guaranteed income stream to annuitants in return for either a lump-sum or periodic investment. But annuity contracts have become increasingly complex over the years.

Variable annuities were introduced in the 1980s, and variable life insurance soon followed. Because these vehicles now house billions of dollars in retirement assets for both individuals and corporations, the importance of asset preservation within them has become a critical issue. This has led to the creation of a number of special insurance riders that provide several different types of living and death benefit protection to contract holders. This article examines several types of riders available in variable annuity contracts today. (For a background reading, see Let Life Insurance Riders Drive Your Coverage.)

What are Living and Death Benefit Riders?
All insurance riders offered within variable contracts and policies fall into one of two categories; living benefit riders generally guarantee some sort of defined payout while the insured or annuitant is still alive, while death benefit riders protect against declines in contract values due to market conditions for beneficiaries. There are many specific forms of each type of rider, and of course these riders are not free. Each rider that is purchased by the contract or policyholder will assess an annual charge on either a monthly, quarterly, biannual or annual basis. Some living benefits will guarantee the contract holder's principal, while others guarantee a certain rate of hypothetical growth as long as certain conditions are met (such as annuitizing the contract instead of taking a systematic withdrawal.) Some death benefit riders likewise provide more protection than others. Some will only guarantee the initial amount of principal invested, minus any withdrawals, while others provide a death benefit equal to the highest recorded value of the contract. An example of how each of these types of riders work is shown as follows:

Examples
Basic Living Benefit Rider
Frank purchases a $100,000 variable annuity contract with a basic living benefit rider. He invests the assets within the contract in a portfolio of subaccounts that perform poorly. Therefore it is only worth $75,000 several years later when he liquidates the contract. However, he will still receive $100,000, because he purchased the rider.

Enhanced Living Benefit Rider
Nancy invests $150,000 in a variable annuity at age 35. She allocates the proceeds among several different subaccounts within the contract and purchases an enhanced living benefit rider that guarantees a hypothetical growth rate of 6% per year. At age 60, her actual contract value is $400,000. However, if she decides to annuitize her contract and commit to a guaranteed stream of income (and this option is often irreversible), then her enhanced rider will pay her a stream of income that is based upon a hypothetical value of approximately $643,000 (equal to $150,000 growing at 6% per year for 25 years.)

Basic Death Benefit Rider
Tom purchases a $200,000 contract at age 50. The contract grows nicely for 15 years and is then decimated by a strong bear market. Tom dies at age 70 when his contract is only worth $185,000. The rider dictates that his beneficiary will receive the original $200,000 that was invested in the contract.

Enhanced Death Benefit Rider
Elizabeth invests $100,000 in a contract at age 45 and allocates the proceeds among several aggressive subaccounts that invest in small-cap and foreign instruments. At age 55, the contract is worth $175,000, but declines to $125,000 over the next five years. Elizabeth dies at age 60, but her beneficiary will receive $175,000-the highest recorded value in the history of the contract.

Other Available Riders
These examples show just some of the types of riders that are available to contract holders. Although most carriers offer all of the riders described above, many also offer other types of specialized riders that provide specific types of protection against various circumstances that can leave annuitants and beneficiaries with less than the amount of the original investment or the growth in the contract. However, as mentioned previously, these riders come at a cost that reduces the value of the contract each year. For example, the rider in the basic living benefit scenario could charge an annual fee of 1% of the contract value. This fee is assessed on an annual basis, regardless of the performance of the contract. If the contract value declines to $88,000 in the second year of the contract, then this rider would deduct an additional $880 from the contract value. Of course, the contract owner would then be able to count on the return of the principal in the contract, regardless of the performance of the contract. Living and death benefit riders are therefore only beneficial when the value of the contract is less than the contract value guaranteed by the rider. They merely serve to reduce the contract value if the performance of the subaccounts turns out to be greater than what is promised by the riders. (For more, see Understanding Your Insurance Contract.)

Impact of Riders
Example 1
Alan purchases a $200,000 contract and opts for both the enhanced living and death benefit riders. The total cost of both riders equal 2.5% per year. His contract grows at an average rate of 7% per year, but the cost of the riders reduces his effective rate of growth to 4.5% per year. He may qualify for the guarantees of the riders simply because the cost of those riders has lowered his rate of growth sufficiently to activate those guarantees.

