Living and death benefit riders are optional add-ons to an annuity contract. The guarantees they offer come at a cost that you should weigh carefully to decide if they're justified. Not all riders are the same, so it's crucial to understand how they work, which type is right for you, or if you need one at all.
- Living and death benefit riders are optional add-ons to an annuity contract that you may buy for an extra fee.
- A living benefit rider guarantees a payout while the annuitant is still alive. A death benefit rider protects beneficiaries against a decline in the annuity’s value.
- Not all riders are the same; it’s important to understand how they work, and if their cost makes them worthwhile to you.
Living and Death Benefit Riders: A Bit of Background
The annuity contracts that were first offered by insurance carriers more than a century ago were relatively simple instruments. They were designed to insure against the risk of superannuation or outliving one's income, and they offered a guaranteed income stream to annuitants in return for either a lump-sum or periodic payments. But annuity contracts have become increasingly complex over the years.
Variable annuities were introduced in the 1950s and variable life insurance in the 1970s. Because these vehicles now house billions of dollars in retirement assets for both individuals and corporations, the importance of preserving their assets has become a critical issue. This has led to the creation of a number of special insurance riders that provide different types of living and death benefit protection to contract holders.
Understanding 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.
- Death benefit riders protect beneficiaries against declines in contract values because of market conditions.
Living and death benefit riders are only beneficial when the value of the contract is less than the contract value guaranteed by the rider.
There are many specific forms of each type of rider and, of course, they are not free. Each one purchased by the policyholder will incur an annual charge either monthly, quarterly, biannually, or annually. Some living benefits guarantee the contract holder's principal and others guarantee a certain rate of hypothetical growth as long as certain conditions are met. The rider, for example, may require you to annuitize the contract instead of taking a systematic withdrawal.
Likewise, some death benefit riders provide more protection than others. One may only guarantee the initial amount of principal invested, minus any withdrawals and another might provide a death benefit equal to the highest recorded value of the contract.
How Types of Riders Work
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. The account is only worth $75,000 several years later when he liquidates the contract. 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. But 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.
These examples show just some of the types of riders that are available. Although most carriers offer all of the riders described above, many also offer other types of specialized riders, including those that give specific 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.
The Cost of Riders
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. So if the contract value declines to $88,000 in the second year of the contract, the 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 reduce the contract value if the performance of the subaccounts turns out to be greater than what is promised by the riders.
Weighing the Cost of Rider Fees
The following examples illustrate the impact of rider fees and whether or not adding one to an annuity contract makes sense.
Average Subaccount Growth
Alan purchases a $200,000 contract and opts for both the enhanced living and death benefit riders. The total cost of both is 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.
Aggressive Subaccount Growth
Alan invests the $200,000 in the contract described above in aggressive subaccounts that have historically posted average annual returns (AAR) of 10% to 12% per year, albeit with substantial volatility. If this pattern continues, he would realize average gains of 7.5% to 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 between $2 and $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
Today, annuities and their various add-ons are far from the straightforward investment vehicles they began as. They are complex and often sport complicated language to match. So, if you're thinking of buying an annuity, or adding a rider to an existing annuity, it is critical to understand how they work. It's important to discern whether or not the cost of the rider will outweigh the benefits and even to ascertain whether or not you need a rider at all.