Have you ever wondered how an annuity's "guarantee" works? Annuity guarantees vary from contract to contract, and you can often alter your contract to include a rider, which is an add-on to the standard annuity contract. While riders can add certain benefits or additional security, these features may include additional fees that could reduce the amount you receive from the contract over time.
While riders come in many shapes and sizes, they typically fall into two categories: living benefits and death benefits. Some of the most advantageous features of annuities, such as monthly income guarantees and lifetime payouts, do not come with off-the-shelf annuity contracts without requiring annuitization. For these features, you may be required to purchase additional riders—adding to the fees and potentially inhibiting any growth you require. While living and death benefit riders may make you feel safer, they may not necessarily help you reach your long-term financial goals.
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The person who initiates the annuity contract with the insurance company and pays the premiums.
The person who receives the income payments from the annuity. The annuitant is often also the contract owner, but not always.
The person who collects the remaining cash value or income payments of an annuity upon the death of the annuitant or owner.
Common Living Benefits
These are common annuity riders that affect the benefits received from the annuity during the annuitant’s life.
Guaranteed Lifetime Withdrawal Benefit (GLWB)
Guaranteed Minimum Income Benefit (GMIB)
Guaranteed Minimum Accumulation Benefit (GMAB)
Guaranteed Minimum Withdrawal Benefit (GMWB)
The GLWB allows the annuitant to receive a guaranteed income for life based on a percentage of the annuity’s principal and to continue receiving that income even if the principal runs out. This can help ensure that retirement income is there when it’s needed. The GLWB can also include a guaranteed growth rate, which sounds attractive on the surface, but is really just a factor in the calculation of how much of your own money you can withdraw each year. These guarantees can be costly, and the fee for this type of rider is in addition to the other fees charged by the annuity provider.
Common with variable annuities, GMIB riders are designed to protect the annuity’s value in case the investments held by the annuity underperform or don’t grow as anticipated. The rider provides a guaranteed income stream that generally lasts for the life of the annuitant. One potential downside: the principal balance is usually forfeited after a set period.
For example, this rider might stipulate that at a certain age, say 85 or 90, the annuity owner must either convert the contract into a series of income payments (i.e., annuitize) or terminate the rider to maintain liquidity and potentially retain the ability to pass the money on to beneficiaries. A GMIB annuity rider tracks two balances:
- the actual cash value based on the performance of subaccount investments
- a virtual balance that annually increases by a defined percentage
At annuitization, the payments are based on the higher of the actual or virtual balances. While this might seem like a great deal, investors should be aware that subaccounts incur expenses, such as transaction costs and administrative fees, tied to maintaining the underlying investments. These additional fees can further erode returns.
Although these riders may seem like an easy additional benefit to the annuity contract, many have strict requirements and conditions in addition to their extra fees. To help protect the insurance company from investment risk, a GMIB rider can often restrict the range of investment choices available through the subaccounts. This can severely reduce the growth of the principal in the underlying annuity, leading to a lower income amount. Some may also may require the holder to convert the deposited funds into periodic payments by turning the entire principal over to the annuity provider, a decision that’s usually irrevocable.
GMAB riders are designed to protect the annuity’s value from market fluctuations. They guarantee the annuity holder a minimum value—typically equal to the amount of premiums paid—if the annuity’s market value falls below the minimum threshold after a set number of years. For example, after a waiting period of 10 years, if market swings have caused your contract’s value to dip below the amount of premiums paid, the insurance company would step the value back up to equal what’s been contributed.
These types of riders provide a guarantee that the annuity owner can still take a withdrawal, even if the cash value of the annuity has fallen below the original amount invested. This withdrawal can be monthly, quarterly or annually over a predetermined period, typically over the contract’s term or until the invested amount is recovered. This type of rider will often cost an additional annual fee.
Investors should keep in mind that withdrawals are limited to a fixed annual amount, and generally aren’t adjusted for inflation. This means the purchasing power of the amount received will likely decline over time because of the eroding power of inflation.
Common Death Benefits
Death benefits are the money owed to heirs (beneficiaries) when the annuity owner or annuitant passes away. The death benefit is usually paid out in one of two ways: as a lump-sum payment from an insurance policy, or, if applicable, as a percentage of the annuitant’s ongoing payments. There are several different types of death benefit riders, but the two most common are basic death benefits and enhanced death benefits.
Basic Death Benefits
Enhanced Death Benefits
A basic death benefit rider, also called standard death benefits, guarantees that after the annuity owner’s death, the insurance company will pay the beneficiary at least the amount of the money that was contributed prior to annuitization. If the policy has been annuitized, only the payments the original annuitant hadn’t collected may go to the beneficiary. The basic death benefit may not amount to much, so there are other options.
