Understanding Annuity Expenses

It’s no secret that annuities have expenses associated with them that aren’t found in other investments. In fact, annuity expenses are the favorite target for those who seem bent on criticizing annuities as investments.  Their usual form of attack is to try to frame annuities in the same investment category of other “equivalent” investment vehicles and then compare the expenses of each. The problem is that there is no direct equivalence when you consider that an annuity is actually an insurance contract that provides certain guarantees unlike any other investment.

Still, it is important to be aware of the expenses that are charged in an annuity contract because, ultimately, they do impact your return on investment.  By understanding annuity expenses, you will be in a position to weigh the long term benefits of annuities versus other vehicles.  The first thing to understand is that, as insurance contracts, annuities have a unique expense structure that is needed to support the guarantees and maintain their integrity as tax favored investments.

It’s also important to note that not all annuities are built the same. They come in different flavors so that they can serve different needs, so the expense structure will vary from one type of annuity to the next.  Generally, the more moving parts an annuity has, such as a variable annuity with its separate investment accounts, the more expenses it will have.  In general, depending on the type of annuity, an annuity investor can expect to pay somewhere between 1.5 and 3 percent of the account balance annually to cover all expenses.  Here is an overview of the expenses typically associated with annuity contracts:

Mortality and Expense Charges,

Also referred to as “insurance” expense, these fees cover the cost of the insuring the principal as a death benefit in a variable annuity. Additionally, the insurer uses these fees to cover its administrative and distribution costs. Any sales commissions and marketing costs are paid from these fees.  These charges range from 1 to 1.5 percent .

Fixed annuities generally don’t charge an annual fee for mortality and administrative expenses. Instead, their costs are covered in the spread between what they earn on their investment portfolio and what they actually credit the accumulation account.  In immediate annuities, these costs are factored into the annuity payout.

Investment Management Fees

Variable annuities include separate investment accounts that are managed by professional managers.  An annual fee is charged that is a percent of the account balances.  Some separate accounts, such as aggressive stock accounts, are actively managed and will charge a higher management fee than a less actively managed  account, such as conservative bond account.  Fees can range from just under 1 percent to as high as 2 percent.

Fixed and Immediate annuities have no separate investment accounts, therefore do not charge investment management fees.

Surrender Fees

Insurers will charge a surrender fee should an investor cancel the annuity contract before the end of a surrender period.  The insurer uses the surrender fee to offset the potential loss it could realize from its portfolio if it has to liquidate bonds at a loss to cover the surrendered funds.  It is also used as a deterrent to discourage investors from withdrawing their funds before the agreed upon timeframe.

These fees can range from 5% to as high as 10% of the surrendered funds, but most contracts have a declining fee schedule whereby the fee is reduced by 1 percent each year until it disappears.  Thus, in most contracts, there would be no surrender charge at the end of five to ten years.

Most contracts allow for annual withdrawals without a surrender charge if they are kept to 10% of the fund balance. Note: Withdrawals made prior to the age of 59 ½ may be subject to a 10% penalty by the IRS.

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Sales Loads

As with some classes of mutual funds, some variable annuity products include a front end sales load, or commission. In most contracts, the sales commission is paid to the salesperson by the insurance company rather than from the investor’s pocket.  This means that all deposited funds go to work for the investor and the insurance company will recover its commission cost from the annual fees.  No-load variable contracts, which are purchased direct from the annuity provider, are becoming much more prevalent.

Charges for Optional Features

Many annuity contracts offer optional features or riders that will enhance the product’s guarantees or protections.  These are added to the contract at the time of purchase, however, the charges are typically factored into the benefit itself.  For instance, is an inflation protection rider is added to an immediate annuity, the cost for providing that protection is covered by reducing the income payout by a certain percent.

Variable contracts that offer living benefit features, such a guaranteed minimum accumulation benefit (GMAB) will usually charge the separate account annually.

State Premium Taxes

Variable annuity investors should also be aware that their state may charge a “premium tax” on the amount invested.  This would be indicated in the prospectus which should be specific to the state in which you live.

Summary

There’s no getting around the fact that the expenses in annuities, especially of the variable kind, can add up, which is a key reason why they may not be appropriate for some investors.  Certainly, if you are in a high current tax bracket you can benefit from tax deferred accumulation.  And, if, for a part of your portfolio, you need more guarantees and protection, then annuities may make sense. In both cases, an annuity can provide superior benefits over the long term.  In any situation, it would be important to weight the long term benefits of an annuity against the costs, and shop rates, fees and expenses thoroughly.