One of the strongest arguments against the use of annuities as an investment is that they are laden with fees and other charges. While it is true that there are numerous fees associated with annuities, annuities provide a bundle of benefits not readily available through other investments and those fees represent the annuity company's compensation for providing that package of benefits. Whether a client needs all of the features of a particular annuity contract offers, and whether the fees are adequately disclosed to prospects are key questions in determining the suitability of the contract for that client. That said, few agents understand the cost structure of the annuities they sell — and perhaps because of this, they fail to adequately disclose and explain those costs. Annuity companies could certainly provide more transparency in how they structure their costs, better training for their agents and more clearly written sales materials.
Fixed Annuity Cost Factors
The simplest annuity, in terms of fees or other charges, is the fixed, single premium, immediate annuity (fixed SPIA). This represents a lump sum deposit with the annuity company, which invests those funds in the company's general assets. Periodic income payments to the annuitant begin immediately. Fixed SPIAs generally have no front-end sales charge or annual contract charges. Since these contracts are annuitized immediately, these contracts generally offer no control or flexibility to the contractholder. The annuitant can simply expect to receive his or her monthly income payment for the rest of his or her life. Some contracts, however, may permit commutation or partial withdrawals, and the annuity company will charge a fee for those distributions. (Commutation is the surrender of the contract once the annuity period begins. If permitted, the contractholder will receive the present value of the expected future payments in a lump sum, less a processing fee.) The only cost component in an SPIA is built into the annuity payout factors.
Immediate Annuity Payout Factors
Each company will develop a schedule of annuity payout factors. These factors represent the monthly income payments that an annuitant will be paid if the account is annuitized. In the case of immediate annuities, the factor is applied when the contract is issued. In the case of deferred annuities (discussed in detail below), the decision to annuitize or not is left to the discretion of the contractholder. If the contractholder chooses to annuitize in the future, the company will offer the annuitant the greater of the annuity payout factors based on current market conditions at the time of annuitization or the guaranteed annuity factors initially set forth in the contract. The guaranteed annuity factors are based on very conservative assumptions, meaning very low payout factors. As a rule, current factors will be more generous than the guaranteed factors (but with ever-increasing life expectancies it is possible that future payout factors may not be so generous, or always exceed the minimum payouts).
Annuity payout factors are shown as the periodic annuity payment per $1,000 of the contract's value. Annuity payout factors are based on the type of payout method selected by the contractholder, the current age of the income recipient, the recipient's gender, the company's assumptions on future interest rates and its projected expenses (including a profit for the company). The company's assumptions and projections are subject to change, so annuity payout factors offered by the company will change over time, too. But once the contractholder decides to annuitize, the current factors at that time are locked in and that factor will be used for all future annuity payments. All future payments will be based only on that factor.
In the case of immediate fixed annuities, the annuity payments will be fixed at the contract's inception. Those payments will never change, unless the contract contains a cost of living adjustment (COLA). [Most current contracts do not contain COLAs, although some new contracts may provide for a small annual adjustment (e.g., 3% per year) to the annuity payments. While better than nothing, such a benefit is not a true COLA as it not tied to the rate of inflation. The trend in the marketplace seems to be toward offering some type of inflation protection.]
All contractholders who annuitize will pay an indirect cost that is built into the annuity payout factors. Immediate annuities are immediately annuitized, so holders of immediate fixed or variable annuities will always pay this cost. Deferred annuity holders who have elected to annuitize their contracts will also pay this cost.
Deferred Fixed Annuities
Deferred fixed annuities (whether funded by a single, lump-sum premium or flexible premiums over time) have far more complex cost structures. Historically, fixed deferred annuities imposed fewer and simpler charges than their variable cousins, but the trend is toward more complexity in both. Purchasers of fixed deferred annuities may pay any or all of the following costs (depending on the contract):
Front-end sales charge. Until recently an up-front sales charge (or "load") was commonly included in a fixed deferred contract. These are very unpopular with consumers; so few contracts today assess this charge. The load is generally stated as a percentage of the initial or subsequent premiums. In many cases it is expressed on a sliding scale — the larger the premium, the smaller the percentage.
