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Optional Variable Annuity Riders

Many commentators liken the marketplace for annuities to an “arms race,” in which each company tries to gain an advantage on competitors. Annuity companies compete vigorously for business, and a significant part of that competition has been in the area of product design. As we saw in the case of EIAs, companies mix-and-match various “moving parts” and indexing methods to differentiate their products from the competition. Companies selling variable annuities use optional riders to enhance their products. Once one company designs a new rider, others respond by introducing options of their own.

All of this creative effort does widen the range of financial planning tools available to consumers. But these optional riders come at a cost — the investor pays an additional premium, of which the sales agent collects a commission. Whether the benefits offered by these riders outweigh their cost, whether customers and agents fully understand these options, and whether the additional commissions encourage unsuitable recommendations are questions uppermost in regulators’ minds.

The optional provisions available on variable annuities can be categorized as enhanced death benefits or enhanced living benefits.

Enhanced Death Benefits

Traditionally, variable annuities have provided a basic death benefit equal to the greater of the current value of the subaccount or return of the initial principal. Most variable annuity contracts available today offer more liberal death benefit guarantees, though these enhanced death benefits are available only at an extra cost — either by charging an additional premium or by building the cost into the base contract’s underlying fees.

While each contract’s terms will be different, the enhanced death benefits in most variable annuity contracts pay the survivors the highest of:

  • Total contributions (less any withdrawals)
  • The current cash value of the subaccount(s)
  • The highest cash value as of stated prior dates (such as prior policy anniversary dates, or the values on specific anniversary dates such as the 5th, 10th, 15th, etc.) up to a maximum age (usually 85) — sometimes called a “ratcheted death benefit”
  • Total contributions (less withdrawals) plus accumulated interest at a minimum guaranteed rate, up to a maximum age
The first two items on this list are the standard death benefits available under the basic deferred variable annuity at no additional cost. The last two are the enhancements. All of these benefits — including the ratcheting benefit and the minimum guaranteed rate — apply only in the event of death.

Effect of Withdrawals on Enhanced Death Benefits

Withdrawals taken by the contractholder during the accumulation phase will have an impact on any minimum death benefits payable to beneficiaries. How will the contract adjust the enhanced death benefit for withdrawals? There are two methods:

  • Dollar-for-dollar: A dollar withdrawn reduces the death benefit by exactly one dollar.
  • Proportional reduction: The withdrawal reduces the death benefit by the same percentage that the withdrawal represents of the current cash value.
Example — Cash value exceeds death benefit: An investor originally invested $100,000 seven years ago. Based on a ratcheting feature (every 5th anniversary), the minimum death benefit is now $125,000. The current subaccount value has grown to $150,000.

Effect of a $15,000 withdrawal:
• Dollar-for-dollar: death benefit drops $15,000 → $110,000
• Proportional: $15,000 / $150,000 = 10% of cash value → death benefit drops 10% → $125,000 − $12,500 = $112,500

When cash value exceeds the death benefit, the proportional method leaves a higher remaining death benefit.
Example — Death benefit exceeds cash value: Same contract, but now the withdrawal takes place in year 8, when the cash value has dropped to $120,000 (death benefit remains ratcheted at $125,000).

Effect of a $15,000 withdrawal:
• Dollar-for-dollar: death benefit drops $15,000 → $110,000
• Proportional: $15,000 / $120,000 = 12.5% of cash value → death benefit drops 12.5% → $125,000 − $15,625 = $109,375

When the death benefit exceeds the cash value, the dollar-for-dollar method results in a higher remaining death benefit.
These reductions also apply when a client chooses to make a partial exchange of this contract for a new one. The amount exchanged is treated as a withdrawal, and the death benefit is adjusted accordingly.

Who Triggers the Death Benefit?

One other important question when contemplating an enhanced death benefit rider: Whose death triggers the benefit? Most contracts are “annuitant-driven” — the benefits are payable upon the death of the annuitant. Others are “owner-driven” — death benefits are paid if the owner dies. In most cases this is a distinction without a difference, since in most contracts the owner (investor) is also the annuitant (measuring life). But when the two are not the same, it is important that both the client and the advisor know whose death will trigger the minimum death benefit under that particular contract.

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