Living Benefits Annuities – Are They Good For You?

By John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA

Living Benefits Annuities have a feature that sounds too good to be true – invest in the securities market and receive a guaranteed minimum rate of return (typically 5% to 6%) or the market return, whichever is greater.  Wow!  No wonder these annuities are hot, especially for those who fear another market meltdown.

How do they work?  The annuity comprises two accounts, only one of which is guaranteed.  The “Account Balance” is the actual value of your investments (net of substantial fees) and has no guarantees.  The “Income Base” starts at the level of your initial investment and grows annually by a guaranteed fixed rate or that year’s return on the Account Balance, whichever is greater.

There is also a significant difference in your ability to withdraw funds from the two accounts.  You can withdraw the entire “Account Balance” in cash at any time (although you may incur fees in doing so).  In contrast, you cannot convert the entire “Income Base” balance into immediate cash.  If you wish to convert the entire balance of the “Income Base” into cash, you must convert it into an immediate annuity, which provides cash payments for as long as you live.

To illustrate how this works, consider “Bob,” a 55-year old who is changing careers.  He has $100,000 in his Traditional 401(k), which he was planning to roll into a Traditional IRA.  He asked us whether it would be better to roll the funds into a Living Benefits Annuity that guaranteed a 6% minimum return, a guarantee that sounded very attractive to Bob.

For our analysis, we used the terms of the actual Living Benefits Annuity.  Under this contract, Bob’s $100,000 would essentially be invested in mutual funds.  Technically, the company puts the money into a separate account, which then allocates the funds among mutual funds of Bob’s choice.  The annuity would “guarantee” a 6% annual return or the return on his portfolio for that year, whichever is greater.  Bob understands that he cannot withdraw the entire Income Base amount at one time, but he can convert the entire amount into lifetime payments.  That is fine with Bob.  He expects to retire in 10 years and plans to turn the investment into an immediate annuity at that time in any case.

Our analysis compared putting Bob’s $100,000 into the Living Benefits Annuity versus low-cost mutual funds in a Traditional IRA.  We assumed that his asset allocation would be the same under both options.

First, we looked at the scenario where the market performs well above the 6% guarantee rate for each of the next 10 years.  In this case, the IRA gives Bob significantly more money, due to the higher fees associated with the Living Benefits Annuity.

What are these higher fees?  In our analysis, we assumed that the mutual fund fees would be the same (even though it is likely that Bob can purchase lower-cost funds with the IRA).  The difference comes from fees that are specific to the Living Benefits Annuity.  The contract we examined included a 1.15% annual separate account fee and a 1.00% annual fee for the guaranteed living benefits, for a total of 2.15% additional fees compared with the IRA.  The contract also included the possibility of other fees, which we also ignored in this analysis.

Suppose the Account Balance (net of fees) increases to $200,000 (a 7.18% annual return).  Since the Account Balance reflects additional fees of 2.15%, the annual return of the IRA account would be 7.18% + 2.15% = 9.33%.  With a 9.33% annual return, the IRA account increases to $244,000 in 10 years.  Because the fees on the Account Balance are so high, Bob would have over 20% more money at the end of 10 years with the IRA.

Second, we looked at a scenario where the market performs poorly, with the IRA posting a pathetic 1% net annual return over the 10 years.  The IRA balance grows to just over $110,000.  But the Income Base under the annuity will have increased 6% per year to $179,085.  Bob believes that he is a lot better off.

But Bob is NOT better off.  In fact, he is worse off.  How can this be?  Because the monthly payments from the Income Base have a lower, less competitive payout rate than Bob can realize if he buys an immediate annuity in the market with the proceeds from the IRA.   Using the payout tables in the contract, the $179,085 in the Income Base would generate monthly payments of $568 for Bob and his wife, with 10 years of payments guaranteed.  But, using quotes from for annuities with the same features, the $110,000 proceeds from the IRA would buy an immediate annuity that would pay Bob and his wife $583 per month.

Third, we looked at a scenario where the market performs very poorly, posting a negative return for the 10 year period.  In this instance, the guaranteed level of the Living Benefits Annuity does perform better than the IRA.  The Living Benefits Annuity still provides $568 per month to Bob and his wife, the same level achieved in the scenario above, while the annuity purchased with the IRA funds provides less than $530 per month.

Bob was quite surprised to learn that the guarantee in this Living Benefits Annuity was substantially weaker than he thought – in essence, it guaranteed him only a 1% return rather than the 6% he was expecting.  In Bob’s defense, very few people understand these products.  They are complex, and the written explanations are difficult to comprehend.  Indeed, we have looked at one prospectus that is over 900 pages long.  And, in our observation, it appears to us that some financial advisors do not fully understand these products either.

So be very careful if you are considering “investing” in a Living Benefits Annuity.  We recommend that you closely examine the projected cash flows under different scenarios – especially the payments you will receive if you convert the Income Base to an immediate annuity.  The results may surprise you as much as they surprised Bob.