Hidden Annuity Benefit Protects Family Wealth

Variable annuities often dangle a "death benefit" feature, promising security for your loved ones if you pass away. Sounds comforting, right? But before you sign on the dotted line, seduced by the promise of protection, you need to ask the hard question: What is this variable annuity death benefit really worth?

Is it genuine protection, or just an expensive add-on designed to look better than it is? Let's cut through the sales pitch and figure it out.

Insights

• A variable annuity death benefit typically guarantees beneficiaries receive at least a minimum amount (like premiums paid or a stepped-up value), even if the market tanks the account value.
• Different flavors of these guarantees exist, from simple return of premium to more complex stepped-up benefits that lock in market gains periodically.
• Taking money out of your annuity during your lifetime usually reduces the death benefit payout your heirs might receive.
• This guaranteed payout isn't free; it comes bundled with fees (often embedded in Mortality & Expense charges or specific riders) that eat into your investment returns over time.
• Beneficiaries generally owe ordinary income tax on the investment gains within the death benefit payout, unlike typically tax-free life insurance proceeds (though the original investment amount isn't taxed).

First Base: What Exactly is a Variable Annuity?

Before dissecting the death benefit, let's be clear on the underlying product. A variable annuity is essentially a contract between you and an insurance company.

You hand over money, and they allow you to invest it across a menu of subaccounts – think mutual funds wrapped inside an insurance contract. The main draw? Your investment earnings grow tax-deferred until you start taking withdrawals, usually in retirement.

This tax deferral can sound appealing, especially compared to a standard brokerage account where you might face annual taxes on dividends and capital gains.

"You’re not going to pay any taxes on growth, whereas in a non-qualified brokerage account, there’s often taxes you have to pay every single year."

Chip Stapleton FINRA Series 7 and Series 66 license holder and CFA Level II candidate

But variable annuities are far more complex than simple investment accounts. They come layered with insurance features, fees, and rules – including the death benefit we're examining.

Decoding the Death Benefit Promise

So, what's this death benefit all about? It's the insurer's promise that if you die before depleting the annuity, your named beneficiaries will receive a certain amount. It acts as a safety net, particularly if your investments perform poorly.

The actual payout is usually the higher of two numbers: the annuity's current account value or a guaranteed minimum death benefit (GMDB) base. Understanding these two components is fundamental.

Account Value: This is straightforward – it's what your investments in the subaccounts are worth at any given moment. It goes up and down with the markets.

Guaranteed Minimum Death Benefit (GMDB) Base: This is the floor value the insurer guarantees your beneficiaries will receive, regardless of market performance.

It's typically calculated based on the premiums you paid, sometimes with adjustments for growth or interest, minus any withdrawals you've taken. This GMDB is the core of the "protection" being sold.

Not All Guarantees Are Built the Same

Insurers offer several types of GMDBs, each with its own calculation method and level of potential protection.

The most common flavors include a Return of Premium guarantee, which simply ensures your beneficiaries get back at least the total amount you initially invested (less withdrawals). Think of it as getting your stake back, even if the market dealt you a losing hand.

Some contracts offer a Simple Interest GMDB, where your premium base grows by a modest, fixed annual percentage (say, 3-5%). This provides a slightly higher floor over time compared to just returning the premium, though withdrawals still chip away at this guaranteed amount.

Then there are the more sophisticated versions. A Stepped-Up Benefit periodically (often annually or on contract anniversaries) compares your account value to the current GMDB base. If the account value is higher, the GMDB "steps up" to lock in that higher value as the new minimum guarantee.

Once stepped up, this new floor typically doesn't decrease due to market downturns, only due to subsequent withdrawals. A similar concept is the Highest Anniversary Value, which promises the highest account value recorded on any past contract anniversary date, again adjusted for withdrawals.

These stepped-up features offer the potential for a significantly higher guaranteed payout if the markets cooperate during the contract term.

The Catch: How Withdrawals and Costs Bite Back

Here’s where the shine can come off the apple. Taking money out of your variable annuity while you're alive directly impacts the death benefit. Withdrawals reduce not only your current account value but also the GMDB base. The exact reduction method – whether it's dollar-for-dollar or proportional – depends on the fine print in your specific contract.

The bottom line? Using your annuity for income during retirement can significantly erode the safety net you thought you were leaving for your heirs. It's a trade-off you need to understand clearly.

Furthermore, these death benefit guarantees aren't offered out of the goodness of the insurer's heart. They cost money. This cost is usually baked into the annuity's overall fees, often through higher Mortality & Expense (M&E) charges or as a separate rider fee.

These fees, which can easily run 1-2% or more of your account value annually on top of underlying fund expenses, create a constant drag on your investment performance. Over decades, this fee drag can substantially reduce your potential returns, potentially costing you more than the death benefit is ever likely to pay out.

You have to weigh whether the potential payout justifies the certain cost.