Enhanced death benefits, as the name implies, provide more transferable wealth than basic death benefits. With enhanced death benefit riders, if certain growth requirements are met, the insurance company steps up the value of the annuity on the annuity’s anniversary date.
Enhanced death benefits come in a variety of forms and for a range of fees. Insurance companies can calculate the beneficiary’s transferable value on a variety of measures:
- highest account value on the annuity’s anniversary
- highest monthly account value
- highest quarterly account value
Enhanced death benefits can even come with roll-up rates for set periods like an income rider.
These benefits usually go into effect only if they would provide more than the annuity’s current value. So, if the annuity’s value is greater than the death benefit when the annuity owner dies, then these benefits wouldn’t apply.
Also, death benefit riders disappear once annuitization occurs. Most annuity contracts require an annuity owner to annuitize the contract when they reach a certain age. But, remember, after annuitization there is no death benefit.
Adding annuity riders comes with costs. In addition to the rider fee, there are base contract charges and other costs that could amount to a fraction of a percentage of your account value per year. The rider fee itself might seem small in isolation, but when combined with multiple rider fees, the costs of holding underlying investment products (like mutual funds in the case of a variable annuity) or a contract that already limits your growth potential like an indexed annuity, your account’s growth may be severely limited. And some annuity contracts don’t allow additional riders after the contract is issued, only when the annuity is originally set up.
So, while riders may sound comforting, it’s always important to think carefully about the costs of any riders added to an annuity contract and be clear about the total fees and additional costs. Calculating all the fees and costs of an annuity contract can help the investor assess whether the likely returns are worth the costs. Too often, investors don’t do their research and end up paying too much for too little benefit. This can have dire consequences on their retirement lifestyle or their ability to leave a financial legacy.
Tax Consequences of Death Benefit Riders
Any gains from a non-qualified annuity that your beneficiaries inherit would be taxed at ordinary income tax rates. This is because dividends, interest and capital gains credited to an annuity aren’t taxed until they are withdrawn.
For income tax purposes, gains on an inherited non-qualified annuity are considered income when the beneficiary receives it. If the beneficiary chooses to receive a lump sum, the tax is payable on everything above the original cost basis; the original cost basis amount is excluded from taxable income.
In the event the beneficiary is able to request periodic distributions, the portion of each payment that comes from accumulated earnings is taxable and the portion that comes from the original premium cost basis isn’t.
The Risks of Riders
Many investors look at annuities as a way to mitigate the risks associated with stock market volatility, but annuities and annuity riders come with risks of their own.
In an attempt to receive guaranteed income for life, investors often forget about inflation, which can erode your purchasing power over time. When buying an annuity, five percent of the contract value may seem sufficient to cover your expenses, but that percentage may not account for inflation.
A common restriction associated with living benefit riders is a waiting period before you can receive a cash flow, which creates liquidity risk. Waiting periods can be detrimental if unexpected costs arise, such as hospital bills or urgent home repairs. In these cases, you may incur surrender fees in order to access your money, further adding to your total costs. Moreover, taking withdrawals before allowed by an income rider can also reduce your future guaranteed income.
One of the most detrimental risks associated with riders is the additional fees on top of existing annuity fees. This effect is exacerbated for those annuities that are positioned to only provide meager CD-like returns. Adding a 1.5% fee to a product that might optimally produce a 2% to 4% annual return can have a demonstrably negative impact over time.
Excessive fees affect you in the short-term with out-of-pocket costs and in the long-term, because every dollar spent on fees is money that’s not earning a return. These fees reduce the effect of compound interest and can further inhibit your ability to meet your long-term goals. For example, consider the fees of an average variable annuity with one common rider:
- Annual annuity fees generally are 1.21% on average.1
- Many variable annuities invest in mutual funds, which will also charge an annual fee averaging 0.98%.2
- Income rider fees typically range between 0.35% and 1.60% annually.3
In the above example, the hypothetical variable annuity fees with one rider could amount to 3.79% annually!4 When compared to other investments, these fees can be excessive and make it difficult to achieve your long-term goals. So when considering an annuity, understand that annuities may not be the best way to limit risk or create ongoing investment income.
1Source: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 114.
2Source: Source: Fisher Investments’ Annuity Evaluation services, as of 8/18/2022. Average mutual fund or sub account fee. Based on average expenses of 2,197 unique variable annuity policies between 7/1/19 and 8/18/2022.
3Source: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 102.
4Total fee of 3.79% includes the 1.21% average annual annuity fee, plus the average annual variable annuity mutual fund fee of 0.98% and the 1.60% income rider fee.
5For qualified investors with $500,000 or more.