Understanding Living Benefit Riders for Indexed and Fixed Annuities
The bucket story is an explanation of how Lifetime Income Riders for Indexed and Variable Annuities work!
written by: Josh Garland, ChFC®
What is an MVA?
An MVA or Market Value Adjustment is either a positive or negative adjustment that is made to the surrender value of an annuity contract. Generally, an MVA is only triggered when a surrender charge will occur; this is a key point that is often overlooked. If an annuity policy is no longer within its surrender charge period then the MVA will no longer exist. Additionally, if a client takes a withdrawal that is within the penalty-free withdrawal corridor, commonly 10%, then that withdrawal will not trigger an MVA. Lastly, not all annuity contracts come with an MVA, so it is important to check the details of the contract to know whether it is present.
How does an MVA work?
In a previous article titled, “How do Index Annuities Actually Work?” I explain that when a client purchases a Fixed Index Annuity (FIA), the insurance carrier will use the majority of the client premium to purchase bonds. The mechanics of an MVA and its reason for existence hinges upon this one characteristic of the FIA creation process. For example, if a client were to purchase a 10 year FIA the insurance company would then in turn buy 10 year bonds with the expectation that this client has committed to a 10 year hold and upon bond maturity those funds will be returned. However, if in 5 years that client decides they want to surrender their annuity policy early, they are required to pay the surrender charge at that time along with the MVA. Whether that MVA will be positive or negative depends upon what has happened to interest rates over that 5 year period. If interest rates have gone up, then the insurance company will suffer a loss when they sell the block of bonds to produce the required funds that must be returned to the client and that loss will then be passed through to the client’s surrender value in the form of a negative MVA. If the opposite were to occur and interest rates had gone down, the insurance company will be able to sell those bonds at a “premium,” and that gain will be passed on as a positive MVA to the client’s surrender value. The exact calculations of the MVA can vary by carrier and often have a maximum MVA level. So please review the carrier specific disclosures for exact details per product.
Here is an example of a great piece that describes how Lincoln Financial Group calculates an MVA:
A Dose of Reality!
At the end of the day, if we are truly presenting annuities the “right” way, to appropriate prospects, then an MVA does more good than bad for our clients.
Here’s why:
- An MVA allows the insurance carrier to pass on some of the risk of loss due to an early surrender, this alleviates product expense and that allows the carrier to offer better interest crediting potential to the client.
- The annuity offered to your client should only have a surrender period that is appropriate for their investment time horizon. If they have expressed that they will likely need funds in 5 years as an example, then they have no business purchasing an annuity with a surrender period longer than 5 years. Remember the MVA only applies when a surrender charge will be assessed. So, when clients hold the policy through the surrender period the MVA can do no harm.
To summarize, a market value adjustment can have a positive or negative effect on your client’s annuity contract. However, as long as your client holds their policy to the end of its surrender period and does not take a withdrawal in excess of their penalty free withdrawal amount then they will remain unaffected by the MVA. So it is important that we present appropriate annuity options that meet our clients’ needs to avoid any potential problem that could arise from an MVA allowing our clients to only benefit from the increased crediting potential.
Annuities come in all sorts of shapes and sizes. They can be a great option for clients spanning the low to high risk spectrum of choices. At their core, annuities will grow tax deferred and avoid probate upon death. Additionally, fixed annuities offer a fixed rate of return that is often higher than what you can receive at the bank. Fixed index annuities offer upside crediting potential that is tied to a market index, but still maintains principal protection. For those who are more aggressive, variable annuities offer full market participation through the use of sub-accounts within the contract. Additionally, these products can add features, known as riders, to provide leveraged long-term care benefits, enhanced death benefits and lifetime income.
It is easy to see that annuities provide a lot of exciting different benefits, but when are annuities actually at their best?
Voltaire said it best when he stated “I advise you to go on living to enrage those who are paying your annuities. It is the only pleasure I have left.”
Here is a French philosopher living in the 1700’s, Age of Enlightenment, who totally understood how to stick it to the man! What do I mean by that? You see, all too often we lose sight of the fact that annuities are insurance products and insurance products are built to protect us against a specific risk. So, what risk does an annuity protect us against? It’s the risk of living too long, otherwise known as longevity risk. Did you know that 1 in 4 65 year olds today will live past the age of 90 and 1 in 10 will past age 95?*
Here’s another eye opener, according to the Employee Benefit Research Institute: the majority of baby boomers will run out of funds for retirement only 10 to 20 years into retirement.**
In other words, annuities are at their very best when they are in a position to do exactly what they were built to do in the first place, which is to provide guaranteed lifetime income. In today’s words, here’s what Voltaire was saying: “If you want to get the biggest possible return out of your annuities and really stick it to the insurance carrier, then just live a long time!” People today are living longer than ever before which means, when used properly, annuities are at their best right now!