"If there’s outsize value provided by those fees, then it makes sense."

Chip Stapleton FINRA Series 7 and Series 66 license holder and CFA Level II candidate

The challenge lies in determining if that "outsize value" truly exists for you, given the guaranteed costs involved.

Tax Realities for Your Heirs

Another critical piece of the puzzle is taxes. Unlike life insurance death benefits, which are generally received income tax-free by beneficiaries, annuity death benefits follow different rules. Your beneficiaries don't get a free pass from Uncle Sam.

When your beneficiaries receive the death benefit payout, any amount exceeding the original investment (the cost basis) is considered investment gain. This gain is taxed as ordinary income to the beneficiary in the year they receive it. They essentially inherit your cost basis.

So, if you invested $100,000 and the death benefit payout is $150,000 (whether that's the account value or the GMDB), your beneficiary owes ordinary income tax on the $50,000 gain. The original $100,000 comes back tax-free.

There's a historical wrinkle: for annuity contracts issued before October 21, 1979, the rules were different, potentially allowing for a step-up in basis at death, similar to other inherited assets. However, for most annuities purchased in recent decades, the gains remain taxable to the beneficiary.

The payout method chosen by the beneficiary (lump sum vs. installments over time) can also affect the timing and potentially the amount of tax due. This tax treatment makes annuity death benefits generally less tax-efficient for wealth transfer compared to pure life insurance.

Analysis: So, Is This Death Benefit Actually Worth It?

Now for the million-dollar question (or perhaps, the hundred-thousand-dollar question, depending on your annuity). When does this guaranteed minimum death benefit actually provide tangible value?

The GMDB only truly kicks in and pays out more than the straightforward account value if two conditions are met: 1) You die, and 2) At the time of your death, your annuity's account value has fallen below the calculated GMDB base.

This typically happens after a significant market downturn or if your investment choices within the annuity have underperformed substantially over a long period.

Think about that. You are paying ongoing fees, year after year, for a benefit that only pays off if your investments perform poorly and you happen to die during that slump.

If your investments do well and the account value is higher than the GMDB base when you pass away, your beneficiaries simply get the account value. In that scenario, you paid for the guarantee for potentially decades, but it provided no additional payout beyond what the market delivered.

This is the core trade-off. You're paying a certain, ongoing cost (through higher fees) for uncertain, conditional protection. It's like paying for expensive collision insurance on a car you rarely drive on dangerous roads.

The "peace of mind" comes at a price, and that price directly reduces the funds available for your retirement or for your heirs if markets perform reasonably well.

Variable annuities, with their layers of fees, surrender charges, complex riders, and tax implications, are notoriously intricate products. The death benefit feature adds another layer to this complexity. Is this complexity justified?

For some, perhaps. If your primary goal is leaving a specific minimum amount to heirs, regardless of market volatility, and you have a very low risk tolerance or anticipate poor market conditions coinciding with your passing, the GMDB might seem appealing despite the cost.

However, for many investors, the high fees associated with variable annuities and their death benefits often outweigh the potential advantages. Simpler, lower-cost investment strategies combined with term life insurance (if the goal is purely death benefit protection) can often achieve similar or better outcomes with far less complexity and cost drag.

You need to run the numbers, understand the fee structure inside and out, and realistically assess the probability of the GMDB actually providing a benefit greater than its cumulative cost.

Don't let the allure of a "guarantee" blind you to the very real costs and complexities involved. Question the assumptions. Challenge the sales pitch. Is this feature truly serving your financial strategy, or is it primarily serving the insurer's bottom line?

Final Thoughts

Determining the worth of a variable annuity death benefit isn't a simple calculation. It depends heavily on the specific contract terms, the type of GMDB offered, the underlying investment performance, the level of fees charged, how long you hold the annuity, whether you take withdrawals, and your personal financial objectives and risk tolerance.

While the GMDB offers a floor for your beneficiaries if markets turn sour right before or after your death, this protection comes at a tangible, ongoing cost that erodes returns in good times and bad. You're paying for insurance against poor investment outcomes within the annuity wrapper.

Before buying into the promise, scrutinize the contract. Understand precisely how the GMDB is calculated, what triggers a step-up (if applicable), how withdrawals impact the benefit, and exactly how much you're paying in fees for this feature. Compare the total costs and potential benefits against alternative strategies, like straightforward investing paired with term life insurance.

Variable annuities are complex instruments. Their death benefits add another layer of intricacy. Making an informed decision requires careful due diligence. Consulting with a genuinely independent financial advisor (one who isn't primarily compensated by selling these products) and a tax professional is often a prudent step.

They can help evaluate if the specific product aligns with your retirement and legacy goals, and whether the death benefit's potential value justifies its cost in your unique situation.

Ultimately, the "worth" is personal, but it demands a clear-eyed assessment of the costs, benefits, and probabilities involved – not just accepting the marketing narrative at face value.