The Hidden Costs of Variable Annuities and How to Avoid Them
When people seeking guaranteed income turn to annuities, they are gaining security … but they need to realize what it's costing them. Surrender charges, fees and earnings caps all come into play.
Annuity sales are escalating, with people looking to roll over retirement savings accounts or other assets into an ongoing income stream. Variable annuities appeal to people because they offer mutual fund investment choices, locked-in gains (or protection from bad market years) and death benefits.
The cost issues on some annuities
Variable annuities, especially expensive riders, may trap you with high fees, income caps and surrender charges that eat away earnings. For example, the guaranteed income stream options typically attract rollover investors, but can be expensive over time. The cost for these guarantees can vary greatly by insurer, but they typically cost from 1% to 1.5% of the total invested year-in, year-out. There are exceptions, so it is important to know areas to watch:
- Surrender charges: All annuities impose penalties on those who switch out of them within a specified period (typically up to eight years with decreasing annual amounts). The insurance company charges these penalties so they can recoup the initial cost of the annuity, which could include a sales commission to whoever sold it. Since many are purchased by retirees for immediate access to funds, they often allow a small amount (usually under 10%) be withdrawn annually.
- Mortality, expense and administrative fees: The insurance company will deduct a flat maintenance fee or a percentage of the total value annually to cover record keeping and administrative expenses. The industry average for mortality and expense fees runs about 1.25% but can be much higher, and administrative fees are typically about 0.15%.
- Underlying fund fees: Investors also pay management fees or expenses imposed by the sub-accounts that make up their investment options. Much like fees on 401(k) options, these vary widely, with index options being among the lowest.
- Fees for additional features: Special features on annuity products all add fees. An investor may pay a small amount for additional death benefits or a cost-of-living annual increase provision, but these costs add up: another 0.6% or more in fees to be exact.
- Earnings caps: While some annuities set floors on market performance so investors' value cannot go down, they usually also have an earnings cap that limits upside potential in good market years. For example, a fund with a 12% cap will only earn that much even if the underlying investment earns 30%.
- Tax deductions: Another rarely discussed downside to annuities is that the investment management fees and other charges are not tax deductible as they would be on other investment accounts. The IRS views them as insurance contracts and fees for things like riders as premiums.
Newer, low-cost options
Variable annuities do offer huge benefits, particularly for those afraid that annual distributions from their 401(k)s will not last throughout their lifetime. Nowadays, there are some variable annuities with lower fees. Low-expense products sold through advisers are currently available from Ameritas, Jefferson National (now part of Nationwide) and TD Ameritrade.
The difference in fee structure can really have a compounding impact over time. For example, Jefferson National's Monument Advisor product has a flat annual fee of $20 per month. A typical variable annuity with a mortality and expense fee of 1.35% would charge about $3,000 annually for an account with a value of $224,000. The Monument Advisor's annual cost of $240 saves about $2,700 a year. Over time, that difference has a considerable impact on someone's retirement income.
An annuity can be a good idea for many people if they look at the costs in totality and work with an adviser who wants to help, rather than make a quick sale.
Comparing costs annually and over time is important. For example, one annuity may feature lower mortality and expense charges than another annuity, but that product may have more expensive investment options.
Consider working with an adviser who is fee-based, as opposed to someone earning a commission. While both may be reputable — and the Department of Labor's new fiduciary standard requires them to put the client's interests first when dealing with retirement accounts — it’s better seeking advice from someone who has less of a personal financial stake in the decision. Additionally, seek someone who considers family finances in totality in the discussion.
Lastly, people do more comparison-shopping when buying an appliance or car than a financial product. However, annuities and other retirement investment choices will undoubtedly have the bigger impact for years to come. Before buying a variable annuity, check the prospectus or other available information about fees, and be sure it is the right choice. Annuities can be complex products to understand. Be sure to ask questions and compare alternatives.
Tyler Harrison’s white paper “Building An Efficient Plan: An Overview of the Evolving 401(k) Landscape" is now available. You can download the full version here.
About the Author
Tyler Harrison, Fiduciary Adviser, AIFA
Founder, Efficient Plan, LLC
Tyler Harrison is an Accredited Investment Fiduciary Analyst (AIFA®) who has been working in the banking and finance field since 2005. Through his work as an independent Investment adviser, Tyler noticed an industrywide need for honest, transparent and conflict-free service within the niche of corporate retirement plans. Aspiring to be the change, Tyler founded Efficient Plan in 2013, an investment advisory firm focused on corporate 401(k) plans and fiduciary services.