This example illustrates the impact that the cost of riders has on subaccount performance. In order to outperform the cost of the riders, most contract holders are probably wise to invest their money in the more aggressive subaccounts, because they have the potential to grow enough over time to allow the contract holder to simply withdraw the current contract value instead.

Example 2
Alan invests the $200,000 in the contract described in the previous example in aggressive subaccounts that have historically posted average annual returns of 10-12% per year, albeit with substantial volatility. If this pattern continues, then he would realize average gains of 7.5-9.5% per year after the cost of the riders is deducted. Consequently, when he begins taking withdrawals 25 years later, his contract could easily be worth $2-3 million, depending upon various factors. If the riders only guaranteed payouts based upon 6% growth per year, then he has essentially wasted his money by purchasing them, much the same way as those who pay car insurance and do not file a claim see no real return on their money. He would have been better off without the riders in this case.

Conclusion
The insurance riders available in most variable annuity contracts today can provide many types of protection for contract owners and beneficiaries. However, the guarantees that they provide come at a cost that must be carefully weighed in order to be justified. For more information on annuity riders, contact your variable annuity carrier or consult your financial advisor. (To learn more, see Are Return-Of-Premium Riders Worth It?)

Related Articles
  1. Insurance

    Who is a Beneficiary?

    A beneficiary is a person or entity that receives funds, assets, property or other benefits from a trust, will, or life insurance policy.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Insurance

    Learn about the SPDR S&P Insurance exchange-traded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers.
  3. Retirement

    Strategies for a Worry-Free Retirement

    Worried about retirement? Here are several strategies to greatly reduce the chance your nest egg will end up depleted.
  4. Taxes

    How to Tell if You Need an Estate Planning Lawyer

    Estate planning is an important and often neglected part of financial planning, which can be costly when avoided or done improperly.
  5. Markets

    The 5 Biggest Canadian Insurance Companies

    Learn more about the insurance industry as a whole, how it functions in Canada, and the five largest Canada-based insurance companies.
  6. Professionals

    What Kind of Insurance Do RIAs Need?

    Advisors spend a lot of time discussing insurance with clients but they also need to consider their own coverage needs as small-business owners
  7. Retirement

    Best Ways to Save For Retirement Without an IRA or 401(k)

    Learn the most common types of savings vehicles used to accumulate money for retirement outside employer-sponsored 401(k)s or IRA accounts.
  8. Insurance

    How to Shop for Home Insurance

    Tips for getting the best protection for your place and possessions.
  9. Professionals

    How to Buy Annuities When Interest Rates Are Low

    The current low interest rate environment complicates the decision to buy an annuity. Here's what financial advisors need to consider for their clients.
  10. Professionals

    Top Retirement Prep Questions to Ask Clients

    Is your client really ready for retirement? Here are some essential questions to ask.
RELATED TERMS
  1. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  2. Wealth Management

    A high-level professional service that combines financial/investment ...
  3. Directors And Officers Liability ...

    Directors and officers liability insurance covers you if you're ...
  4. Contingent Annuitant

    Someone designated by an annuitant to receive the annuitant’s ...
  5. Contingent Beneficiary

    1. A beneficiary specified by an insurance contract holder who ...
  6. Living and Death Benefit Riders

    Living and death benefit riders are a descriptive class of contractual ...
RELATED FAQS
  1. Are variable annuities subject to required minimum distribution (RMD)?

    Variable annuities are insurance contracts that provide tax-deferred growth of assets that can later generate a guaranteed ... Read Full Answer >>
  2. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  3. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  4. Can a variable annuity be rolled into an IRA?

    You can roll qualified variable annuities, such as other qualified retirement plan accounts, into a traditional IRA. Non-qualified ... Read Full Answer >>
  5. What are the main factors that impact share prices in the insurance sector?

    The main factors that impact share prices in the insurance sector are interest rates, earnings and actuarial risk. In the ... Read Full Answer >>
  6. For what types of financial instruments would I want to calculate the present value ...

    Because the present value of an annuity formula relies on a consistent interest rate and identical payments for a set period ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!