Variable Annuities with Living Benefits

Background
Clients and prospects – as well as radio listeners – often come to us with questions about annuities with living benefits. One of biggest concerns for retirees is whether they will run out of money. The insurance industry has attempted to address this question by offering living benefit riders attached to variable annuities, and, in some cases, equity indexed annuities. If utilized properly, a living benefit is the equivalent to a self-funded pension. The annuity is simply the vehicle used to provide the pension income stream.

This newsletter will provide a simple explanation of the most popular living benefit rider – the Guaranteed Lifetime Withdrawal Benefit. We should note right up front that we are not recommending these products to clients at this time. While we have never been fans of variable annuities, in general, due to their cost structure, the living benefit side has had some appeal. However, variable annuities, especially those with living benefits, have been a major source of declining profits at insurance companies during the last two quarters. As a result, many companies are rewriting the provisions of these products or raising fees on existing contracts. In addition, while it is our belief that most insurance companies will survive this recession, the financial stability of some insurance companies may be tested. Overall, the level of uncertainty both on the product and company level gives us reason to advocate caution on these annuities.

However, we do feel that anyone being offered one of these products deserves a straightforward understanding of how they work. From there they can ask their own questions.

Explanation of Living Benefits
While conceptually, the idea of living benefits is attractive, contracts can be complex and confusing. It is not unusual for someone to misunderstand what they are purchasing. “I am going to get 6% guaranteed,” several radio listeners have quoted their annuity sales persons. “Yes, but not if you don’t follow the rules and only if the insurance company doesn’t change the rules,” we respond.

When purchasing a variable annuity, the policy owner deposits a lump sum with the insurance company, which is invested in underlying mutual funds, called sub accounts. A guaranteed living benefit rider is then layered onto the annuity.

The rider adds a second accumulation track. The first accumulation track is the contract value, which is simply the market performance of the underlying sub accounts, minus any withdrawals and the annual fees, which typically run about 3.50%, although some contracts are pushing 4%. (Technically, the cost of this type of annuity should not matter, as long as the purchaser intends to use only the living benefit and has no expectation of withdrawing from the annuity more than is permitted.) The second accumulation track is the annuity value that increases annually based on contract guarantees.

The most popular living benefit is the Guaranteed Lifetime Withdrawal Benefit – GWB. The GWB typically guarantees a 5%-6% annual increase in the annuity value, here called the “withdrawal base or WB,” for a period of time or until withdrawals begin. After withdrawals commence, the WB can only increase if the contract value is higher than the WB and the policy allows for resets. Contracts purchased in 2005-2008 are unlikely to ever catch up with the accumulation track, due to recent poor market performance and high fees. For new purchases, the contract value will need, on average, to increase by more that the guaranteed accumulation rate plus fees to take advantage of the reset option.

Guaranteed withdrawals are based on the age of the annuitant at the time the withdrawals begin. Typically, the contract allows for lifetime 5% withdrawals for annuitants who start payments at ages 59.5-69; a 6% withdrawal rate for start ages 70-79, and a 7% withdrawal rate for those over 80. However, since the beginning of 2009, a number of insurance companies have dropped the withdrawal rate for 60 year olds to 4%, making this benefit less attractive in early retirement.

The rider also allows you to end the withdrawals at any time and have access to the remaining contract value of the policy for emergencies – a selling point for the annuity. However, as noted above, the contract value is often less that the withdrawal base, and with certain policies, withdrawing benefits beyond the guaranteed amount can end the rider altogether or significantly decrease the benefit.

Conclusion
Living Benefit riders require self discipline and self knowledge in order to make them work effectively. Know your income needs for retirement and the sources to meet those needs. Mentally, add the annuity to the pension/social security side of the equation, thereby resisting the temptation to access the principal. Let the product work as intended – as an income stream where the risk is assumed by the insurance company – not you.

Current market volatility has made annuities with living benefits appealing but also more risky to buy. Before purchasing, understand completely how these products work and what changes to fees and benefits are allowed under the contract. Also review carefully the financial stability of the underlying insurance company. Then proceed with caution.

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