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Enhanced death benefit riders on annuities: what they pay and cost
Return-of-premium, step-up and roll-up death benefit designs compared with invented numbers: what each pays an heir after a market drop, and what it costs.
An enhanced death benefit rider is an optional add-on to a variable annuity, and sometimes to other market-linked annuities, that promises your beneficiary more than the account is worth if you die after the markets have fallen. It costs an extra annual charge, and what it pays depends on which of three designs the contract uses: a return of premium, a step-up to the highest anniversary value, or a roll-up that grows your premium at a stated rate. The designs pay very different amounts in the same market, so the useful questions are which one you are being offered, what it costs and how likely it is that your heirs will ever collect more than the account value.
All of the numbers below are invented to make the arithmetic visible. They are not the terms of any company's contract. Real contracts differ in the details that matter most, which are how withdrawals reduce the benefit, when the benefit stops growing and what the annual charge is based on. For the basic death benefit that comes with every variable annuity, see what happens to an annuity when you die.
What the standard benefit pays, and what the rider adds
Most deferred annuities pay the beneficiary at least the account value at death. In a fixed annuity, that value does not fall, so the standard benefit is usually enough. In a variable annuity, the money sits in subaccount investments that rise and fall with markets, and the account value at the owner's death could be below what the owner put in. An enhanced benefit is meant to cover that gap. It is typically described as "the greater of" the account value or a guaranteed amount, where the guaranteed amount is calculated by the rider's formula.
Three points apply to all the designs:
- It is a death benefit, not an income benefit. The rider's guaranteed amount is a calculation that pays your beneficiary only if you die. It is not money you can withdraw. The same is true of the benefit base used by an income rider, a distinction covered in benefit base versus account value: the number income riders really use.
- It is paid by a charge you pay every year. The charge usually reduces the account value whether or not anyone ever collects.
- It is limited by the contract's terms. Most riders stop growing at a stated age, cap the roll-up and shrink when you take withdrawals.
The three designs
Return of premium
The simplest design pays the greater of the account value or the premiums paid, reduced by withdrawals. If you invested $100,000 and the account is worth $90,000 at death, the beneficiary receives $100,000. If the account is worth $130,000, the beneficiary receives $130,000. It protects against a loss, but it never pays more than what you put in unless the account itself grew.
Step-up, also called a ratchet
A step-up design locks in the highest account value on a set date, usually each contract anniversary, and pays the greater of that highest value or the current account value. If the account hits $126,000 on one anniversary and later falls to $90,000, the beneficiary's guaranteed amount stays at $126,000. The benefit ratchets up when the account does and never goes down because of the market. It may also stop stepping up at a stated age, such as 80, though the locked-in amount remains.
Roll-up
A roll-up design grows your premium at a fixed percentage each year, regardless of what markets do. A 5 percent roll-up on $100,000 is worth $105,000 after one year, and about $115,763 after three, if it compounds. Some roll-ups use simple interest rather than compound, some stop after a number of years or at a cap such as double the premium, and some apply only until a particular age. The beneficiary receives the greater of the roll-up amount or the account value. A roll-up can exceed what the account earned for years in a row.
Some contracts combine them and pay the highest of the roll-up, the step-up and the account value. That is more expensive and often more complicated. Contract language, not the brochure label, decides what the benefit is.
A worked comparison
Say an owner puts $100,000 into a hypothetical variable annuity at age 65 and adds no money. The account value at the end of each year, in this invented market, runs as follows.
| End of year | Account value |
|---|---|
| 0 (purchase) | $100,000 |
| 1 | $112,000 |
| 2 | $126,000 |
| 3 | $90,000 |
| 4 | $95,000 |
| 5 | $108,000 |
The owner dies at the end of year 3 or the end of year 4. No withdrawals have been taken. The roll-up is 5 percent compounded, and the step-up uses anniversary values. Here is what a beneficiary would receive.
| Design | Guaranteed amount, death at end of year 3 | Death at end of year 4 |
|---|---|---|
| Standard (account value only) | $90,000 | $95,000 |
| Return of premium | $100,000 | $100,000 |
| Step-up to highest anniversary | $126,000 | $126,000 |
| 5% compound roll-up | $115,763 | $121,551 |
The roll-up numbers come from $100,000 × 1.05^3 = $115,762.50 and $100,000 × 1.05^4 = $121,550.63. The step-up pays $126,000 because the best anniversary value was in year 2. Compared with the standard benefit, the extra amount at the year 3 death is $10,000 for return of premium, $36,000 for the step-up and $25,763 for the roll-up.
