Annuity Fees and Expenses

Expenses should be a top priority for any financial services consumer.  Many people have been conditioned to be aware of expenses when it comes to investment products.  Indexed-bases investment management companies such as Vanguard have contributed greatly to this awareness by consistently demonstrating the detrimental impact that expenses have on investment performance over time, and how actively managed and more expensive mutual funds actually tend to underperform their index-based peers.

Annuity expenses are subject to frequent criticism—particularly in the broader financial media.  While the topic is hugely important, it makes sense to keep a few things in mind when it comes to annuity expenses.

First, remember that annuities are insurance products that serve risk management objectives.  You can’t compare the expense structure of an insurance product to an investment product—it’s like comparing apples to oranges.  It is expensive to create and maintain many of the guarantees offered by annuities, and these insurance protections are not available through investment products.

Second, like any insurance product, only buy what you need when it comes to annuities.  Different annuities serve different purposes, and their expense structures will reflect this.  For example, a straightforward fixed annuity such as a single premium immediate annuity should be significantly less expensive than a variable annuity with living benefit features.  Make sure that you understand and actually need the risk management features that a given annuity affords.

A very approximate range of direct annuity expenses would be zero through three percent.  Again, at the zero end of the range is a simple fixed annuity and at the three percent end is the variable annuity with living benefit riders.

The following are the various components of annuity expenses:  

Insurance Charges

Insurance charges, which are typically in the range of 1 – 1.5 percent—come into play with variable annuity products.  The charges consist of:

• Mortality and expense charges: these charges cover the cost of the insurance guarantees built into the product—specifically longevity-related risk and any death benefits built into the product.
• Administrative charges: these charges cover operating costs of the insurance company.
• Distribution charges: these charges cover financial advisor compensation and related selling costs.

Investment Management Fees

Investment management fees also come into play with variable annuities.  These costs cover the expenses associated with management of the investment products—often mutual funds—in the sub-accounts.  Investment fees for actively managed (versus passively managed index funds) mutual funds are often in the range of 1 percent.

Surrender Charges

Surrender charges or surrender fees are often a feature of deferred annuities.  These charges would be incurred by the annuity owner if the contract is cancelled within the first several years.  Surrender charges often start at 7 percent and decrease 1 percent per year over the course of several years. 

Front End Loads

Similar to certain classes of mutual funds, a front-end load is a charge—typically in the range of 5 percent—that would be imposed at the time the annuity is sold (the “front end”).  Front-end charges are uncommon with annuities. 

Riders and Optional Features

Annuity buyers have many optional features to consider at the time of purchase, and there are costs associated with these options.

Some of these costs are indirect.  For example, the cost of inflation protection or cost of living adjustments (COLA) will often be reflected in lower payouts relative to non-inflation protected products.

In contrast, the living benefit features that accompany variable annuities have direct expenses:

• Guaranteed minimum withdrawal benefit (GMWB): typically cost 40 – 60 basis points (40 – 60 percent of 1 percent) per year.
• Guaranteed minimum income benefit (GMIB): also typically cost 40 – 60 basis points per year.
• Guaranteed minimum accumulation benefit (GMAB): typically cost 20 – 60 basis points per year.

Share Classes

Share classes reflect the expense structure of variable annuity products.  Share classes include: A-Shares; B-Shares; C-Shares; L-Shares, and; X-Shares.   The glossary section of Annuity Digest has detailed descriptions of the various share classes.

Premium Taxes

Certain states impose premium taxes on variable annuity purchases.