Surrender charges. As the name implies, this charge applies if the contract is surrendered, but may also apply if the contractholder makes a substantial partial withdrawal. Most fixed deferred annuities allow withdrawals up to 10% of the contract balance each year without penalty, any excess withdrawal is subject to the charge. Each contract will spell out how the penalty is applied to excess withdrawals (is the 10% applied to each year separately or can unused withdrawals from one year be "rolled over" into future years?) but the 10% penalty-free figure is fairly standard industry wide. The surrender charge is usually a expressed as in a declining schedule: for example 5% if surrender in the first year, 4% in the second year, 3% in the third year, until the surrender charge reaches zero in year 6. In the case of flexible premiums, the clock may start ticking based on contract’s date or the contract may call for surrender charges on a rolling basis, with the new timeframes applied for each additional premium paid to the company. Most contracts will waive surrender charges upon the death of the annuitant (or contractholder). Likewise, many contracts will waive the charge if the owner is confined to a nursing home, becomes disabled, or suffers from a "dread disease" listed in the contract's terms.
These two charges (sales charge or surrender charge) allow the company to recover its "acquisition costs" -- the cost to put the contract in force. One of those acquisition costs, but by no means the only one, is a commission paid to the salesperson. Almost all fixed annuities are sold by commissionable agents and the company must recover that cost, as well as the cost to develop the product, administrative costs, and a profit. If the contract is kept in force long enough, the company will eventually recover the acquisition costs and make a profit from various aspects of the contract. But if the contract is terminated in the early years the company loses those costs and the opportunity for profit. Hence the surrender charge (or its predecessor, the sales charge).
Contract charges. A few deferred annuity contracts assess an annual charge. If the company does impose a contract charge it will generally waive the fee when the account balance exceeds a certain amount (e.g. no contract charge if the account balance exceeds $50,000). In effect, this is a fixed dollar fee per contract to cover administrative expenses of small, less profitable contracts.
Market Value Adjustment. Fixed annuities are typically backed by fixed-income investments such as bonds held in the company's general assets. If interest rates increase after the contract is issued, contractholders may choose to surrender the contract and to take advantage of other higher-yielding investments. Unfortunately for the company, if interest rates increase, the value of their fixed-income investments will decrease — and the company may have to sell investments at a loss to pay off the surrendered contracts. The market value adjustment addresses this situation. It states that if interest rates (based on some benchmark index) are higher at the time of surrender, the surrender value will be decreased; and vice versa if interest rates have declined. Generally speaking, the market value adjustment applies only on withdrawals in excess of the penalty-free amount, and only during the surrender charge period.
Interest rate spread. The interest rate spread (or yield spread) is typically the contract's greatest source of profit for the company. The spread represents the difference between what is promised to the contractholder and what the company can earn from its investments. This is also one of the most shadowy costs to the contractholder. The company will disclose what rate of interest it is will pay on the contract, but the rate of return the company earns on its investments is not disclosed (at least not directly to the contractholder).
Variable Annuity Cost Factors
Variable annuities begin with premium payments to the annuity company, which invests those funds in a separate account (typically a portfolio of stocks). The contract is credited with accumulation units (similar to mutual fund shares) that vary in value. Put another way, the cash value of the variable annuity depends on the investment performance of the separate subaccount. If annuitized, the accumulation units are converted into a fixed number of annuity units. Future annuity payments will vary based on change value of the annuity units.
Variable annuities, in effect, represent an investment vehicle wrapped within an annuity contract. Variable annuity contract have a number of costs, some relate to the subaccount's investments, others apply at the contract ("wrapper") level. These types of fees apply to all variable annuities whether immediate or deferred:
Front-end sales charge. These are as unpopular with variable annuity investors as they are with fixed annuity purchasers. Recently, however, some variable annuity companies have reintroduced these types of charges, in part due to heightened regulatory scrutiny and bad press associated with surrender charges. Contracts with a front-end sales charge will not have any surrender charges and may have lower annual operating costs.
Surrender charges. If the company does not have a front-end sales charge, it probably will have surrender charges. These operate the same way in variable annuities as in fixed annuities.
Contract charge. This is a small, fixed dollar amount charged annually. It is often waived for contracts with balances exceeding a stated minimum amount (e.g., greater than $50,000).
