Mini-Course Series - Annuities (Part 4) by Institute of Business & Finance

MINI-COURSE SERIES

ANNUITIES Part IV

ANNUITIES

LIVING BENEFIT OVERVIEW Before the introduction of living benefits in the late 1990s, there were few guarantees provided by a variable annuity that benefited the original investor. However, with the introduction of living benefits, also known as “guaranteed living benefits,” all this has changed. Living benefits have greatly increased annuity sales. A number of former critics of variable annuities, particularly those that compared annuities to mutual funds, now embrace the tax-deferred investment—because of living benefits. It is estimated 80% of variable annuity sales include a living benefit. The best way to understand any living benefit is that there are now two contract values—current value and living benefit value. A guaranteed living benefit is a rider that can be added to a variable annuity contract. According to The Wall Street Journal, the cost of the rider ranges from 0.15% to 1.1% per year. Most insurers charge 0.60% or more annually. The great majority of insurers require a living benefit rider be selected before the contract is issued. A few insurers allow the rider to be added in the future. In such a case, the charge for the rider would not begin until the feature was added to the contract. With almost all insurance companies, the rider cannot be changed or cancelled once selected; the entire contract would have to be terminated (subject to any remaining surrender charge). It is also common to see a required 810 year holding period before the benefit either commences or is fully realized. If a living benefit is selected, the number of subaccount options is usually limited; this reduces risk to the insurer who guarantees the living benefit. Typically the most extreme aggressive and conservative subaccounts such as money market, sector and small stock subaccounts are not available for the living benefit. Withdrawals made before the required holding period ends do not receive any kind of living benefit. How the withdrawal calculation is made affects the contract’s living benefit. Some insurers use a dollar-for-dollar adjustment; others use a percentage figure. It is common to have a surrender period shorter than the required living benefit holding period (e.g., the contract may be 100% liquid after five years but the living benefit does not kick in until after the 8th or 10th year). The advisor needs to review what happens during the liquidation phase of a variable annuity with a living benefit. Some contracts may guarantee that during liquidation the contract owner still has upside market potential; other contracts may credit the account 1-3% annually once payments commence. Still other contracts include no growth or interest crediting during liquidation.

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ANNUITIES

A living benefit is a form of insurance. If the variable annuity does well on its own, the rider may, in hindsight, have been a waste of money—similar to someone who buys fire insurance and the house never burns down. However, whether or not the benefit is ever utilized, this rider allows more aggressive investing and provides peace of mind. Another important consideration is the cost of the living benefit. The advisor will also want to know if the annual cost of this benefit can increase in future years and, if so, if there is a lifetime cap. The four most popular living benefits are the: [1] guaranteed minimum account value (GMAV), [2] guaranteed minimum income benefit (GMIB), [3] guaranteed minimum income payments (GMIP) and [4] guaranteed minimum withdrawal benefit (GMWB). Notice that each of these four riders begins with the words “guaranteed minimum.” A living benefit, regardless of subaccount and market performance, either offers a minimum rate of return during the accumulation phase or a minimum withdrawal rate during liquidation.

Guaranteed Minimum Account Value A guaranteed minimum account value (GMAV) promises that after an 8-10 year holding period, the investor will have a contract value at least equal to original principal. The crediting is straightforward, with no strings attached after the benefit is utilized. The penalty period may be several years less than the required holding period for the living benefit. If the contract’s value is greater than the premium (principal) contributions, the benefit has no value. After the penalty period, which is typically shorter than the requisite GMAV period, the owner can surrender the contract, go into more aggressive or conservative subaccounts with the same insurer or continue as is. Contracts cancelled before the required GMAV holding period lapses do not receive any type of living benefit. For example, your client invests $200,000 in a variable annuity with a GMAV that requires a nine-year benefit holding period. At the end of nine years, the client’s contract has shrunk to just $40,000, a combination of a bad stock market and the client making too many poorly timed exchanges. Since she held the contract for the required nine years, the living benefit kicks in and she now has a contract worth $200,000. She can now do whatever she wants with this money (e.g., lump sum liquidation, tax-free exchange, contract continuation, etc.).

