Summary

Twenty years ago, variable annuity purchasers had the same flexibility to tailor their annuity to their particular needs as the color choices Henry Ford offered to Model T purchasers. You could have any color you wanted as long as it was black. Twenty years ago, a state of the art variable annuity might have offered stock, bond and money market fund options. If the insurance company was on the cutting edge, there was a death benefit that guaranteed that beneficiaries would receive at least the purchase payments back if the owner died during the accumulation period.

The VA world has certainly changed since then. Purchasers can often choose among over 100 investment options. More recently and more importantly, insurance companies have developed a number of riders which allow the purchaser to select that combination of features that are most suitable to their personal characteristics, their financial circumstances and their reasons for buying the annuity. Insurance companies are offering an alphabet soup collection of riders, including GMABs, GMDBs, GMIBs, and GMWBs.¹

This article will provide a brief description of how each of these riders operates and the investor need they're intended to meet. More importantly, this article will discuss the opportunities and challenges this proliferation of riders creates. The ability to custom design an annuity gives an agent an opportunity to work with a client and demonstrate the value they're adding by helping the client pick those riders that fit the client's needs and disregard the others.

The challenge for the supervisors overseeing the agents and the broker-dealers is to build a training program that educates the agents on how the riders operate, for whom they are suitable and how the riders can be explained to clients in an understandable manner. Broker-dealers will also need to have tracking systems and a supervisory structure in place to make sure that the lessons learned in the training program are being applied at the point of sale.

Death Benefits

Although variable annuities have always been sold as long-term retirement planning vehicles, one barrier to sales has always been investor concern that s/he would die in close proximity to a sharp market decline that would eliminate market gains that had been accumulated over an extended period. For example, the Dow Jones Industrial Average in October 1987 fell almost 25% from 2639 to 1993.

The basic death benefit in the old variable annuities, generally offered at no charge, provided that the beneficiary would receive the greater of: account value; or, premium payments. In essence, the insurance company was guaranteeing that premium payments would earn a return equal to the fees charged by the insurance company and the underlying investment options, typically in the 2%-2.5% range.

Insurance companies then decided to offer, for a fee, a third element. In addition to guaranteeing the greater of account value at death or premium payments, a guarantee of account value on a specified contract anniversary was added. Initially, the benchmark valuation dates were relatively widely spaced, for example, the account value on every fifth contract anniversary. Competition forced the carriers to reduce the time between benchmarks so that GMDBs were set at the highest value of any contract anniversary. The charge for such a rider is approximately 0.25%.

Some carriers took yet a different approach to GMDBs. The death benefit would be the greater of account value or premium payments accumulated at a specified interest rate, with 5% not being atypical. The charge for this type of rider might be approximately 0.35%.

Some insurance companies concluded that it was illogical to impose an asset-based charge for a GMDB since doing so has the perverse effect of costing the investor more as her/his account appreciates, the exact point at which the insurance company’s risk of having to make a payment under the GMDB was declining. These companies changed the charge structure so that it was based on the company’s amount at risk, just like a cost of insurance charge. On a monthly basis, the company would compare the guaranteed minimum death benefit to the account value and impose a charge based on any difference. This method for charging produces a more attractive value proposition for the customer.

In addition to the various GMDBs described above, insurance companies also are offering riders which automatically increase the death benefit otherwise payable. In essence, the increase equals a percentage of any appreciation over the life of the contract. The explanation of this formula is not so simple in that it refers to the account value plus withdrawals less purchase payments multiplied by a specified percentage based on the annuitant’s age at the time the contract is issued. This feature might appeal to a person who wanted to increase the death benefit, but might have difficulty buying insurance due to their medical condition.

Accumulation Benefits

There are also riders which guarantee that account value after a specified amount of time, for example 10 years, will be at least equal the account value when the rider is purchased, plus any purchase payments made in the first year. If at the end of the 10 years the account value does not meet the minimum amount promised, the insurance company will increase account value by the amount of the shortfall. At that point, the contract owner has the option to renew for another 10 years.

These guarantee features also allow contract owners to lock in increases in account value before the 10 year period is completed. Once the contract has been held for five years, the contract owner would have the option, on any contract anniversary, to purchase a step-up benefit that replaces the prior minimum amount with the contract value on the contract anniversary on which the step-up is selected. Once a step-up is taken, the 10-year benefit period starts again. Once five years have passed, the owner has the right to elect a new step-up.

