While I discussed a variety of ways that insurance companies manage the risks around supporting lifetime income guarantees, fees are the headline mechanism for managing the guarantee risk. Fees can be used to purchase financial derivatives and support other forms of risk management for the guarantee.
Deferred variable annuities generally have several types of ongoing fees. The first relate to the underlying funds expenses that would be included with any mutual fund investment. The only issue to consider here is whether the funds within the subaccounts have elevated fees due to the inclusion of 12b-1 fees in their expense ratios, and whether investment options available to the individual outside of the variable annuity also include 12b-1 fees as well. These fund fees are charged on the contract value of underlying assets and would end if the contract value depletes.
The second type of fee relates to mortality and expense charges for the insurance company. These fees help to support the risk pooling needs of the insurance company as well as basic annuity death benefits (such as the return of the contract value or the total premiums paid into the annuity not yet received as distributions, whichever is higher) and also help to cover the costs of business and to support the profit needs of the company. These fees are also generally charged on the contract value of assets. The annuities may also have a small fixed annual fee as well, at least for accounts with lower balances.
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A third type of fee that may exist temporarily are contingent deferred sales charges (or surrender charges) for those seeking nonlifetime distributions above the allowed level in the early years of the contract. Surrender charges receive much of the criticism related to the fee levels for variable annuities.
Variable annuities are liquid in that they may be surrendered with the contract value returned as an excess distribution above the guaranteed distribution level. But in the early years of the contract, surrender charges may limit the portion that can be returned without paying a fee. For instance, surrender charges could work on a sliding scale basis starting at 7 percent in the first year the annuity is held, and then gradually reducing by 1 percent a year down to zero after the seventh year that the annuity is held. In this case, after the seventh year the surrender charges end, and the contract value will be fully liquid in all subsequent years.
The purpose of these charges is to help the insurance company offset the large fixed costs involved in setting up a new annuity contract that can otherwise only slowly be offset through the ongoing mortality and expense charges of the annuity over longer periods. The largest of these fixed costs is the commission paid to the adviser selling the variable annuity. Surrender charges would not be charged on any guaranteed lifetime distributions, and often variable annuities allow free annual withdrawals of up to 10 percent of the assets before surrender charges begin. Surrender charges may also be waived for required minimum distributions when held in qualified retirement plans.
Newer variable annuities designed for noncommission advisors will generally have lower fees in part because the advisor will charge for their service separate from the annuity rather than being paid through the annuity. There is no longer an upfront commission to be paid by the insurance company. Mortality and expenses fees should also be less for these no-commission variable annuities since a portion of the fees is no longer siphoned off to pay the advisor.
Rightly, the insurance company can offer these annuities as a lower-cost option to consumers. However, consumers must monitor whether ongoing charges from their financial advisor taken from outside of the annuity may offset the lower costs within the annuity. Financial advisors will be paid somehow, such that while shifting these fees from being collected within the annuity to moving directly to the advisor outside the annuity will reduce the internal costs to the annuity, it may or may not reduce the overall costs for financial tools and advice for the end consumer. There are exceptions, but variable annuities are rarely sold directly to consumers; most variable annuity sales require the involvement of a financial advisor. One final point here is that by lowering the internal costs to the annuity, there is a greater opportunity to obtain step-ups and more lifetime income from the annuity.
Finally, optional riders providing living benefits through a lifetime withdrawal guarantee or a stronger than standard death benefit guarantee require an additional ongoing charge. The rider is charged while the contract value remains positive. Rider charges end after the account is depleted and the guaranteed benefits continue to be made with insurance company resources.
Rider charges can be confusing because they may be charged in three different ways. The most expensive option is to have the rider charged on the benefit base. As the contract value approaches $0, this will increase the rider cost as a percentage of remaining assets and work to deplete the contract value more quickly. Two other options include charging the rider on the contract value of assets and charging the rider on a declining benefit base equal to the benefit base less cumulative guaranteed withdrawals. Charging on the contract value could be more expensive in scenarios with market upside and strong growth for the contract value, while charging on the declining benefit base could be more expensive if the contract value declines quickly and if there is a long deferral period.
For these optional riders, it is clearly worthwhile not to pay for riders that you do not intend to use. It is often counterproductive to pay for strong income guarantees and strong death benefits on the same variable annuity because these benefits are often at odds. It is also important to keep in mind that most variable annuity contracts allow provisions for these fees to be increased (or decreased) and one should take note of the maximum possible charges allowed by the contract.
With these various fees, it is possible that total variable annuity fees could add up to three to 4 percent. This, along with surrender charges, is how variable annuities have developed a reputation as being a high-cost financial product.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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