Under most variable annuity contracts there is an assumed investment rate (AIR) that the investment portfolio must earn in order for benefit payments to remain level. If the investment performance exceeds the AIR, the level of benefit payments will increase. On the other hand, if the selected investments underperform the AIR, the level of benefit payments will decrease.
Example. Assume a variable annuity contract is issued with a 6 percent AIR and a beginning unit value of $20. The contract is issued with a payout of one hundred units per month (providing an initial monthly payment of $2,000 per month). Assume the investment yield during the first month of the contract was 10 percent; during the second month the investment yield was 4 percent. The monthly benefit can be calculated by monitoring the changes in the unit value and by comparing the actual performance with the assumed 6 percent interest rate. During the first month, the 10 percent return on the portfolio exceeds the assumed 6 percent AIR by 4 percent, which leads to a 4 percent increase in the $20 unit value. The new unit value is now $20.80 ($2,080 per month). During the subsequent month, because the actual return is only 4 percent, which is 2 percent less than the AIR, there will be a 2 percent reduction in the unit value to $20.38 ($2,038 per month). The unit value could actually drop below the beginning $20 value ($2,000 per month) if investment performance remains below the assumed 6 percent level for an extended period of time. However, for an increased cost, some annuities provide a guarantee that the monthly payment will never drop below the initial monthly payment, regardless of adverse investment performance.
Selecting an AIR
Under some contracts, the purchaser is able to select the AIR from a narrow range of possible rates (such as 3, 5, or 7 percent). It is much easier to receive an increasing stream of benefit payments by selecting a lower AIR; however, initially this can be more expensive (meaning the starting monthly payment will be reduced). The effect of choosing a different AIR can be demonstrated by returning to the example of the previous question.
If an AIR of 8 percent rather than 6 percent is chosen, the benefit increase in the first month will be 2 percent instead of 4 percent. The unit value changes to $20.40 instead of $20.80. The next month’s decrease in benefits is more drastic, a 4 percent reduction rather than the 2 percent reduction. The unit value decreases to $19.58 instead of $20.38 from the lower AIR. Choosing the less costly higher AIR will start with a higher initial benefit (i.e., with an 8 percent AIR, the starting payment in the above example would likely have been higher than $2,000) but will increase the likelihood that benefit payments increase less rapidly and decrease more rapidly.
Keep in mind that although variable annuity contracts are intended to provide a hedge against inflation and protect the purchasing power of the benefits through positive market returns, the increases in market value have not always occurred at exactly the same time that prices increase. Often prices go up significantly before the market provides high returns and increases the level of benefits. These temporary mismatches between price increases and benefit increases are inevitable and can lead to a temporary loss of purchasing power.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM