What Covers The Cost Of A Variable Annuity's Death Benefit

A variable annuity's death benefit, a safeguard for your beneficiaries, guarantees that they will receive a specific amount upon your passing. Understanding what funds this protection is crucial to grasping the true cost and value of this feature. While seemingly straightforward, the mechanics behind covering the death benefit can be complex, involving mortality and expense (M&E) risk charges, potential rider fees, and investment performance. This article will delve into the various components that contribute to the cost of a variable annuity's death benefit, clarifying how these elements interact and ultimately impact your investment.

The Foundation: Mortality and Expense (M&E) Risk Charges

At the heart of funding the death benefit lies the mortality and expense (M&E) risk charge. This fee compensates the insurance company for taking on several key risks:

• Mortality Risk: This covers the risk that annuitants, as a group, will live for a shorter period than actuarially predicted. If annuitants die sooner than expected, the insurance company needs funds to cover the promised death benefits.

• Expense Risk: This covers the risk that the insurance company's operating expenses will be higher than anticipated. Unexpected increases in administrative costs, regulatory compliance, or other operational overhead can strain the insurer's financial resources.

• Guaranteed Death Benefit: This component directly funds the guarantee that your beneficiaries will receive a specific amount, regardless of market performance.

The M&E charge is typically expressed as a percentage of the annuity's assets, usually ranging from 0.25% to 1.50% annually. This fee is deducted regularly, usually daily or monthly, from the annuity's assets.

How M&E Works in Practice:

Imagine you have a variable annuity with $100,000 invested, and the M&E charge is 1.00% per year. This translates to a $1,000 annual deduction. The insurance company pools these M&E charges collected from all annuity holders. This pooled money is then used to pay out death benefits to beneficiaries when an annuitant passes away. Any surplus remaining in the pool after paying death benefits contributes to the insurance company's profitability.

Understanding Death Benefit Riders

While the M&E charge provides a base level of death benefit protection, many variable annuities offer optional riders that enhance this protection. These riders come with additional fees, but they can provide significant benefits, especially in volatile markets. Common types of death benefit riders include:

• Stepped-Up Death Benefit: This rider periodically "steps up" the death benefit to the highest value the annuity has reached on a specified anniversary date (e.g., every 5 years). This protects gains earned within the annuity from market downturns.

• Enhanced Earnings Benefit: This rider guarantees that your beneficiaries will receive at least the original investment amount plus a specified percentage of any earnings.

• Annual Reset Death Benefit: Similar to the stepped-up death benefit, this rider resets the death benefit annually to the current market value if it's higher than the original investment.

Funding Death Benefit Riders:

The cost of these riders is typically covered through additional rider fees, which are also expressed as a percentage of the annuity's assets. These fees can range from 0.25% to 1.00% or higher, depending on the specific rider and the insurance company.

Example:

Let's say you add a stepped-up death benefit rider to your annuity with a fee of 0.50% per year. On top of the 1.00% M&E charge, you'll now pay a total of 1.50% annually for death benefit protection.

The Role of Investment Performance

While M&E charges and rider fees directly fund the death benefit guarantees, the investment performance of the underlying subaccounts also plays a crucial, albeit indirect, role. Here's how:

• Higher Account Value: Strong investment performance leads to a higher account value. This, in turn, increases the base amount of the death benefit, especially if the annuity has a stepped-up or annual reset feature.

• Offsetting Fees: Positive investment returns can help offset the impact of M&E charges and rider fees. If your investments are performing well, the fees deducted may have a smaller impact on your overall account value.

• Risk Management: Annuity providers manage the risk associated with death benefits by carefully selecting and monitoring the underlying subaccounts offered within the annuity. They may also use hedging strategies to mitigate potential losses.

Important Note: While investment performance can enhance the death benefit, it's crucial to remember that variable annuities are market-based investments. Poor investment performance can erode your account value and potentially reduce the death benefit if it's not protected by a rider.

Factors Affecting the Cost of Death Benefit Coverage

Several factors influence the overall cost of death benefit coverage in a variable annuity:

• Age and Health: Generally, the older you are and the more health risks you have, the higher the M&E charges and rider fees may be. This is because the insurance company assumes a higher probability of paying out the death benefit sooner.

• Type of Death Benefit: As mentioned earlier, the type of death benefit you choose significantly impacts the cost. Stepped-up, enhanced earnings, and annual reset riders typically come with higher fees than a basic death benefit.

• Annuity Provider: Different insurance companies have different pricing structures for their variable annuities. Comparing M&E charges, rider fees, and the features offered is essential.

• Market Conditions: Market volatility can influence the cost of death benefit riders, particularly those that offer downside protection. In times of uncertainty, insurance companies may increase fees to compensate for the increased risk.

• Contract Features: Some annuity contracts have features that can impact the cost of the death benefit, such as withdrawal penalties or surrender charges. Understanding these features is crucial before investing.

Beyond the Explicit Costs: Considering Opportunity Cost

While M&E charges and rider fees are the direct costs associated with a variable annuity's death benefit, it's essential to also consider the opportunity cost. This refers to the potential returns you could have earned if you had invested your money in a different investment vehicle with lower fees.

• Comparing Alternatives: Before investing in a variable annuity for its death benefit, compare the potential returns and fees to other options, such as life insurance or a diversified portfolio of stocks and bonds.

• Weighing the Benefits: Evaluate whether the peace of mind and guaranteed death benefit offered by the annuity are worth the higher fees compared to alternative investments.

Navigating the Nuances: Due Diligence is Key

Understanding the costs associated with a variable annuity's death benefit requires careful examination of the contract and a thorough understanding of the underlying fees. Here are some tips for navigating the process:

• Read the Prospectus: The prospectus is a legal document that provides detailed information about the annuity, including all fees and charges. Read it carefully before investing.

• Ask Questions: Don't hesitate to ask your financial advisor or the insurance company questions about the death benefit, the fees, and how they are calculated.

• Compare Quotes: Get quotes from multiple annuity providers to compare M&E charges, rider fees, and the features offered.

• Consider Your Needs: Determine your specific needs and goals for the annuity. Do you prioritize growth potential, downside protection, or a guaranteed death benefit?

• Seek Professional Advice: Consult with a qualified financial advisor who can help you assess your needs and determine whether a variable annuity is the right investment for you.

Understanding the Trade-offs: Guarantees vs. Growth Potential

Variable annuities offer a valuable combination of investment potential and death benefit protection. However, it's crucial to understand the trade-offs involved. The guarantees provided by the death benefit come at a cost, which can potentially limit your investment growth.

• Balancing Act: Finding the right balance between guarantees and growth potential depends on your individual risk tolerance, time horizon, and financial goals.

• Scenario Planning: Consider running different scenarios to see how the annuity would perform under various market conditions. This can help you assess whether the death benefit protection is worth the potential trade-off in growth.

Alternatives to Variable Annuity Death Benefits

While variable annuities offer a specific type of death benefit, several alternative options can provide similar protection for your beneficiaries:

• Life Insurance: Term life insurance provides a death benefit for a specific period, while whole life insurance offers lifelong coverage and a cash value component.

• Trusts: A trust can be used to manage and distribute assets to your beneficiaries after your death.

• Payable-on-Death (POD) Accounts: These accounts allow you to designate a beneficiary who will receive the funds upon your death.

• Joint Ownership: Owning assets jointly with your spouse or other family members can ensure that they automatically inherit the assets upon your death.

Conclusion: Making an Informed Decision

The cost of a variable annuity's death benefit is covered primarily through mortality and expense (M&E) risk charges and, if applicable, rider fees. Investment performance also plays an indirect role by influencing the account value and potentially offsetting the impact of fees. Understanding these components, along with the factors that affect the cost and the available alternatives, is crucial for making an informed decision about whether a variable annuity is the right investment for your needs. By carefully evaluating the guarantees, fees, and potential trade-offs, you can determine whether the death benefit protection offered by a variable annuity aligns with your financial goals and risk tolerance. Remember to consult with a qualified financial advisor to discuss your specific circumstances and make the best choice for your future.