Chapter 1 — Annuity Basics (continued)

Many of the latest enhancements to variable annuities expand the range of possibilities available during the annuitant’s lifetime. For this reason, they are sometimes called “living benefits.” All deferred variable annuities offer a number of living benefits as part of their basic contract — availability of various investment sub-accounts, cost-free transfers between sub-accounts, dollar cost averaging, automatic rebalancing tools, and guaranteed minimum annuity payout factors — all included at no additional cost. In addition, most companies offer three optional enhancements for an additional premium:

• Guaranteed Minimum Income Benefit (GMIB)
• Guaranteed Minimum Accumulation Benefit (GMAB)
• Guaranteed Minimum Withdrawal Benefit (GMWB)

Some companies require the prospect to elect the enhancement only upon the contract’s issue; others permit them to be added later. Some companies allow only one enhancement; others permit more than one. After electing the enhancement, some companies allow the contractholder to discontinue it later (eliminating the additional premium cost); others require the enhancement to remain in force for the life of the contract. Each contract is different — read the fine print carefully.

Guaranteed Minimum Income Benefit (GMIB)

The GMIB guarantees a minimum income to the annuitant regardless of adverse investment performance in the contract’s separate account(s). The contract creates a “benefit base” (also known as the “income base” or “protected value”) from which the minimum income payments will be calculated. The benefit base usually represents the initial investment compounding at a guaranteed rate of growth (typically 5–7%). Some contracts adjust the benefit base using a “step-up” provision — the company adjusts the benefit base upward if cash values exceed the existing benefit base at stated intervals, usually the contract’s anniversary dates. Some contracts use both methods: annual guaranteed growth plus a possible step-up bonus. Regardless of how it is calculated, the benefit base does not apply to lump sum withdrawals; it is simply a value from which future minimum income payments (annuity payments) will be calculated.

The GMIB rider comes with many restrictions. Most contracts impose a waiting period of 7 to 10 years before the provision becomes effective. After that period, the contractholder may choose to apply for the guaranteed income payments. Usually the contractowner must annuitize the account under a lifetime payout method, and most contracts give the owner a short window to exercise the GMIB provision (usually 30–60 days following each anniversary date). Remember: when the contract is annuitized, the contractholder loses control of the contract and a lot of flexibility.

Payments under the GMIB are typically based on a less-favorable annuity payout schedule (due to lower interest assumptions, an age setback, or both), applied to the benefit base rather than the account’s current cash value.

The age adjustment or lower interest rate assumptions are indirect costs of utilizing the GMIB rider. For this rider to be worthwhile, the benefit base must exceed the current cash value of the separate account(s) when the account is annuitized. This rider is of value only if investment growth in the separate account lags behind the minimum guaranteed rate in the GMIB. The primary benefit: the ability to annuitize on a higher benefit base if market performance is unfavorable, guaranteeing a certain income stream regardless of the market’s performance. These advantages come at a cost: the premium to buy the rider, and possibly less-favorable payout rates or an age setback.

Partial withdrawals from the variable annuity during the accumulation phase will impact the benefit base and consequently any future guaranteed minimum income payments. Companies may adjust the benefit base using the same dollar-for-dollar or proportional methods discussed for death benefits. The proportional method provides a lower reduction (more favorable to the client) if the contract’s cash value exceeds the benefit base. If the benefit base exceeds the cash value, the dollar-for-dollar method is best for the client.

Guaranteed Minimum Accumulation Benefit (GMAB)

The GMAB promises that the cash value of the contract will be at least a minimum amount at the end of the guarantee period (sometimes called the waiting or vesting period — usually 7–10 years). The basic guaranteed amount is typically the initial investment (single premium contracts) or total premiums paid during the guarantee period (flexible premium contracts). In some ways this is similar to the death benefit guaranteed to beneficiaries, but the difference is that the benefit is not triggered at an unpredictable date by death — instead it is guaranteed at a specific date during the annuitant’s lifetime.

In addition to this base guarantee, the GMAB rider offers a “step-up” provision that allows the contractholder to increase the guaranteed value on stated dates (such as the contract’s anniversary date). If the contractholder exercises this right, a new guarantee period begins, and the stepped-up value becomes guaranteed as of the end of that new period.

