Many owners of variable annuities purchased in the mid-2000s have been receiving letters from the insurance companies offering substantial sums for giving up the guarantees provided in their income or death benefit riders.
The riders were named a confusing alphabet soup of initials that would drive a Scrabble champion nuts. Known as GMIB, Enhanced GMIB, Enhanced GDB, GWB, GAB, etc., they were coupled with their method of computing the increases – automatic step-up and ratcheting to name a couple.
The riders aimed to provide a degree of assurance that no matter what market conditions were, the income and/or death benefit for the policyholder would still grow and the policyholder would receive undiminished benefit distributions. The benefit accounts are a calculated amount, separate from the underlying annuity value. Here is an example of how it would work:
Harry, aged 60, purchased a $300,000 variable annuity in 2007. Along with the basic annuity, he elected to buy a combination death benefit and income benefit rider with a 6% “growth rate,” which is guaranteed by the insurance company to be credited until age 85. Harry has yet to take a withdrawal from his policy. As a result of the financial crisis and of the cumulative fees charged by the policy, his actual policy value is $200,000. However, as a result of the riders he purchased, the value of his income and death benefit is $425,000. By the time Harry reaches age 70, the benefit will grow to over $506,000, and they will continue to grow until he is 85. These generous values were predicated on the insurance companies’ assumptions that his account might earn close to 6% anyway. And the thought was that, even if it didn’t, the fees for the riders and the policy surrenders by people who never took advantage of the benefits would earn the insurance company a nice profit.
The financial crisis radically changed those assumptions.
Why are insurance companies making you the offer to buy out your riders?
Very simply, the insurance companies found themselves on the hook for an ever-growing liability, as the difference between actual policy values and guaranteed benefits widened. When you factor in our ever-increasing longevity, the looming liability looks huge. In addition, due to the presence of the lowest interest rates we’ve seen in years, the insurance companies cannot earn the way they used to on their own portfolios.
Why the buyouts are being offered is only half the answer you need. You need to know what to do if you have to decide among different options, which may include taking a lump sum to move the policy, keeping the rider in exchange for choosing a lower rate-of-return on the principal, or paying a higher fee for the same benefits you have.
Should you receive an offer, consider the following:
- Are you currently taking income from the policy? Are you receiving a significantly higher income than you could receive elsewhere?
- Do you have another source of guaranteed income? If you choose to keep the policy without the riders, do you have sufficient other assets to draw upon to make up the shortfall?
- Do you have a death benefit value significantly higher than the policy value? Do you need it? Will it be significant to your family after your death, or not?
- What is your current age and state of health? Will you likely be able to take advantage of all the policy has to offer? Does the income benefit rider provide a spousal benefit?
- Does the rider provide other significant benefits such as doubling income if you are in a nursing home? If so, what triggers the benefit? Must the disabled person be the policyholder, or will the benefit also be paid if the spouse is admitted to the nursing home? Will the income be enhanced upon admittance or is there a waiting period? Does the rider apply only to nursing homes, or will it pay for home care or assisted living?
- If you surrender the policy, what are the income tax consequences?
- Will any remaining surrender charges on the policy be waived when you accept a settlement sum and move the policy?
- If you elect to keep the policy but give up the riders for a buyout, what is the income tax, if any, on the buyout amount paid to you?
- If you chose to keep the policy, what will be the effect of withdrawals on the guaranteed amounts after any offer has been accepted?
- Do you know the total cost of keeping the policy? That usually would include a combination of the following fees: sub-account fees, mortality and expense charges, and administrative charges. Should you keep your riders? What are the fees for the death benefit riders and income benefit riders? Will they increase?
- How are the rider fees going to be calculated? Are they charged against the account value or the guaranteed value? For example, say your rider fee is 1.1 %. You have $50,000 of investments in the policy, yet your guaranteed income benefit has grown to $100,000. If the rider fee is charged against your actual account value, then the effective rate is 1.1%. But if the rider fee is based upon the guaranteed income benefit of $100,000, then the effective rate charged against your funds is actually 2.2%. Make sure you know what the fee basis is and whether it will change.
- Is the rider “RMD friendly”? The Required Minimum Distribution concept applies to tax-qualified retirement annuities like IRAs. If you funded your annuity with the proceeds from an IRA or employee-sponsored retirement plan, you will be required to make distributions from your retirement accounts at age 70 ½, or by April 1 of the following year. Required Minimum Distributions grow with your age, and, as you get older, the government requires you to take out a higher percentage of your principal and pay taxes on the distribution. The impact on the crediting of the rider can be dramatic should you take a withdrawal in excess of the credited amount. Each company treats excess withdrawals differently, but in certain contracts the income benefits are suspended while the costs continue.
While some annuity contracts exempt RMD amounts from impacting an income rider, if your contract does not, at some point the RMD factor may grow to an amount larger than the guaranteed income provided by the rider. RMD amounts may be aggregated from any or all of your retirement accounts, so you may be able to minimize the RMDs taken from the account with riders. However, if you don’t have sufficient other retirement accounts to make up the difference between your credited income benefit and your required minimum distribution, the extra withdrawal amounts may have a dramatic effect on how future income is credited.
- At what age will the rider benefits be frozen and cease to grow? At what age will you be forced to annuitize the policy?
- If you have a policy with a death benefit option, what effect will withdrawals have on the death benefit?
- If you have a policy with a significant death benefit, taking into account the total fees charged and investment performance, will there be sufficient value in the annuity to keep the death benefit in force? If not, will the company accept additional deposits?
One last question, but a very important one: Do you still have enough confidence in the insurance company and agent who sold it to you to keep the policy?
These questions are merely a starting point. Every policy and rider is different. Every family has different needs and objectives. No decisions should be made without entering into a thorough analysis with an unbiased professional who is familiar with the insurance industry as well as your unique financial situation.
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