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*Wells Fargo Retirement Survey (2012)
**The EBRI Retirement Readiness Rating:™ Retirement Income Preparation and Future Prospects, Employee Benefit Research Institute, 2011
Written By: Josh Garland, ChFC® | FPG | 877.455.0119
An annuity is a contractual agreement between a consumer and an insurance company that will provide a set of benefits depending upon the type of annuity contract that is selected. The benefits are most commonly in the form of a guaranteed stream of income, the opportunity to earn interest or both. The interest that is earned within an annuity contract will grow tax deferred and upon death, the death benefit will go directly to the designated beneficiary, avoiding probate.
What types of annuity contracts are there?
There are four distinct types of annuity contracts, Single Premium Immediate Annuities (SPIA), Deferred Income Annuities (DIA), Single Premium Deferred Annuities (SPDA) and Flexible Premium Deferred Annuities (FPDA). Both SPDAs and FPDAs can then be further broken down into sub-categories which are Fixed Annuities, Fixed Index Annuities and Variable Annuities.
A Single Premium Immediate Annuity (SPIA) is an annuity contract that in exchange for a single premium payment will begin distributing an immediate stream of income to the designated payee of the contract. Note that no additional premium contributions will permitted after the policy is issued. An immediate stream of income means that payments will begin within a period of no more than 12 month from the issue date of the contract. The consumer will normally have multiple income benefit choices for how they would like to receive their income benefit payments.
- Life Only: Payments are paid only if the Annuitant is living and upon death of the Annuitant, annuity payments stop and no further benefits are payable.
- Life with Period Certain: Payments are paid if the Annuitant is living. If the Annuitant dies before the elected period certain has been completed, annuity payments will continue to be paid to the beneficiary as scheduled until the period certain has ended; at which time annuity payments will stop and no further benefits are payable.
- Life with Installment Refund: Payments are paid if the Annuitant is living. If the Annuitant dies before the sum of annuity payments paid equals or exceeds the single premium, annuity payments will continue to be paid to the beneficiary as scheduled, until the sum of all annuity payments paid equals the single premium; at which time annuity payments stop and no further benefits are payable.
- Life with Cash Refund: Payments are paid if the Annuitant is living. If the Annuitant dies before the sum of annuity payments paid equals or exceeds the single premium, a lump sum death benefit equal to the premium paid less the sum of all prior annuity payments will be paid to the beneficiary, at which time annuity payments stop and no further benefits are payable.
- Period Certain: Annuity payments will be made for the elected period certain. If the annuitant dies prior to the end of the period certain payments will continue to be paid to the beneficiary as scheduled until the remained of the period certain has ended. Once the period certain has ended annuity payments will stop and no further benefits are payable. (Note payments will stop even if the Annuitant is still alive.)
A Deferred Income Annuity (DIA) is an annuity contract that works very much like a SPIA. The key difference between a SPIA & DIA is that the income distributions from a DIA will start at an elected date sometime after 12 months from the issue date. The consumer will elect the income start date at the time of contract and will also have income benefit choices like those of a SPIA although they will be limited to:
- Life Only
- Life with Cash Refund
Note that with a SPIA or a DIA the income benefit election can be based on either a single or joint life. Additionally, it is prudent at this time to note that this process of exchanging a premium payment for a guaranteed stream of income such as those provided by a SPIA or DIA is called “Annuitization.”
A Single Premium Deferred Annuity (SPDA) is an annuity contract that in exchange for a single premium payment will provide interest credits to the principal value of the contract for a specified period of time. As implied by the name this type of contract will only allow one premium payment and will not accept additional contributions. The way that interest is credited to the contract will depend upon which of sub-categories of SPDAs has been chosen.
- Fixed Annuity: A fixed annuity will credit a fixed rate of interest that does not fluctuate to the annuity contract each year. Fixed annuities can be further broken down into 2 sub-categories:
- Traditional Fixed Annuities will have a guaranteed fixed rate for a specified time period, say 1 year for example, that is declared by the insurance company at policy issue and will then renew the rate each year on contract anniversary date thereafter. The rate could then increase or decrease, but will not go below a declared minimum guaranteed rate that is set by the insurance company at policy issue.
- Multi-Year Guaranteed Annuities (MYGA) will have a guaranteed fixed rate that is locked in and does not fluctuate for the duration of the annuities term. This term is chosen at policy is and is also known as a surrender period. Generally, a longer term will offer a higher fixed interest rate than a shorter term.
- Fixed Index Annuity: A fixed index annuity will credit interest to the contract based on the performance of a market index, commonly the S&P 500 Index. These contracts will allow the contract owner to participate in gains of the market index up to a limited amount while at the same time protecting the value of the contract if the market index performance is negative.
- Variable Annuity: A variable annuity will credit interest to a contract based on the performance of its sub-accounts which are similar to mutual funds. The sub-account options will allow the contract owner to have unlimited market exposure to the full gains or losses of the stock market via the elected sub-accounts.
A Flexible Premium Deferred Annuity (FPDA) is an annuity contract that works that same as an SPDA having the same sub-category annuity options, however these policies will allow for additional contributions in future years.
Disclosure: The content of this article is for informational purposes only. All information or ideas provided should be discussed in detail with a licensed insurance agent, advisor, accountant or legal counsel prior to implementation.
