We begin with the growth process for the guaranteed benefit base during the deferral or accumulation period before distributions begin. This growth is important because it is subsequently used to determine the amount of guaranteed lifetime income provided by the annuity. The deferral period can be skipped if the retiree wants lifetime distributions to begin immediately.
Deferred variable annuities with income guarantee riders generally support the ability to lock-in a guaranteed growth rate on the benefit base during the accumulation period before guaranteed distributions begin, including the ability to define the benefit base as the high watermark of the contract value of the underlying assets on anniversary dates over the history of the rider. This benefit base is a hypothetical number used to calculate the amount of guaranteed income paid during the withdrawal phase. It is distinct from the contract value of assets, which is what the owner could access based on actual account growth net of fees and any surrender charges.
For example, if the rollup rate for the benefit base is an annually compounding 6 percent, the value of the benefit base would double in approximately twelve years. The benefit base could be even larger if the contract value grew larger on the relevant dates when this is checked. Conversely, the actual contract value of the underlying assets will be determined by market performance. After the twelve-year accumulation period has passed, if the market has underperformed and the value of the benefit base is significantly higher than the contract value of the underlying assets, then the income guarantee is “in the money.” The benefit base is larger than the contract value. In such a case, the owner may wish to continue paying for the rider and to receive the guaranteed income as calculated on this higher benefit base.
On the other hand, if markets performed well during those twelve years, the contract value of the underlying assets may be close to or the same as the value of the benefit base. In this case, the retiree may consider whether it is worthwhile to begin taking distributions with the income guarantee, to have the contract value of the underlying assets returned to an unprotected investment portfolio, or to exchange into a different annuity with better withdrawal opportunities for the contract value.
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Generally, the benefit base can grow at the higher of either a guaranteed rollup rate or the high watermark achieved through investment growth of the contract value for the underlying assets held inside the annuity. But the interaction of these two possibilities can get confusing. I’ll talk about both rollups and step-ups, which are not interchangeable terms. Rollups are a guaranteed minimum growth rate for the benefit base, and step-ups are increases for the benefit base triggered when the contract value of the underlying assets in the annuity subaccounts have grown to achieve a new high watermark value. Let’s start with the rollup rate.
What is the guaranteed rollup rate for the benefit base? Is it a compounded rate or simple rate?
To begin, we can consider a rollup rate that is applied annually on the contract anniversary for when the annuity was opened. If a variable annuity offers a 5 percent guaranteed compounded rollup rate during the deferral period, then the benefit base supported by a $100,000 premium would grow to $127,628 after five years (100,000 x 1.05 ^ 5) and to $162,890 after ten years (100,000 x 1.05 ^ 10).
If this were instead a 5 percent simple growth rate, then 5 percent of the initial premium would be added to the benefit base after each year, leading to $125,000 after five years and $150,000 after ten years, for instance. The longer the deferral period, the more opportunity a compounded rollup rate has to move ahead, with growth on past growth, relative to a simple rollup rate on the initial premium. For instance, with these numbers provided, we can see that a 5 percent compounded growth rate would beat a 6 percent simple growth rate after ten years, as the latter would have only growth to $160,000.
Exhibit 5.1 provides an example of $100,000 placed into a variable annuity at age fifty-five which offers a 5 percent annual compounded growth rate on the benefit base. As mentioned, after ten years, the benefit base has grown to $162,890. If the contract value of the underlying assets never grew to exceed this guaranteed rollup rate when checked on the relevant dates, then this would reflect the benefit base for the annuity.
It is worth emphasizing that the guaranteed rollup rate is not a guaranteed investment return. It does not apply to the contract value of assets. It only applies to the benefit base used to calculate guaranteed income amounts. This detail is a constant source of confusion for individuals.
Exhibit 5.1: Guaranteed Benefit Base for $100,000 premium in a Deferred Variable Annuity with a 5 Percent Annually Compounded Rollup Rate
Retirement Researcher
When are rollups vested into the benefit base?
Most commonly, the rollup rate is applied annually on the anniversary date for when the contract went into effect, and this is also when the benefit base would be vested at the new higher value. That is the case illustrated in Exhibit 5.1.
Some variable annuities will apply the rollups on a more frequent basis, such as daily, monthly, or quarterly. With compounding, more frequent rollups can provide an edge because there is more opportunity for interest to accumulate on interest. However, the question remains about when the rollups become vested. More frequent rollups might still only vest on the contract anniversary date. The only reason this could be a problem is for someone seeking to begin distributions midyear. Even though rollups are more frequent, if they do not vest until the anniversary date, then the benefit base will not yet be higher when calculating the income guarantee. Withdrawals before the anniversary date would not factor in any of the potential growth for the year.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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