At Capital Investment Advisors, we often meet with investors who previously purchased an annuity and want to know, “How much am I really paying for my variable annuity?” As fee-only investment advisors, we are constantly reminding our clients to be sensitive to investments with additional fees on investment performance. And, quite frankly, it’s hard to find investments more expensive than a variable annuity. That said, if you already hold a variable annuity or if you’re considering purchasing one, it’s important to understand what they are and their true cost.
What is a variable annuity?
A variable annuity is an insurance contract that is a tax-deferred retirement vehicle that allows you to choose from a selection of investments, and then pays you a level of income in retirement that is determined by the performance of the investments you choose. These investments are similar to mutual fund investments, only they are called sub-accounts. The contract value of the annuity is determined by the underlying investments held in stock or bond sub-accounts.
What does a variable annuity really cost?
While we already discussed the contract value of the annuity above, there are also a couple of additional fees.
First, investors in a variable annuity are charged for “mortality and expense” (M&E), which usually runs from 1 percent to 1.75 percent annually. There’s a running joke in the annuity industry that refers to this fee as the “meals and entertainment” fee!
Second, there are “sub-account expenses” which apply to the individual investments within the annuity. These fees are usually 1 percent or higher. Both of these fees are hidden within the annuity and deducted from the account value on a daily basis. As such, it is difficult for most investors to determine what they’re actually paying in total expenses.
The additional bells and whistles
In addition to the M&E expense and sub-account expenses, most variable annuities are purchased for the additional “bells and whistles” you can have added to your annuity contract… for a fee, of course. Additionally, I say purchased because most annuities are sold, not bought. There are many different features and benefits you can add to annuity contracts, some of which I’ll cover in another post, but the most popular are “Guaranteed Income Benefits.”
Basically, these features guarantee either you, or you and your spouse, receive a minimum amount of income each year. For this “income insurance,” the fee typically starts above 1 percent and can approach 2 percent. It’s important to understand that this fee is a hard charge against the account value (accumulation value) and is usually a percentage of the benefit value on your annuity. As such, in a declining market this fee becomes a larger and larger percentage of the account value!
If that were not enough, most annuities also come with surrender charges. A surrender charge means that if the annuity is cashed in before a specific period of time the purchaser will pay an additional charge. Typically, the surrender charge on variable annuities start at seven years and can run much higher. You can invest in an annuity with a shorter surrender charge, however, you’ll pay even higher fees for the early liquidity. If you need access to your investments during the surrender charge period, you will pay a surrender charge, usually starting at around 7 percent, on the total amount withdrawn.
Bottom line, an annuity is a contract between you and an insurance company. Annuities can be a useful investment if used properly. However, before you purchase one you should ask yourself, “How much am I really paying for my variable annuity?” Be sure you understand how much it really costs before signing on the dotted line. If you’ve invested in an annuity that’s charging you north of 2 percent or greater, it may be time to consult a fee-only investment advisor to get an unbiased opinion.