Fixed Annuity Fees Explained

Before we delve into the details of fixed annuity fees, we will first talk a little bit about what exactly a fixed annuity is.  A fixed annuity is when a person deposits a set amount of money with an insurance company for the promise of a set future stream of income.  The person cannot outlive this income.

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Fixed Annuity Example

For example suppose the person buying the annuity is a 55 year old female.  She gives 200,000 to the insurance company and they give her 3% guaranteed annual interest on the money for the next 10 years.  At age 65 when she is ready to retire, she will have 200,000 compounded at 3% for 10 years or $268,783.  At that time she may receive a new interest rate for the next 10 years which she can accept or not.  She will probably want to start taking regular monthly or annual withdrawals at this time.

She can annuitize the contract which means she gives up all access to the lump sum and just accepts the disbursement terms from the insurance company or she can set up regular payments to come out of the annuity.

Benefits of a Fixed Annuity

Since the woman above purchased a fixed annuity rather than a variable annuity, she does not have any exposure to the stock market declines.  However, she does not have the benefits of the market gains either.  She may feel that just having peace of mind is better than potential upside. As long as the insurance company is financially solid and can pay her the income stream for the rest of her life, she is set. 

The insurance company is in effect insuring her future retirement income.  The credit quality of the insurance company is the only variable with this contract.  There are costs to offering this type of insurance.

E  Fees Associated with Fixed Annuities

There are several fees that you should know about before you purchase your fixed annuity.  One of the fees you will pay is commonly known as M&E fees.  This stands for mortality and expenses fee. Mortality fees are insurance guarantees associated with the contract. 

This might include a guaranteed death benefit paid to survivors and the fee for guaranteed income for life incase you live longer than expected.  This fee also covers commissions, selling and administrative expenses for maintaining the contract. The insurance company usually includes these fees as part of the guaranteed interest rates.

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Surrender Charges Associated with Fixed Annuities

When you purchase your fixed annuity you should make sure that you understand what the early surrender charges will be.  Depending on the contract you purchase you will more than likely have an early surrender charge of some sort.  That is why it is important that you only look at an annuity as a long term investment vehicle.  Many surrender charges will start at a high preset rate and will decrease with each year until the charge eventually goes away. 

An example would be if you have a seven year surrender schedule.  In the first year you would be charged 7% for surrendering the contract.  In the second year it would be 6%, in the 3rd year it would drop to 5% and so on until after the 7th year the surrender charge would be zero.

Many fixed contracts will start a new surrender period if you lock into new rates so make sure you want to keep the money in the contract for the new time span.  If not you may want to consider other options.  Most annuities, but not all will allow you to withdraw up to 10% of the value each year without incurring any surrender charges. 

You need to make sure your contract allows this though.  There are a few contracts in the marketplace that will give you a little bit above average returns but they take this feature out of the contract.  Just read all the details before you purchase your contract. 

The first fee typically imposed by an annuity will be what's known in the industry as a "mortality and expense" (M&E) charge. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the contract. In general, these fees in a variable annuity will be charged as a percentage of the average value of the investment and will probably be quoted in terms of "basis points."

A basis point is 1/100th of 1%. Thus, an M&E charge of 115 basis points means a fee of 1.15% will be assessed against the value of the investment. According to the National Association of Variable Annuities (NAVA), the industry average M&E in 1997 was 1.15%. In a fixed annuity, these charges are usually incorporated in the insurance company's determination of the periodic interest rate or the annuity payment amount during the distribution phase.

Surrender Charges

The existence of surrender charges should alert many a Fool that annuities are something to be treated with skepticism. Many annuities will impose a surrender charge if the annuity is cashed in before a specific period of time. That period may run anywhere from 1 to 12 years. A typical surrender charge is one that starts at 7% in the first year of the contract, and declines by 1% per year thereafter until it reaches zero.

The charge is made against the value of the investment when the annuity is surrendered, and its purpose (other than simply to make money for the insurance company) is to discourage a short-term investment by the purchaser. For that reason, an annuity should always be considered a long-term investment. In the typical fixed annuity, though, this charge will not apply provided no more than 10% of the investment is withdrawn per year.

Management Fees

Management fees on subaccounts are assessed by variable annuities, and they are the same as an investment manager's fees in a mutual fund. These fees will vary depending on the various subaccount options within the annuity. In general, they will be somewhat less than those charged by a managed mutual fund within the same investment category -- though not necessarily. According to NAVA, the 1997 industry average for subaccount management fees was 82 basis points, or 0.82%.

That's somewhat lower than many managed stock mutual funds, but it's over four times that of an unmanaged stock index fund like the Vanguard Index 500, which only charges 18 basis points. Also, just as an aside, the returns published by an insurance company for its annuity subaccounts will be the net returns after all management fees have been deducted. So, just as a mutual fund's stated return does not reflect the impact of any sales commissions, the subaccount return does not reflect the impact of M&E charges that have been assessed against the investment.

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