The Costs of Variable Annuities
Variable annuities are notorious for their expense. Like other types of investment products, there are other costs associated with variable annuities apart from your actual purchase payments (i.e. your original investment).
Before taking out a variable annuity, be sure to understand all of the actual and potential charges the annuity provider charges. You should factor in such costs when assessing the viability of variable annuity investments.
Standard Variable Annuity Fees
The following are some of the standard fees charged by insurance companies on variable annuities:
Mortality and Expense Risk Fee
Remember that in a variable annuity, the insurance company guarantees that your heirs will receive at least the sum of your purchase payments (minus withdrawals) if you die before you start receiving your distributions. In case of a market downturn, the total value of your annuity account may actually be well below your original investment, in which case, the insurance company will suffer a loss. To insure against such a loss, they charge the mortality and expense risk (M&E) charge.
You can't fault insurance companies for insuring themselves against possible loss. However, you should be aware that the M&E charge is a charged yearly and calculated as a percentage of the total value of your account for that year. This is quite expensive, considering the fact that the insurance company's potential risk is minimal. Specifically, the insurance company can only lose the deficit between your actual purchase payments minus withdrawals - the death benefit guaranteed - and the total value of your account.
To illustrate, if your account's value this year is $100,000 and the M&E charge is 1.5%, then your "life insurance" premiums for this year would be $1,500. If your account's value the following year rises to $112,000, your M&E charge for that year would be $1,680. That's one very expensive life insurance! You can certainly find a life insurance product that charges lower premiums than that.
In fact, the M&E charge is the main source of profit for insurance companies offering variable annuities. It is also from the M&E profits that variable annuity sales agents earn their commission.
Like your local bank, insurance companies charge their customers administrative fees. These fees cover the costs of keeping your records straight. This is where insurance companies get the money to pay for their administrative personnel's salaries, administrative supplies' procurement costs, etc.
How much do insurance companies charge their variable annuity customers for record-keeping? It varies from one insurance company to another. Note, however, that administrative fees are always charged yearly. They may also be calculated as:
- a percentage of your account's value, or
- a flat fee.
If you are investing a large amount of money through an annuity account, you should look for a variable annuity product that charges a flat fee (among other considerations, of course). This also true if you intend to invest in high-yield products through your annuity account; in a variable admin fee arrangement, you'll pay more administrative fees the bigger your account's value gets.
Fees Charged by Funds
Variable annuity accounts are invested mainly in mutual funds. As you know, mutual funds charge their investors sales loads, fund management/administrative fees, etc. Who do you think ends up paying for these mutual fund fees? It's certainly not your insurance company. You - the variable annuity owner - pay these fees.
Now, this should not really be such a big issue. You'd have to pay these, too, if you were making a direct purchase of mutual fund shares. The difference, however, is that you also have to pay your insurance company fees (e.g. the M&E charge, optional features charges). The costs of your actual investments on top of the fees charged by your insurance company make investing in mutual funds through variable annuities more expensive than making a direct investment in the same funds.
Potential Variable Annuity Fees
While the above fees are always charged by insurance companies, the following fees do not always apply. They are incurred only in special cases, say, when you opt for an extra benefit or when you surrender your variable annuity.
Extra Feature Charges
Some variable annuities are very attractive because of their value-added features like long-term care insurance, minimum income/distribution guarantees and stepped-up death benefits. You should know, however, that such attractive features actually mean additional fees as well.
In some cases, the fees for extra features are included with the M&E charge - i.e. you're charged a higher M&E rate. In some cases, they'll be declared as separate charges that you have to pay for annually. In any case, variable annuities with extra features are always more expensive than variable annuities without such features.
Therefore, don't be feature-happy and activate any of the optional "benefits" in your variable annuity product unless:
- you really need them, and
- you're sure you can't get comparable benefits by purchasing a cheaper stand-alone product.
Variable annuities are associated with mutual fund investments. Such investments are not as liquid as cash or cash equivalent assets. Thus, a variable annuity customer summarily deciding to withdraw a large part or all of his money from his annuity account places his annuity provider in a tight spot.
To protect its liquidity, insurance companies stipulate a "surrender period" in their variable annuity contracts. During the surrender period, typically a period of several years, a variable annuity account comes with a yearly renewed maximum withdrawal limit (e.g. 10%). If, within the surrender period, an annuity account owner makes a withdrawal that is larger than the allowed maximum, he will have to pay surrender charges on this withdrawal.
Surrender charges are a percentage of the amount exceeding the allowed withdrawal maximum. They also decline throughout the surrender period. In the first year, surrender charges can be 8%. In the following year, it can be 7.5%. In the third year, it can be 6.5%, and so on and so forth.
To illustrate, suppose you have an annuity account that you opened through a lump sum investment of $30,000. You have a surrender period of 8 years, and every year within this surrender period, you are allowed to withdraw 10 percent of your account's face value without incurring a surrender charge. Surrender charges are at 8% in the first year, 7% in the first, 6% in the third, and so on - declining 1% every year that goes by.
Let's say that during the annuity's second year, its value has risen to $33,000 but you wish to make a withdrawal. If you don't want to incur a penalty charge, you must withdraw only up to $3,300. If you withdraw $10,000 from your account, you will incur the 2nd year surrender charge of 7% on the amount of withdrawal exceeding the $3,300 limit. That's 7% of $6,700 or $469.
Variable annuities have a tax deferral benefit because they are meant to serve as alternative retirement plans. Thus, annuity account holders who withdraw their money from their account before they are 59 and ½ years old may actually be charged a federal penalty tax of 10%.
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