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ANNUITIES

Guaranteed Minimum Income Benefit In order to benefit from the guaranteed minimum income benefit (GMIB), two things must happen. First, the GMIB rider must be in place for 7-10 years. Second, if at the end of the required GMIB holding period (or later) if the rider is used, lifetime annuitization or liquidation over 10-20 years is required. A GMIB guarantees a minimum growth rate, typically 5-7% compounded per year. The lengthy liquidation phase of the GMIB contract is required in order to limit the insurer’s risk. Thus, the total holding period for a GMIB is most likely in the 20-30 year range if you add the required accumulation period with the required distribution phase. The actual numbers could be higher or lower, depending upon the actual longevity of the investor and how the GMIB feature is defined. For example, your client just invested $100,000 in an annuity with a GMIB feature that guarantees 7% annual compounding during the accumulation phase. The GMIB feature would have been 5%, but because of the client’s older age, he is guaranteed 7% yearly accumulation. The GMIB rider requires an eight-year holding period. The contract’s penalty period is five years. At the end of eight years, the client’s then current contract value is $140,000 and his living benefit value is $172,000 ($100,000 multiplied by a factor of 1.72, which is how 7% grows if it compounds for eight years). The client has a difficult decision: take $140,000 with no strings attached (the penalty period was five years; eight years for the living benefit) or accept the GMIB liquidation requirements for the $172,000. The reason the decision is difficult is because the annuitization of $172,000 may result in monthly payments that are lower than $140,000 annuitized from another insurance company. There may also be other considerations: [1] control over principal, [2] life expectancy, [3] need for a lump sum, [4] how the rest of the client’s money is invested and [5] the gap between the contract’s value and its living benefit valuation (the larger the gap, the more attractive GMIB liquidation becomes).

Guaranteed Minimum Income Payments As the name implies, the guaranteed minimum income payment (GMIP) rider promises that at least a specified amount will be sent to the investor each month, quarter or year. GMIP requires annuitization. The typical benefit guarantees that the investor will receive at least 80%-90% of the first annuitized payment for life, regardless of market performance or the level of interest rates.

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ANNUITIES

For example, your income-oriented client just invested $100,000 in a GMIP annuity and wants immediate income. The client selected a fairly aggressive asset allocation portfolio that historically has averaged 7% annually after fees. The client’s first lifetime monthly check is for $560. A year or so later, the client starts to receive monthly checks for $600. At this specific point in time, the checks are actually higher than what was going to be paid out under the living benefit. The checks are higher due to subaccount performance. A few months or years later, the market tanks and the client starts to get $498 a month under the GMIP feature (a figure that would still be higher than traditional variable annuitization that has experienced moderate-to-severe market declines).

Guaranteed Minimum Withdrawal Benefits A guaranteed minimum withdrawal benefit (GMWB) assures the investor that he can take out 5-7% a year of the contract’s value. The income stream lasts at least until the investor has received back 100% of principal, regardless of market conditions. Some contracts base the 100% recovery amount on the contract’s valuation just before the GMWB is opted for; other contracts include a step-up (ratchet) feature. A step-up feature resets the minimum account value at some future point in time, such as every 4th, 5th or 6th contract year. A reset feature is a positive addition to a GMWB because the contract owner now has a chance to participate in the upside potential of the markets during liquidation. For example, your client wants some growth now but income in a few years. She invests $100,000 in a GMWB variable annuity. During the next three years the $100,000 grows to $123,000. Weeks later, the client decides she wants an income stream. Because of her age now, she is guaranteed a minimum annual withdrawal rate of 6% of the $123,000 ($7,380 per year); the duration of her payments are guaranteed for at least the next 16.7 years ($123,000/$7,380 = 16.7). Her income would last substantially longer if the net growth rate was even just 2-3% in the subaccounts selected. Typically, GMWBs reward subaccount performance. In the example above, your client’s income stream could last 10-20 or more years past the 16.7- year figure (i.e., if the underlying subaccounts annually net 4-5% after all applicable annual fees, principal is then being depleted very slowly). Some insurers have modified the traditional definition of GMWB (shown above) to ensure a form of withdrawal benefit will last for life.

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Living Benefit Summary The nuances of an insurer’s living benefit rider(s) can come close to rivaling those of an equity-indexed annuity (EIA). Living benefits are more complex than first meets the eye. More often than not, it is what happens during the living benefit liquidation phase that needs the most scrutiny. The consequences of any partial withdrawal along the way also need to be examined. If the living benefit requires annuitization, find out if the client’s actual age will be used or the client’s age minus 5-10 years (which would mean a smaller payout and less cost to the insurer). An “age adjustment” never benefits the client. As mentioned at the outset of this section, living benefits are covered from a slightly different perspective a later section.

THINGS TO DO  Your Practice Savvy advisors realize that every investment is a trade-off—you get something in return for sacrificing something else. Variable annuity living benefits provide certain guarantees at a price. Most homeowners have fire insurance, even though the chances of a fire are likely to be well under 1000 to 1. Historically, stocks lose money about once every 4-5 years—yet few insure their investment portfolio.  The Next Installment Your next installment, Part V, covers five topics: the legal reserve system, state guaranty funds, a Wall Street Journal question and answer section on annuities, how to view Social Security payments as a fixed-rate annuity with CPI adjustment and generating lifetime income using fixed-rate annuities, stocks and bonds. You will receive Part V in a few days.  Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about its designation programs: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

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