The ticking time bomb of forced drawdowns on variable annuities

Advisers’ elderly clients who hold older variable annuities have a ticking time bomb on their hands: potential forced annuitization that will deactivate their accrued death benefits.
Buried within the fine print of variable annuity prospectuses, insurers detail the conditions under which they will distribute a client’s annuity in the form of a stream of payments. When signing up for a contract, clients can choose an annuity commencement date — the date on which they will begin receiving income payouts — but insurers usually set an upper limit on the age by which clients must start receiving payouts. Typically, this ranges anywhere between the mid-80s to as late as 95 or 100, depending on the carrier and the terms of the contract.
Advisers are finding, however, that though some insurers used to be willing to extend the annuitization date on a case-by-case basis, they are now pushing to begin disbursement of the account as soon as possible. This has been particularly debilitating for clients who have death benefits that are significantly larger than their account values. What’s worse, is that there’s no way out of the contractual agreement.
Those most affected by it are clients with dollar-for-dollar death benefits, where the value of the death benefit is reduced by the exact dollar value of any withdrawals made from the account value. These features were customary with older annuity contracts. In the past, advisers would recommend that clients “strip” the account value by making a withdrawal, investing the money elsewhere and allowing the contract to continue with a small account value and a large death benefit.
Such was the case for Thomas B. Hamlin, founder of Somerset Wealth Strategies Inc. He has a 92-year-old client with an $81,000 death benefit and an account value of about $10,000. “For the last couple of years, he’s been allowed to extend the annuity commencement date, and now the company wants to force him to annuitize, liquidate or exchange the contract,” Mr. Hamlin said. “He would lose the death benefit, which is a massive loss for his estate.”
In other scenarios, required minimum distributions from a variable annuity could also lead to the loss of the death benefit.
Scott Stolz, president of Raymond James Insurance Group, offered an example: A client has $70,000 in the account value and a dollar-for-dollar death benefit worth $130,000. The client pulls $65,000 from the account. His death benefit is reduced by the same amount, falling to a death benefit of $65,000 on an account value of $5,000. However, required minimum distributions from the account value will lead to a zero balance in a short period of time.
RMD calculations on variable annuities with dollar-for-dollar death benefits become problematic because they are based on the sum of the account value and the actuarial present value of the death benefit that’s over the account value, according to Mr. Stolz. The problem here is that the RMDs calculated this way will quickly deplete the account value.
“The rate at which they liquidate the account, the client will have all of the money out of the policy in about six or seven years, and at this point, the death benefit will go away: The account value hits zero and the death benefit hits zero,” Mr. Stolz said. The alternatives are limited in this case, but there’s the possibility of taking an RMD from another source.
Generally, there are few ways out of a forced annuitization. Clients and advisers haven’t been fully aware of its perils, and wholesalers historically haven’t discussed the issue much.
“The information is in the fine print, and wholesalers will say that their companies don’t do that, but they can,” said Carrie Turcotte, president of Crest Financial Strategies. “So you have to ask, ‘At what age can the company force it?’”
Nevertheless, the forced annuitization age is a detail that’s buried within the prospectus, so there’s a cautionary tale for advisers.
“It’s never as easy as the product reps or wholesalers make it sound, and it’s our job to dig as deep as we can in the comprehension of these contracts,” said Ms. Turcotte.