There is an ongoing debate in the financial services industry about the usefulness of variable annuities and the purpose they serve in an individual's financial portfolio. Many feel that variable annuities are not suitable for the majority of investors, especially since the financial benefits are often eroded by fees and penalties. However, some added features may make a variable annuity suitable for certain investors, depending on the investor's financial profile and retirement horizon. In this article, we look at the living-benefit feature, and how it can benefit the investor.
Variable Annuities - A High-Level Primer
A variable annuity is a tax-deferred financial product that pays benefits to the annuitant over a specified number of years and a death benefit to the annuitant's beneficiaries. The benefit paid to the annuitant is usually based on the purchase payments and the performance of the underlying investments. The underlying investments can be diversified and rebalanced, which provides the investor with flexibility to monitor and manage his or her portfolio.
However, a variable annuity product may be subject to a variety of fees:
- Surrender charges if withdrawals are made before certain periods
- Mortality and expense risk charges
- Underlying fund expenses
- Administrative fees
- Charges for special features that are added to the annuity
(For more on the advantages and drawbacks of variable annuities, see Getting The Whole Story On Variable Annuities.)
The Living-Benefit Feature
The living-benefit feature is usually optional and available at the cost of paying additional fees. However, despite the additional cost, some financial advisors and consumers feel that it is worthwhile to receive the guaranteed benefits provided. The living benefit – as the name suggests – is intended to guarantee the benefit provided to the annuitant and toward that end, usually offers guaranteed protection of the principal investment, the annuity payments, and/or guarantees a minimum income over a specified period to the annuitant and beneficiary. (For more on living benefits, including potentially unexpected costs, read The Cost Of Variable Annuity Guarantees.)
There are several types of living-benefit features, including the following:
- Guaranteed Minimum Accumulation Benefit (GMAB)
The GMAB guarantees that the value of the annuity will not fall below the principal investment amount, which is referred to as accumulation, regardless of the market performance of the underlying investments. Of course, withdrawals are not factored into this guarantee, as they will reduce the amount of principal.
In order to be eligible for this guarantee, the contract usually includes a stipulation that requires the principal investment to be held for a minimum period, with no withdrawals occurring during that period.
- Guaranteed Minimum Withdrawal Benefit (GMWB)
The GMWB living benefit usually provides a guarantee that the annuitant will receive a stated amount through withdrawals from the annuity. At a minimum, the aggregate total withdrawals will be no less than the principal amount invested, but can be more than that amount. Generally, the guarantee covers a minimum principal payment over a fixed period or over the life of the annuitant and beneficiary, with payments continuing to the annuitant's beneficiary after the death of the annuitant.
- Guaranteed Minimum Income Benefit (GMIB)
Under the GMIB feature, the annuitant is guaranteed a minimum rate of return on the principal, regardless of market performance of the underlying investments. Based on the return, the annuitant is guaranteed minimum annuity payment amounts, which can be more than projected if the market performance of the investments produces a rate of return that is higher than the guaranteed minimum rate of return.
Usually, the principal amount is required to remain untouched for a minimum number of years in order for the annuitant to be eligible for this benefit.
The actual name used to label these benefits may differ among financial institutions, and the specific provisions of the products may also vary. As such, investors should review the features of the products in which they are interested to determine if they include the benefits they desire. While the guaranteed benefits are often the most attractive features of these fixed annuities, it still does not provide a one-size-fits-all solution, and suitability will depend on the investor's needs and financial profile. (For more on the technical aspects of living benefits, see Variable Annuity Benefits: What The Fine Print Won't Tell You.)
Living Benefits Vs. Traditional Portfolios
Investing in a traditional portfolio that allows direct investments in stocks, bonds and mutual funds provides more flexibility than investing in an annuity. However, investment risks can be tempered or even eliminated with a variable annuity that includes a GMIB feature. In addition, the living-benefit feature can help to provide peace of mind through guaranteed income for individuals with no risk tolerance due to factors such as limited assets in their retirement nest egg, a short retirement horizon or just simply extreme caution about losing market value on investments. (Learn how much volatility you can stand in Personalizing Risk Tolerance.)
On the other hand, investing in a variable annuity allows limited control over when the annuitant receives income and the amount of income received. Once the income amount and annuity period is determined, the annuitant is usually locked into the income amount and schedule, except for where the amount decreases or increases due to market performance. A traditional investment portfolio allows more flexibility, as the owner can withdraw any amount or percentage based on the financial need or want at the time of withdrawal.
Determine Suitability Before Buying
With many investors seeing their retirement portfolios losing significant market value, a variable annuity with a living-benefit feature can be a good solution for protecting retirement nest eggs. Of course the pros must be considered along with the cons. For instance, consideration must be given to the life expectancy of the annuitant so as to determine whether the annuitant will likely take advantage of the living benefits. For someone with a debilitating illness and/or a short life expectancy, a variable annuity - including one with a living benefit - may not be a good addition to the individual's retirement portfolio. (Learn how annuities can protect you against longevity risk in Inflation-Protected Annuities: Part Of A Solid Financial Plan.)
Research and Comparison Shop
One of the negative opinions about annuities is that they are often pushed onto unsuitable investors because of the high commission that the investment advisor usually receives for selling the product. This is not always the case, however, as many financial advisors do work with clients to ensure they receive products that are suitable for their financial and retirement profiles. (Learn how to choose a professional who will meet your needs in Find The Right Financial Advisor.)
Furthermore, investors can choose to buy these products directly from issuers that do not receive a commission from the sale. In many cases, additional services and customer support are provided in exchange for the commission. That said, if there are no added benefits provided, then it may make sense to purchase the product from a self-service provider. As such, investors should ask themselves or their investment advisors what is received in return for the commission (Read more in Full-Service Brokerage Or DIY?)
A key determining factor that affects the choice between an annuity and a traditional portfolio is the individual's need for guaranteed income. For someone with little or no risk tolerance or limited financial resources, an annuity may provide the needed guaranteed income stream.
Determination of suitability cannot be overemphasized and is not usually based only on the size of an individual's nest egg and retirement horizon. Pairing unsuitable products with investors is one of the worst mistakes that can be made with financial planning. For many of these individuals, this investment decision is the last step taken on their way to retirement, and often the mistakes cannot be corrected without costing them large amounts of fees. Regardless of how good a product may seem to be, it will not be ideal for every investor, and special care must be taken to ensure that the investor not only understands the benefits and features of the product, but is also aware of how it compares to other financial products.