Since this is an accumulation (not income) provision, annuitization is not required at the end of the guarantee period or to exercise the step-up provision. To manage risk, many companies restrict the types of separate accounts available — highly volatile accounts may not be available when a GMAB rider is selected, or the company may require a defined model portfolio. Withdrawals are often permitted but will reduce the guaranteed accumulation amount, using the dollar-for-dollar or proportional methods, or a combination (e.g., dollar-for-dollar for withdrawals not exceeding 5% of the guarantee amount, proportional for any excess).

Guaranteed Minimum Withdrawal Benefit (GMWB)

The GMWB rider — sometimes called the guaranteed partial withdrawal benefit — is the newest of the enhanced living benefits. It guarantees return of principal through a series of partial withdrawals, regardless of the separate account’s investment performance. The guaranteed amount is typically the greater of total contributions to the contract or the cash value at the time of the first withdrawal. Most contracts allow annual withdrawals of up to 5–7% of the guarantee amount.

The key distinction between the GMWB and the annuity phase of a basic contract is that the contractholder retains control over the cash value (can change investment subaccounts, exchange the annuity, etc.). By contrast, if the contract is annuitized under the GMIB, the contractholder loses that control and flexibility. Another difference: the GMIB guarantees growth in the benefit base; the standard GMWB only guarantees the initial investment.

Most GMWB riders do not impose a waiting period; withdrawals can be taken in the first year. Some companies offer a “bonus” for contractholders who do not take withdrawals in the early years — an extra amount added to the guaranteed funds available under the GMWB.

Like GMAB riders, the annuity company may restrict the range of investment alternatives available. Usually highly volatile subaccounts will not be available, or the company may require a diversified “model portfolio.” This is designed to protect the annuity company from excessive investment risk.

One of the strongest arguments against the use of annuities as an investment is that they are laden with fees and other charges. While it is true that there are numerous fees associated with annuities, annuities provide a bundle of benefits not readily available through other investments, and those fees represent the annuity company’s compensation for providing that package of benefits. Whether a client needs all of the features a particular contract offers, and whether the fees are adequately disclosed are key questions in determining suitability. Few agents fully understand the cost structure of the annuities they sell — and perhaps because of this, they fail to adequately disclose and explain those costs.

Fixed Annuity Costs

The simplest annuity in terms of fees is the fixed, single premium, immediate annuity (fixed SPIA). This represents a lump sum deposit with the annuity company, which invests those funds in its general assets. Periodic income payments begin immediately. Fixed SPIAs generally have no front-end sales charge or annual contract charges. The only cost component in an SPIA is built into the annuity payout factors.

Deferred fixed annuities have far more complex cost structures. Purchasers of fixed deferred annuities may pay any or all of the following costs, depending on the contract:

Variable Annuity Costs

Variable annuities represent an investment vehicle wrapped within an annuity contract. They have a number of costs — some related to the subaccount’s investments, others applied at the contract (“wrapper”) level. These types of fees apply to all variable annuities, whether immediate or deferred:

Equity Indexed Annuity (EIA) Costs

EIAs are a form of fixed annuity where the rate of return is tied to the performance of a stock index. Unlike variable annuities with their separate subaccounts, equity indexed contracts are backed with equity indexed stock options held in the company’s general account. To cover the cost of those options, the company imposes participation rates, yield spreads, or caps. These “moving parts” perform the same function as the interest rate spread in a traditional fixed annuity — creating a difference between what is promised to the contractholder and what the company earns. The company earns the full return of the index; the moving parts reduce the return promised to contractholders and thus generate a profit.

Unlike the interest rate spread (the most opaque cost of a fixed annuity), EICs disclose the costs imposed by their moving parts openly — although these are rarely explained to prospects as a “cost.” Most EIAs do not impose a front-end sales charge, but rely instead on surrender charges. Surrender charges are central to many complaints about EIAs, and advisors must carefully consider how surrender charges affect suitability for each client’s unique situation.

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