Most variable annuity (VA) contracts include an insurance component that provides a death benefit. The death benefit is usually triggered by the passing of the annuitant, although there are contracts in which the contract owner’s death triggers the benefit. That's because annuities allow for the owner and annuitant to be different people.

Key Takeaways

  • Death benefits in a variable annuity (VA) may be triggered by the death of the annuitant or the contract owner.
  • Fees for a VA death benefit are part of the mortality and expense charge (M&E), included in the VA prospectus, and can be as high as 2% of the contract value.
  • The standard death benefit is initially set at the amount invested and then resets according to the contract. Once set, it only decreases if the contract owner takes a distribution.
  • Enhanced death benefits riders, which guarantee an annual step-up in the VA's cash value, can be used to increase a death benefit's value for the recipient.
  • Before investing in a variable annuity with M&E fees, consider the extra costs and whether the benefits are important in your situation.

The Cost of a Death Benefit

The fee for the standard death benefit in a variable annuity is part of the mortality and expense charge (M&E), which varies by contract and share class as well as insurer. VA share classes—which include B, C, and L—are usually linked to the length of the contract’s surrender schedule. M&E fees for each share class can be found in the VA prospectus. 

Many investment-only variable annuities do not include a standard death benefit and have no M&E fee. But for a VA that does have an M&E charge, the cost can be as high as 2% of the contract value. The fee is charged every year and insurers use various methods to calculate when the fee is automatically swept from the VA cash value. If you have a VA worth $250,000 and a 1.25% M&E charge, for example, you are essentially paying $3,125 a year for insurance. For many people, this can be a very expensive way to buy a limited amount of death benefit with a cost that continues to increase if the VA balance grows.

How Death Benefits Work

The standard death benefit in a VA is set initially at whatever amount is invested. Depending on the VA, the death benefit then resets—either on the contract anniversary date if the contract value has increased or whenever the contract cash value reaches a new high. Additional investments in the annuity can also help increase the death benefit. Once set, the death benefit doesn't decrease if the contract declines in value, but it does decrease if the contract owner takes a distribution. The adjustment may be a dollar-for-dollar or percentage decrease.

Many contracts also offer an enhanced death benefit rider that can be purchased for an additional fee of around 0.5% to 1.0% of the contract value. The additional fee is charged each year. Enhanced death benefits vary, but many contracts offer an annual guaranteed step up. The contract may, for example, guarantee that the death benefit will increase by the greater of 5% a year or reset to the highest contract value. Over time, it is not unusual for a VA to end up having a death benefit that is higher than the actual contract surrender value.

Annuity beneficiaries may pay income or capital gains tax on death benefits they receive, but these benefits don't have to go through probate.

Maximization Strategies

If you already own or are considering purchasing a VA with M&E fees, here are a couple of strategies to consider.

For a conservative investor or someone with a shortened life expectancy who wants to leave the money in the VA to their spouse (or someone else) but is concerned about making an investment that could lose value, the enhanced death benefit offers a solution. Since the value of the enhanced death benefit grows each year, the beneficiary is guaranteed to receive the greater of the death benefit or VA market value. There is no potential for a loss. This strategy also allows the investor to allocate the funds more aggressively, knowing that a guarantee is in place if they were to pass away during a market decline.

In an existing VA where the death benefit is higher than the cash value, the contract can be partially surrendered. In a partial surrender, you leave some of the cash value in the contract, which helps preserve a portion of the death benefit. To make this strategy work, be sure to leave enough cash value in the VA to cover any future M&E and contract fees. Also, be sure to check on any remaining surrender fees before making a distribution, and if the VA is an IRA, be sure to make a trustee-to-trustee transfer.

The Bottom Line 

Variable annuities with M&E fees can be an expensive way to invest if you don’t need the added benefits. Before making any investment decision it’s important to fully understand what you are paying for and gauge whether the added cost makes sense in your particular situation.