Notice what the table does not show. If the owner dies at the end of year 1, year 2 or year 5, when the account stood at or above every guarantee, all four designs pay about the same, because the account value is the "greater of" winner. The rider only matters in a window in which the account is below the guarantee and the owner dies. In this example, that window opened in year 3. In a market that never fell, it would never open.
What the extra protection costs
Riders are priced as an annual percentage of either the account value or the benefit base. Suppose, as an invented illustration, the annual charges are 0.20 percent for return of premium, 0.30 percent for the step-up and 0.50 percent for the roll-up, each charged on the year-end account value. Over the first four years the year-end values total $112,000 + $126,000 + $90,000 + $95,000 = $423,000.
- Return of premium: 0.20% × $423,000 = $846.
- Step-up: 0.30% × $423,000 = $1,269.
- Roll-up: 0.50% × $423,000 = $2,115.
Compare each with the extra paid out in the scenario where the owner dies in year 3: $10,000, $36,000 and $25,763. In that outcome, each rider paid out far more than it cost. In the outcome where the owner is still alive at the end of year 5, the owner has paid five years of charges and no one is owed anything extra, because the rider pays only on death. The question is therefore not whether the market recovers, but whether death comes during a shortfall. A rider works like insurance: most people who pay for it never collect, and the few whose heirs do collect are paid from the pool.
A second path: the market that keeps rising
To see the other side, run the same purchase through a different invented market in which the account earns 8 percent a year for four years: $108,000, $116,640, $125,971 and $136,049 at the year-ends. Now compare the guarantees at the end of year 4.
- Account value: about $136,049, which beats every guarantee.
- Return of premium: $100,000, lower than the account, so it pays nothing extra.
- Step-up: the highest anniversary value is the current account value, so it equals the account.
- Roll-up at 5 percent: $121,551, again below the account value.
Every rider is worth zero extra in this path. The owner has still paid the charges. At the invented 0.50 percent charge on the year-end values ($108,000 + $116,640 + $125,971 + $136,049 = $486,660), the roll-up cost about $2,433. That is the price of protection that was not needed, which is how insurance usually looks in hindsight. In a market that behaves like the first table, the same rider looks like a bargain. A buyer cannot know in advance which path will occur, which is why the decision turns on how much the heirs' outcome matters and how much the owner is willing to pay for certainty.
Two further costs matter. The charge reduces the account value, so it drags on growth: 0.50 percent a year on a $100,000 account is about $500 a year, which compounds into the account's long-run performance. And the rider is often one of several, along with the contract's base mortality and expense charge and an income rider, so the total can rise quickly. The guide on annuity fees, explained lists them, and add up your variable annuity's layered fees in actual dollars shows how to add them up in dollars.
How withdrawals reduce the benefit
This is where many owners get surprised. Contracts reduce the guaranteed amount when you take money out, in one of two ways.
- Dollar for dollar. A $10,000 withdrawal lowers the guarantee by $10,000.
- Proportionally. The guarantee falls by the same percentage as the withdrawal represents of the account value at the time.
Take the step-up guarantee of $126,000 in year 3, when the account is worth $90,000. The owner withdraws $10,000. Under the dollar-for-dollar method the guarantee becomes $116,000. Under the proportional method, $10,000 is 11.1 percent of $90,000, so the guarantee falls by 11.1 percent: $126,000 × (1 − $10,000 ÷ $90,000) = $126,000 × 0.8889 = $112,000. The proportional reduction is $14,000, not $10,000. When the account is down, a proportional method removes more of the guarantee per dollar withdrawn, which is the moment the owner most needs the protection. Some contracts use dollar-for-dollar up to a stated annual limit and proportional beyond it. The contract states which method applies.