Withdrawal Benefits

Guaranteed withdrawal benefits give contract owners the right to withdraw a percentage of their contract value each year while the balance of the contract value remains invested and can be accessed through a full surrender at anytime. A withdrawal benefit provides contract owners access to payments in a guaranteed amount without the finality of annuitization options based on a life contingency that does not provide access to a lump sum or payments on any other basis than the one set forth in the selected annuity option.

While conceptually a GMWB is relatively straightforward, a completely different picture is revealed when the operations of a GMWB are examined. A GMWB involves concepts such as a Benefit Base, the Guaranteed Annual Withdrawal Account, the Guaranteed Annual Lifetime Withdrawal Amount, the Benefit Base Accumulation Rate and the Benefit Base Accumulation Cease Date.

As an example of how complex these features became, the Benefit Base is the greater of a, b, c or d where:

1. is the Contract Value on the date of the first withdrawal, just before the first withdrawal;
2. is the sum of "1" plus "2", where:
1. is the Contract Value on the rider effective date accumulated on a daily basis using the Benefit Base Accumulation Rate (shown in the Additional Contract Specifications) until the earliest of (i) the Benefit Base Accumulation Cease Date (shown in the Additional Contract Specifications); (ii) the Annuitant’s attainment of age 80 for Single Life Guarantees or age 80 of the younger of the Annuitant and the Joint Annuitant for Joint Life Guarantees; and (iii) the date of the first withdrawal; and
2. is each purchase payment received after the rider effective date but prior to the first withdrawal, accumulated on a daily basis using the Benefit Base Accumulation Rate (shown in the Additional Contract Specifications) until the earliest of (i) the Benefit Base Accumulation Cease Date (shown in the Additional Contract Specifications); (ii) the Annuitant’s attainment of age 80 for Single Life Guarantees or age 80 of the younger of the Annuitant and the Joint Annuitant for Joint Life Guarantees; and (iii) the date of the first withdrawal; and,
3. is the highest Contract Value as of a contract anniversary date until the earlier of the Benefit Base Accumulation Cease Date (shown in the Additional Contract Specifications) and the date of the first withdrawal; and
4. is the Contract Value on the last Step-Up Date before the Annuitant’s attainment of age 80 for Single Life Guarantees or age 80 of the younger of the Annuitant and the Joint Annuitant for Joint Life Guarantees.

Once the dollar amounts of the annual and lifetime withdrawal amounts are set, the rider addresses the impact on the amount of subsequent permitted withdrawals if the owner withdraws more or less than the amount the rider originally permitted. There is also an impact if additional purchase payments are made after the permitted amounts are established. As with the GMABs, the purchaser of a GMWB can choose a Step-Up Benefit on any contract anniversary after the fifth anniversary, so long as it is at least five years after the most recent Step-Up Benefit has been chosen.

Income Benefits

A GMIB assures owners that, notwithstanding adverse investment performance, they will have a specified minimum amount available if they choose to annuitize. The minimum amount equals purchase payments (frequently limited to early contact years) plus interest earned assuming a fixed interest rate, for example, 5%. As with all these riders, the promised value is reduced on a proportional basis if there are any withdrawals.

There are typically a variety of conditions owners must meet during the accumulation period if they want to take advantage of this benefit. For example:

1. the benefit must be chosen when the contract is issued;
2. account value must be allocated in accordance with an asset allocation program administered by the insurance company;
3. the contract must be held for at least 8 years and the annuitant must be age 62 before annuity payments can be taken; and,
4. the annuitant must select from life annuity options with fixed payments.

Finally, although the charge for the GMIB might currently be .50% annually, the insurance company typically has complete discretion to raise the charge, perhaps to as high as 1.00% at anytime, at which point the owner’s sole recourse is to cancel the GMIB.

Opportunities and Challenges

The wide variety of benefits now available with variable annuities offer a number of opportunities for investors, registered representatives and their broker-dealers, but they also offer significant challenges to registered representatives and broker-dealers.

