The annuity contracts that were first offered by insurance carriers over a century ago were relatively simple instruments. They were designed to insure against 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.
(For a background reading, see Let Life Insurance Riders Drive Your Coverage.)
What are Living and Death 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 policyholder will incur 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.
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, the account 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.)
Examples of the Impact of Riders
Alan purchases a $200,000 contract and opts for both the enhanced living and death benefit riders. The total cost of both riders equals 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.
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 million to $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.
The Bottom Line
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?)