Variable annuity contracts are generally more expensive than mutual funds. The richer the guarantees carried by a contract, the higher the corresponding costs will be. Fees are charged on account value.
Deferred variable annuity contracts will generally charge:
An administrative fee (typically from 0.10 to 0.25%). This fee covers reporting, generating reports, online security and account access. Administrative fees may be waived for accounts with initial balances of more than $1 million.
Mortality and expense fees (typically ranging from 1.0% - 1.5%). These fees are used to provide insurance death benefits if the contract holder passes away and to compensate the insurance company for risks associated with holding the contract.
Mortality and expense fees will vary based on how much the insurance company has promised to pay at the death of the owner. Simple death benefit options, such as promising to return the current account balance to the contract owner at death, will have lower mortality and expense charges (0.5 – 1.0%) than those promising more sophisticated death benefits (such as a multiple of the contract premium), or elaborate calculations taking into consideration the highest contract value on specific contract anniversary dates (1.0% - 2.0%).
Fees for any additional optional benefits. These benefits, such as guaranteed minimum returns or sustainable lifetime withdrawals, will add to the cost of a contract. While additional features vary widely by insurer, they can generally be pooled into “income” related features, “death” related features or “access” related features.
Income feature fees guarantee that a cash flow stream from the contract will continue uninterrupted regardless of market fluctuation. Income features vary dramatically by insurance companies but generally range in annual cost between 0.5 – 1.5%. Consumers who do not currently need withdrawals from the annuity contract should consider their options carefully before purchasing this type of benefit.
Death feature fees are generally wrapped into the mortality and expense charges of a contract. The simplest death benefit is a return of the initial premium paid to the insurance company. More complicated features promise an elevated death benefit of some sort. Death provisions can be complicated and are often not needed by consumers using annuities as an investment and retirement tool.
Access feature fees ensure access to your funds, enabling you to withdraw account dollars free of any early withdrawal penalty in the event of a terminal illness, disability or long-term care need. Access features may be standard in some contracts but may carry additional cost in others.
In addition to these fees, variable contracts will also charge direct or indirect asset management fees. All totaled, a deferred variable annuity will typically range in cost between 1.75% annually, for a contract with few bells and whistles, to as much as 4% annually, for a contract with income and death benefit guarantees. 1
Variable annuity Payout Phase
The scenario of a $1,000,000 Variable Annuity purchased at age 65 with an annual payout of 5% per year for life, or $50,000 in annual payments for life, starting immediately also illustrates the payout phase for a deferred variable annuity that has built up $1,000,000 in principal before lifetime income payments of 5% start at age 65.
Assuming 4% in total fees, an additional $40,000 in payments is paid out annually to the insurance company, which effectively requires the variable annuity to earn at least 9% per year in order to maintain a million dollar balance. Any return below that level will chip away at your principal. 1
Variable annuity contracts do not protect the principal against market losses, so a drop in principal can come when an account pays out more than it earns but also can result from losses to the market value of the portfolio. This means that extreme market losses as experienced most recently in 2008 can cut a portfolio’s value in half within a short period of time, or 5 years of low earnings, say at 5%, can eat away $200,000 of your principal, leaving only $800,000 in the account. If earnings are only 1% over 5 years, the resulting principal balance will be only $600,000 simply due to fees and payouts. Once principal loss occurs, that 9% earning requirement will grow. For example, if the portfolio balance drops to $500,000 then the minimum return requirement would be 16% just to maintain the new $500,000 principal. 1
It’s important to keep an eye on fees when earnings can change over the 20 to 30 years of modern retirement. Morningstar’s 2013 recommendation to reduce the annual 4% withdrawal rule to just 2.8% is a result of retiree’s longer life expectancy. 2
While there are some variable annuities that offer lower fees, the reduced fees in one area, they may come at the cost of more expensive investment options so consider the total of all fees together. 3
The video below can help you understand more about the fees associated with variable annuities.
Citations.
1 - kiplinger.com/article/retirement/T003-C032-S014-7-myths-about-variable-annuities.html
2 - morningstar.com/videos/582877/time-for-the-3-withdrawal-rule.html
3 - kiplinger.com/article/retirement/T003-C032-S014-how-to-avoid-hidden-costs-of-variable-annuities.html