Taxes and the beneficiary
A death benefit above the account value does not change the tax rules for annuities. For a non-qualified annuity, the beneficiary owes ordinary income tax on the part of the proceeds that exceeds the owner's cost basis. Say the basis is $100,000 and the step-up pays $126,000 at a time when the account is worth $90,000. The beneficiary receives $126,000 and has $26,000 of taxable income, even though the account never held that gain. For a qualified annuity inside an IRA or other plan, nearly all of the proceeds are taxable. The enhanced amount is still better than the lower one, because you pay tax on a larger sum and keep more after tax, but it can surprise people who expect the benefit to be tax-free as life insurance is. See how annuities are taxed and annuity beneficiaries and inherited annuity options for the rules and the beneficiary's timing choices.
Who each design suits
| Design | Suits | Weak points |
|---|---|---|
| Return of premium | A buyer whose main worry is that heirs receive less than was invested; usually the lowest charge | Pays nothing for gains the market gave up; protection stays flat over decades |
| Step-up | A buyer who expects the account to climb and wants to lock in gains for heirs | Charge can be higher; a rising market raises the guarantee but the charge may be on the guarantee; usually stops stepping up at a set age |
| Roll-up | A buyer with a long horizon who wants a guarantee that grows even when markets are flat | Often capped or limited by age; highest charge; heavy reduction with withdrawals; may not apply after annuitization |
Which, if any, is worth buying depends on facts about the buyer and not on the design. Owners who plan to leave the annuity to heirs and who are in good health are more likely to want it. Owners who plan to spend the money, or who have other sources of legacy, may find they are paying for a benefit they are unlikely to use. Owners in poor health should be cautious in the other direction, because the benefit's value is greatest when death comes during a shortfall, but some contracts impose waiting periods or limit the benefit after certain ages.
Alternatives to consider
- Choose a contract that does not need a rider. A fixed annuity or a buffered index-linked contract does not expose heirs to the same market drop, though each has its own trade-offs; see variable annuities: how they work, what they cost, who they suit.
- Use life insurance for the legacy. If the goal is a specific sum for heirs, a life insurance policy states the amount, while an enhanced annuity benefit depends on the market and the formula. Insurance requires underwriting, which is not available to everyone, and it has its own cost.
- Keep the standard benefit and hold other assets for heirs. The account value passes to the beneficiary at death anyway.
- Compare the rider's annual cost with the extra amount it could pay. If the rider costs $1,269 over four years and the plausible shortfall is $36,000 only in years when you die during a crash, you are comparing a certain small cost with an uncertain large payment, which is what insurance is. The question is whether that exchange fits your finances.
Questions to ask before adding a rider
- Which design is it, and does the contract describe it as the greater of the account value or the guarantee?
- What is the annual charge, and is it applied to the account value or to the guarantee?
- How do withdrawals reduce the guarantee, dollar for dollar or proportionally?
- At what age does the benefit stop growing or stepping up, and what happens after annuitization?
- Is the rider optional, can it be removed later and does the charge change?
- Does the owner's or the annuitant's death trigger the benefit? In some contracts the answer differs, as described in owner, annuitant, beneficiary: how three roles change what happens at death.
A licensed agent or the insurer can answer these, and the answers belong in writing. For a tax or estate question, a tax professional or estate attorney should look at the contract.
Key takeaways
- An enhanced death benefit rider pays only if you die, and only more than the account value when the account has fallen below the rider's guarantee.
- In the worked example, a death at the end of year 3 produced $100,000 (return of premium), $115,763 (5% roll-up) or $126,000 (step-up), against $90,000 under the standard benefit.
- The annual charge is paid whether or not anyone collects, so compare it with the plausible shortfall rather than the best case.
- Proportional withdrawal reductions can cut a guarantee by more than the dollars withdrawn, as the $126,000 step-up fell to $112,000 after a $10,000 withdrawal.
- Heirs still pay ordinary income tax on the gain portion, including any amount that exceeds the account value.