Details on Lifetime Annuity Costs
When you are shopping around for the best annuity to purchase, you need to understand the costs and expenses you will encounter before you start. If you are purchasing a fixed annuity as compared to a variable annuity, the costs will be different. Variable annuities usually have higher costs associated with them because there are a lot more options and moving parts to these annuities.
Fixed annuities as well as variable annuities will both have sales commission costs. Many times these are lower on a fixed contract than on a variable annuity. These are the sales commissions that are paid to the financial institution that sold the annuity to you. Fixed annuities are much easier to manage. You are guaranteed a set rate for a set number of years and you don’t have many other options. Variable annuities give you many more options for investing. We will discuss theses differences later.
Costs for a Fixed Annuity
If you are considering purchasing a fixed annuity you may not see a lot of upfront costs listed with your contract. There are implicit fees associated with the annuity though. These costs will be taken from the contract through a reduction in the actual interest rate that your contract is credited.
For instance market interest rates on a 5 year CD may be 3%. However, the 5 year guaranteed rate on your fixed annuity may only be 2.25%. The lower return is because the insurance company is charging you to manage your annuity and to design it and make it available to you. So that is a cost that you really don’t see but in a way it is there.
Another thing to look at with a fixed annuity is the early surrender fees. If you purchase a $100,000 annuity and it guarantees 2.5% for seven years, you need to be aware of the fact that if you terminate the annuity before the seven years are over, you will pay a surrender fee.
Usually on a seven year contract this will start at around 7% in the first year and decrease sometimes by 1% a year until the seventh year is over. Some fixed annuities have surrender charges that start at 7% and stay there for the first three years and then start decreasing. Read the contract detail before you purchase your annuity so you understand all the specifics of your annuity.
Costs on a Variable Annuity
The costs on a variable annuity are a bit more complex than those on a fixed annuity. As we discussed earlier, variable annuities have a lot more options and benefit riders than fixed annuities do. Their structure is a bit different so the costs of managing these types of annuities are a bit more expensive.
To start with, you will have what is referred to as M & E expenses. This stands for Mortality and Expense charges. Most variable annuities promise to return at least the amount of money you invested in the event of your premature death if you have not taken any distributions. If you have started taking distributions they may pay a death benefit that is a minimum of what you invested, minus your withdrawals. The insurance company will have to do this even if the market has dropped if this is an option in the contract.
This charge also includes administrative expense for managing the annuity. This can include a lot of different things. The M & E expense on most variable annuities will be anywhere from ½ % to 1 ½ % of the contract value annually. Many people feel that these fees are too extreme but you would not have a lot of the benefits that an annuity offers if you did not have these fees. The insurance companies would not offer them for free.
A variable annuity will also have early surrender fees. They work a lot like the fixed annuity commissions we discussed earlier.
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A lot of people gripe and complain about annuity costs, but these contracts have been around for years and they do take some of the uncertainty of building a retirement income off the individual investor’s shoulders. If this was not a profitable business for the insurance companies though, rest assured these investment vehicles would disappear. They would probably also disappear if they provided no benefit to the individual investor as well.
Explicit costs include: 1. Mortality and expense charges (M&E) of 1.25%-1.45% of the value of the annuity annually (this is the industry average)... M&E is supposed to cover just mortality and expense, but it mostly covers profit. This becomes apparent once you realize that the insurance company actuaries all use the same numbers for mortality. The high cost annuity providers charge 1.25%-1.45% for M&E while the low costs providers charge about .25%-.30%.
Explicit costs also include 2. A variable account mutual fund annual expense ratio of about 1.50% (this is the cost of the average mutual fund; it includes investment management fees and 12-b(1) fees). The explicit costs associated with a variable annuity on the low side are, therefore, 2.50% (the M&E fee of 1.00% plus the fund annual expense ratio of 1.50%). The higher end of the scale is 3.35% (the M&E fee of 1.85% plus the fund annual expense ratio of 1.50%). Both the low side and high side of explicit costs can increase if riders for living benefits are elected--which is being done more and more now. And that is a good subject for another article - too much to include here.
Implicit costs include:
- Brokerage commissions paid internally on transactions of .45%. This cost is not included in a fund's annual expense ratio but instead in a separate, obscure document called a Statement of Additional Information.
- Bid-ask spread costs (these costs provide a "market maker" with a profit for providing liquidity in a market) of .40% (for the most liquid stocks) to 10.00% (for the least liquid stocks)
- Market impact costs of .40% (these costs are caused by the impact on the market price of a stock when it is bought or sold). The implicit costs associated with a variable annuity on the low side are therefore 1.25% but can all the way up to more than 10.00%. Don't forget that many of the mutual funds used in annuities are actively-managed and, therefore, have much higher costs than passively managed mutual funds (i.e., index funds and asset class funds).
The Bottom Line
Now to total things up: Explicit costs of 2.50%-3.35% plus implicit costs of 1.25% (I'll ignore the 10.00%, since that's just too scary) for a grand total of 3.75%-4.60%. Costs also include:
- Cost of surrender charges
- The cost of additional investment advisory services that are included in many arrangements
- Commissions received for selling to the annuity retail buyers (which being explicit costs are different than the implicit brokerage commissions earned on transactions internal to a mutual fund)
- The cost of the increasingly negative compounding effect caused by lost money?
Since some people will claim these costs are exaggerated, therefore let me quote from a randomly selected company, directly from the prospectus of Ohio National Variable Account A of the Ohio National Life Insurance Company ONcore Series of Variable Annuities Supplement to the Prospectuses dated May 1, 2009 in which, on page 8, Summary of Maximum Contract Expenses the Maximum Possible Total Separate Account Expense is listed as 5.45%. This does not include any of the implicit costs referred to above. It also does not include the fund operating expenses listed on page 9 with a range without waivers of .35% to 26.26%!
When you consider that the long term stock market returns are approximately 10.5%, how can you really do well in a variable annuity with these high costs dragging down any possible market returns? Income tax deferral won't make up the difference in lost earnings for many many years and maybe never.
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