Opportunities

Investors now can custom design a variable annuity to meet their own risk tolerances, anticipated holding period and ultimate use of the variable annuity. The following are some very general descriptions of the investors who would find the various benefits attractive or unattractive:

GMDB
More likely to purchase:

• Older investor
• Aggressive investor
• Have health issues
• Unable to buy life insurance except on a rated basis

Less likely to purchase:

• Investor having a shorter-term investment horizon
• Conservative investor
• Has substantial life insurance

GMIB
More likely to purchase:

Less likely to purchase:

• Unlikely to annuitize
• Long holding period
• Open to effecting a tax-free transfer to another insurance company
• Annuity is small part of assets

GMAB
More likely to purchase:

• Aggressive investor
• Intends to invest to hold until the end of the initial benefit period
• Intends to make substantially all of their purchase payments during the first contract year

Less likely to purchase:

• Conservative investor
• No carrier loyalty and would be receptive to a tax-free exchange before the initial benefit period ends
• Could envision annuitizing before the initial benefit period ends

GMWB
More likely to purchase:

• Aggressive investor
• Maintain access to their account value without committing to annuitization

Less likely to purchase:

• Conservative investor
• Indifferent to access to contract value during the accumulation period

Registered representatives and broker-dealers also have found that these new benefits enhance their business for a number of reasons. First, these new benefits allow the registered representative to address some of the reasons investors have for being reluctant to buy a variable annuity. The fact that many of the benefits are only available at the time a contract is issued establishes the reason for registered representatives to contact their clients holding existing variable annuities that are no longer subject to a surrender charge to discuss whether a tax-free exchange to a new variable annuity with additional features might be advisable... subject to suitability standards.

Challenges

"It is only through effective training and a comprehensive supervisory system that firms can ensure that customers receive important disclosures concerning these complex products and that they are sold to customers for whom they are suitable." (NASD News Release, Dec. 4, 2004, Mary L. Shapiro, NASD Vice Chairman Regulatory Pricing and Oversight).

If Mary Shapiro feels this way about variable annuities generally, it is not difficult to imagine her views on a broker-dealer’s responsibilities when it comes to the wide variety of riders which are now available. As should be evident from the brief descriptions above, understanding how these riders operate is not an assignment for the inexperienced, impatient or faint-hearted registered representative. The next step is being able to explain the rider to a customer. After that, the registered representative and the customer will need to determine which, if any, of the riders meet a customer’s need. A further question is whether the charge for the rider is reasonable in relation to its value to the customer.

Given all these complexities, it may be advisable for the broker-dealer Product Selection Committee to determine which variable annuities the broker-dealer offers and to put a limit on the number of variable annuities and riders which are authorized for sale. The broker-dealer may decide that the burden of providing comprehensive training on the riders offered by 15 insurance companies and the resultant responsibility to supervise the sales activities of representatives selling the different riders from so many companies exceed the benefits to the broker-dealer and its customers of having so many choices. The broker-dealer, of course, also needs to consider the regulatory risks and customer litigation that could ensue if the broker-dealer and its registered representatives do not meet their responsibilities.

With that as background on the challenges broker-dealers face in offering these new riders, you should carefully review the accompanying article in this magazine by my colleagues John Hartigan and Andrew Southerling, The State of Play in Variable Annuities: Revisiting Best Practices for Sales which discusses in detail best practices for training and supervising registered representatives who are selling variable annuities.

Conclusion

As the Baby Boomers approach retirement and begin to focus on whether their accumulated assets will support them during their increased life expectancy, variable annuities, because of the income distributions that cannot be outlived, should be increasingly attractive. At the same time, the variable annuity industry has developed a variety of riders that allow annuities to be tailored to the needs of customers. This is certainly an excellent development for variable annuity customers and broker-dealers trying to help their customers plan an investment program. Broker-dealers must, however, take steps to ensure that their training programs and supervisory structures keep pace with the complexities of the new generation of riders and those to follow.

Michael Berenson, Senior Counsel in the Washington DC office of Morgan, Lewis & Bockius, LLP has over 25 years experience counseling clients on issues related to the design and sale of fixed and variable insurance products.

¹Guaranteed minimum accumulation benefits, guaranteed minimum death benefits, guaranteed minimum income benefits and guaranteed minimum withdrawal benefits.