Most variable annuity (VA) contracts include an insurance
component that provides a death benefit. The death benefit is usually triggered
by the passing of the annuitant, although there are contracts in which the
contract owner’s death triggers the benefit. Annuities allow for the owner and
annuitant to be different people.
What Does
the Death Benefit Cost?
The fee for the standard death benefit in a VA is part of
the mortality and expense charge. The mortality and expense charge (M&E)
varies by contract and share class as well as insurer. VA share classes, which
include B, C and L, are usually linked to the length of the contract’s
surrender schedule. M&E fees for each share class can be found in the VA
prospectus.
Many investment only variable annuities do not include a
standard death benefit and have no M&E fee. For a VA that does have an
M&E charge the cost can be as high as 2% of the contract value. The fee is
charged every year and insurers use various methods to calculate when the fee
is automatically swept from the VA cash value. For example, if you have a VA
worth $250,000 and a 1.25% M&E charge you are essentially paying $3,125 a
year for insurance. For many people this can be a very expensive way to buy a
limited amount of death benefit with a cost that continues to increase if the
VA balance grows.
How Does the
Death Benefit Work?
The standard death benefit in a VA is set initially at
whatever amount is invested. Then, depending on VA, the death benefit resets on
either the contract anniversary date if the contract value has increased or
whenever the contract cash value reaches a new high. Additional investments in
the annuity can also help increase the death benefit. Once set, the death benefit
does not decrease if the contract declines in value. However, the death benefit
does decrease if the contract owner takes a distribution. The adjustment may be
a dollar for dollar or percentage decrease.
Many contracts also offer an enhanced death benefit rider
that can be purchased for an additional fee of around 0.5-1.0% of the contract
value. The additional fee is charged each year. Enhanced death benefits vary,
but many contracts offer an annual guaranteed step up. For example, the
contract may guarantee the death benefit will increase by the greater of 5% a
year or reset to the highest contract value. Over time, it is not unusual for a
VA to end up having a death benefit that is higher than the actual contract
surrender value.
Maximization
Strategies
If you already own or are considering purchasing a VA with
M&E fees here a few strategies to consider.
For a conservative investor or someone with a shortened life
expectancy who wants to leave the money in the VA for their spouse (or someone
else), but is concerned about making an investment that could lose value, the
enhanced death benefit offers a solution. Since the value of the enhanced death
benefit grows each year, the beneficiary is guaranteed to receive the greater
of the death benefit or VA market value. There is no potential for a loss. This
strategy also allows the investor to allocate the funds more aggressively,
knowing that a guarantee is in place if they were to pass away during a market
decline.
In an existing VA where the death benefit is higher than the
cash value the contract can be partially surrendered. In a partial surrender
you leave some of the cash value in the contract which helps preserve a portion
of the death benefit. To make this strategy work be sure to leave enough cash value
in the VA to cover any future M&E and contract fees. Also, be sure to check
on any remaining surrender fees before making a distribution and if the VA is
an IRA be sure to make a trustee to trustee transfer.