Insurance charges. Perhaps the most confusing expense in a variable annuity is the insurance charge. Variable annuities are an investment wrapped with an annuity contract, and that contract provides various benefits in addition to the pure investment nature of the subaccount. There are minimum guaranteed death benefits and guaranteed annuity payout factors built into the contract. And these need to be paid for. The "total insurance expense" represents three factors: mortality and expense charges (M&E), administrative charges, and distribution charges. Mortality and expense charges compensate the annuity company for the death related benefits. If mortality experience is more favorable than the company expected, the company will earn a profit. Administrative charges compensate the company for overhead and operating expenses. Distribution charges compensate for sales related expenses, most notably commissions to the salesperson. Insurance charges are usually quoted as percentage of the subaccount's assets and are deducted from the investment's annual investment return. (Fixed annuities do not impose insurance charges; they rely on the interest rate spread to cover these costs.)
Please note: some commentators and marketing materials refer to the "total insurance charge" as "mortality and expense". When analyzing specific variable annuity contracts, it is important to compare "apples to apples", which means digging into the fine print to see how the contract labels its expenses. It is also important to note the different types of guarantees each contract makes — the M&E expense may seem higher in one contract than other, but that may be because it offers better features, e.g., a higher death benefit, better annuity payout schedules, etc.
Investment charges. In addition to the contract fees, there will also be fees associated with managing the investments in the subaccount. These are expressed as a percentage of the assets under management, and are analogous to the expense ratio in the mutual fund. The charge reimburses the company for the investment manager's fees and transaction costs in operating the subaccount's portfolio. Investment charges vary widely based on the type of investment in the subaccount: money market and index funds have the lowest charges, then bond funds, diversified stock funds, with specialty stock funds or non-security investments (real estate or natural resources) charging the most.
Charges for riders. The insurance charges described above compensate the company for the basic guarantees of the variable annuity contract. As was discussed in detail earlier, many variable annuity companies offer a wide range of optional riders, including GMIBs, GMABs and GMWBs. Each of these comes at an additional cost, usually expressed as a percentage. Each rider will detail how the cost is computed. For example, the cost of a guaranteed minimum income benefit (GMIB) rider is typically 35-50 basis points (0.35% -0.50%) per year, which may be assessed against the account's cash value or the benefit base, depending on the contract. The cost of guaranteed minimum accumulation benefit (GMAB) riders typically run 20-25 basis points per year, although in some older contracts it may be as little as 10 basis points. GWAB fees are usually assessed against the annuity's cash value. The charge for a guaranteed minimum withdrawal benefit (GMWB) rider is usually 35-50 basis points per year, although some companies will waive this cost if the contractholder does not exercise her right to make a withdrawal during a stated period of time (e.g., the first seven years of the rider's life). Newer contracts may offer holders a "combination rider" that incorporates GMIB, GMAB and GMWB features into one rider. The cost for a combination rider is usually around 60 basis points. Enhanced death benefit riders typically cost 35 basis points per year or less. This rate may be assessed against the subaccount's cash value or the guaranteed death benefit provided by the rider.
Annuity payout factors. As with fixed annuities, annuity payout factors applied to variable annuities have an indirect cost built in to them. The standard payout factors reflect current interest rate assumptions. It is important to note that holders who annuitize using a GWIB rider may be required to use special annuity payout factors. These special factors are based on less-favorable interest rate assumptions or an age setback — and these represent additional costs to the contractholder.
Equity Indexed Annuity Costs
Equity Indexed Annuities are a form of fixed annuity. What sets them apart is that the rate of return is tied to the performance of a stock index as opposed to a renewal rate set at the annuity company's discretion. Unlike variable annuities with their separate subaccounts, equity indexed contracts are backed with equity indexed stock options held in the company's general account. To cover the cost of those options, the company imposes participation rates or yield spreads. Remember that traditional fixed annuities rely on interest rate spreads -- the difference between what the company promises the contractholder and the rate the company earns on its investments -- to generate a profit for the company. The participation rates, yield spreads and caps perform the same function in an EIC — creating a difference between what is promised to the contractholder and what the company earns. In the case of EIC, the company earns the full return of the index; the "moving parts" of the EIC serve to reduce the return promised to contractholders, and thus generate a profit for the company. The interest rate spread was the most shadowy cost of a fixed annuity. EICs by contrast disclose the costs imposed by the moving parts openly, although it is rarely explained to prospects as a "cost". Perhaps this is because most agents are just as confused by the complexity of an EIC’s interconnected "moving parts" as clients are.
Like other fixed deferred annuities, EIAs may impose many of the same charges. Most EIAs do not impose a front-end sales charge, but rely instead on surrender charges. Surrender charges are central to many complaints of EIAs and advisors must carefully consider how surrender charges affect the suitability of EIAs for each client's unique situation.