Deferred variable annuities with income guarantee riders have gained popularity as a retirement income tool providing behavioral solutions for the annuity puzzle. Retirees are not always comfortable seeing the premiums disappear from their portfolio balances when buying income annuities that convert a lump-sum premium into a protected lifetime income. Many features of a variable annuity could be replicated by combining an income annuity with an aggressive investment portfolio, but both of those choices can be tough for retirees to accept.
A deferred variable annuity can provide a palatable alternative. Its appeal to retirees is based on its combination of downside protection with a lifetime income stream, upside growth potential through its underlying investments, and maintaining liquidity for the underlying assets, while also offering the potential for tax-deferral when compared with taxable investments. Retirees can see their account values, they can continue to invest in funds within the annuity subaccounts, and any funds remaining at death are available to beneficiaries as a death benefit. These features can provide a happy compromise leading to a palatable way for retirees to take advantage of risk pooling as a part of their retirement income plan.
Nevertheless, the features and workings of deferred variable annuities with income riders can be rather complex. Prospectuses about variable annuities can be hundreds of pages long. Frankly, this is an area where I wish variable annuity providers would simplify matters by adopting standardized features that are easier to understand and compare. But because there are many moving parts to a variable annuity, and because consumers tend to latch on to certain characteristics and downplay other important characteristics, we find ourselves in a situation in which different providers seek to tweak the characteristics of their product offerings in ways that will better appeal to consumers while adjusting other less salient features in a less attractive direction.
This process often leads to greater overall complexity. It also means that not all variable annuities are created equal and some will perform better than others. An important caveat for this discussion is that I generally describe competitively priced variable annuities, and that is not a description fitting all products on the market.
For those just starting to investigate deferred variable annuities, complexities relate to understanding how the income guarantee works and how its fees are structured. A few key terms include the contract value of assets, the guaranteed benefit base, the possibility of step-ups, and the rollup rate applied during the deferral period. Different companies will use different names for these features and some translation from the terms I use may be necessary when looking at a specific product.
A guaranteed lifetime withdrawal benefit rider supports an income for life at a fixed withdrawal percentage (based on the age when distributions begin) of the guaranteed benefit base. The guaranteed benefit base is a hypothetical amount used to calculate the guaranteed withdrawals. It initially equals the premium paid into the annuity, which is also the initial contract value for the assets. Over time, the contract value of assets can rise or fall depending on realized investment returns and as fees and distributions are taken from the asset base. On any contract anniversary, if the contract value of the underlying assets has reached a new high watermark and exceeds the guaranteed benefit base, that base is stepped up to the new high watermark value. This increases the subsequent amount of guaranteed income. If the retiree does not take out more than the guaranteed withdrawal amounts, guaranteed withdrawals never decrease, even if the account balance falls to zero. One exception to this is that some companies market a feature that allows for higher distributions when assets remain and lower distributions after assets deplete. The contract may be terminated at any point with the contract value of the remaining assets, net of any potential surrender charges, returned to the owner. During the deferral period before distributions begin, a variable annuity may also offer a guaranteed rollup rate to increase the benefit base automatically over time if the value of the underlying contracted assets has not otherwise grown larger on its own.
I’ll aim to provide a big picture overview of the key features to understand when trying to figure out how a variable annuity works and when trying to compare different variable annuity options. This will hopefully prepare you with a list of questions to ask to make sure you understand the variable annuity contract under consideration. This discussion fits into four general categories: how do guarantees grow during the deferral period, how are guaranteed withdrawals determined and how can they grow during the distribution period, what is the death benefit, and how does the insurance company manage the risk it creates by offering the guarantee?
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon