Death Benefits in a Variable Annuity

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.

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 an 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.

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.  

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.

Variable annuities with M&E fees can be an expensive way to invest if you don’t need the added benefits. Before making any investment decision it’s important to fully understand what you are paying for and if the added cost makes sense in your particular situation.