The Scary Truth
In an article written by David Weldon of ThinkAdvisor, titled Most Americans Illiterate Regarding Retirement Income Planning, I learned that 80% of Americans have little to no understanding of basic retirement income strategies! The American College of Financial Services conducted a Retirement Income Literacy study on a group of 60 to 75 year old Americans in an effort to test their understanding of how to make their hard earned savings last through retirement. The basic 38 question quiz resulted in 80% of respondents receiving a score of ‘F’ (Fail)! This by itself highlights a major concern and it is important that retirees understand that their vision of retirement is at risk every day!
Here are the four risks of retirement you never saw coming… or at least 80% of your clients didn’t:
1. Market Volatility Risk: On October 9, 2002 the S&P 500 Index® dropped 49% and then again on March 9, 2009 we experienced a drop of 57%. This is twice in the past 14 years that we have seen the market cut in half.
“However, despite these drops, over this same time period the S&P 500 Index® grew 21%.” With time and patience the ability to recover from losses is present, although you may not have the time to wait! For example, if you were planning to retire at this time next year and the market drops 50% today you will require a 100% return over the next year, just to break even!
2.Longevity Risk: People are living longer today than ever before on average a 65 year old male today can expect to live to age 84 and a 65 year old female can expect to live to age 86. In addition about 1 out of every 4, 65-year old’s today will live to age 90, and 1 out of 10 will live past age 95! At a time when 50% of people are living beyond average life expectancy, it’s no wonder the number one concern of pre-retirees is outliving their income!
3.Interest Rate Risk: An individual bond is generally considered conservative
and is unaffected by changes in interest rates, as long as you hold the bond to maturity. However, many investors enjoy the interest income potential and diversification of bond funds which can actively buy and sell bonds prior to reaching maturity and are therefore
subject to interest rate risk. For example, if your bond fund has a 5-year duration, a 1% rise in interest rates would result in a 5% drop in value, conversely a drop in interest rates would result in a gain. So why is this so important today? Over the past 33 years bond funds have historically done very well as we have generally experienced a decreasing interest rate environment.
It’s no secret however that today we are in a historically low interest rate environment giving more concern to the risk of rising rates in the near future.
4.Inflation Risk: The purchasing power of $1.00 is the key factor when it comes to inflation risk. Today, $129 of good’s would have only cost you $100 in 2004; this means that the purchasing power of every dollar today is worth $0.78 when compared to a dollar 10 years ago.
If you’re thinking to yourself, “yeah, everyone knows that inflation is a problem” but still not getting the gravity of the risk, then let’s look at it another way… The Federal Reserve estimates that there is approximately $11 trillion dollars sitting in cash holding. Assuming that you had been in a low 15% tax bracket over the past 10 years, your bank would need to have paid you interest of 3.035% per year on your $100 just to break even with inflation. How much interest is your bank paying you? Are you sure it’s enough to keep up with inflation?
A Solution to the Risks
One potential solution to these four risks of retirement may be a Fixed Index Annuity. A Fixed Index Annuity has the ability to:
- Remove market volatility risk by protecting principal during a down market, which takes downside risk out of the picture.
- Provide a guaranteed stream of income that will last for your lifetime when you elect to add a lifetime income rider. This is an optional benefit/feature that can be add to a fixed index annuity contract, usually for an additional charge, that will often provide an annual growth to the income rider account coupled with an age based withdrawal factor.
- Deliver upside potential growth based off of the performance of a market index which lowers the interest rate risk associated with a bond fund, but maintains the conservative allocation by protecting principal.
- Provide the potential for higher interest crediting that than available with other safe / fixed interest options. This allows you the opportunity to keep up with inflation, protect purchasing power and defer taxes.
Do you hold yourself out as a financial professional? Do you understand the many risks to retirement and have the ability to verbalize the problems that exist and the potential solutions that are available to solve them? If so, are you using that knowledge to educate the American people? If 80% of Americans who are currently at retirement age cannot pass a basic test on the topic then we need to understand that the greatest risk to their retirement would be for us to hold on to that information. I am ready to work at this together, are you?
David Weldon, ThinkAdvisor. (2015, April 9). Most Americans Illiterate Regarding Retirement Income Planning [Article]. Retrieved from http://www.thinkadvisor.com/2015/04/09/most-americans-illiterate-regarding-retirement-inc?page_all=1
1. Genworth. (2014, October). Managing Market Volatility. Retrieved from https://pro.genworth.com/riiproweb/productinfo/pdf/160890B.pdf
2. Genworth. (2014, October). Outlasting Longevity Risk. Retrieved from https://pro.genworth.com/riiproweb/productinfo/pdf/160890D.pdf
3. Genworth. (2014, October). Overcoming Interest Rate Risk. Retrieved from https://pro.genworth.com/riiproweb/productinfo/pdf/160890C.pdf
4. Genworth. (2014, October). Defusing Inflation Risk. Retrieved fromhttps://pro.genworth.com/riiproweb/productinfo/pdf/160890A.pdf