The costs and fees of annuities.
One of the common criticisms levied against annuities is their cost structure.
Those in favor of annuities say you shouldn’t compare them to other investments because they’re insurance products that offer guarantees not offered elsewhere. Fixed and indexed annuities credit a minimum amount of interest each year and may credit a non-guaranteed rate of interest in some years. Annuities also guarantee a stream of lifetime income, if you choose. Those guarantees have a cost.
People who do not recommend annuities say they are inefficient investments because of the fee structure. Many people claim that a mutual fund manager can earn you a better return for less cost than an annuity. But a mutual fund can not guarantee you a minimum annual return, nor can it guarantee a lifetime stream of income that won’t run out during your lifetime. Those guarantees are what requires higher fees than what you might pay on other investments.
The deduction of annuity fees is similar to taxes being deducted from your paycheck: it happens automatically and you hardly notice. That’s become insurance companies deduct those costs from the returns on the investments they make with your premium dollars. The company may earn 6 percent annually on its investments and credit 3 percent to your annuity’s account value. The remaining 3 percent, called a spread, goes toward the insurance company’s expenses and profit.
Some expenses will actually be assessed during the payout phase of the annuity contract because the annuity owner will receive a lower payout when opting for certain features.
Breakdown of annuity fees
Fixed annuities charge annual fees that may total 2 percent to 3 percent or more of the account value. Variable annuities will cost more because they also have investment management costs. Annuity expenses can be divided in the following categories:
Mortality and expense charges. These cover the cost of the insurance guarantees built into the product and help the insurance company mitigate the longevity risk of offering lifetime guarantees.
Administrative charges. These cover the insurance company’s operating costs.
Selling or distribution expenses. These charges pay for the agent’s commission and other related costs incurred by the insurance company during the process of selling the annuity.
Optional benefit expenses. Most optional features that add value to the annuity contract will be assessed an additional fee, usually less than 1 percent of the account value. These features include income riders, certain death benefit options, and cost-of-living adjustments. Consumers should weigh the benefit of these features because they can save money by not adding them to the contract.
Explanation of surrender charges
One of the most criticized charges on annuities is the surrender charge an owner incurs if he or she cancels the contract before the expiration of the surrender period. Consumer often don’t understand why they have to pay the insurance company to access some of their money or to get it all back.
The reason is that insurance companies do not charge annuity buyers upfront even though they have to pay agents a commission ranging from 2 percent to 10 percent of the premium paid. The company needs to invest premium for a certain period to recoup the expense of the agent’s commission. That period is the surrender period. As long as you hold onto the annuity for the duration of the surrender period, the insurance company can recoup what it paid for the commission and doesn’t need to assess a surrender charge. Cancel the contract sooner and the company loses the premium it was using to invest.
If you decide to remove some or all of your money from the annuity before its surrender period, you will likely have to pay a surrender charge. This is typically a percentage of the amount withdrawn. The percentage will decline over time. For example, your annuity may have an 8 percent surrender charge if you withdraw funds in the first year, a 7 percent charge in year 2 and a 6 percent charge in year 3.
The longer the surrender period, the higher the commission paid to the agent. For example, one insurer currently pays 8.5 percent of premium to agents on an annuity with a 14-year surrender period, but only 4 percent on one with a 5-year surrender period. The insurance company can pay a higher commission on longer surrender annuities because it has more time to earn a return on the invested premium. And if the annuity owners surrenders the policy early, the surrender charge assessed will be much higher on the 14-year annuity than on the 5-year product.