You might be considering an annuity as part of your retirement strategy. The benefits of tax-deferred growth and a guaranteed income stream in retirement can be quite appealing. But before you commit to putting your initial premium into an annuity, it’s good to know what other costs of an annuity are involved.
Does your annuity come with benefits that have additional costs? Does the base contract have any features that will cost you in some way? How much are you paying for the specific benefits that are provided with your particular annuity contract?
Understanding your options, and their pros and cons, can help you make a well-informed decision. Here, we will discuss the different fees and charges that are assessed by life insurance carriers when they issue these contracts.
Before going further, let’s clarify what an annuity is. An annuity is a contract between an individual and an insurance company. In exchange for an annuity premium, the life insurer makes certain promises in the future. One example is for the annuity owner to receive a guaranteed retirement income stream for the rest of their life.
In this article, we will talk about three main types of annuities: fixed, fixed indexed, and variable.
Fixed annuities pay a guaranteed rate of interest for a set period of time. Your money is backed by the cash reserves of the insurance company.
Fixed index annuities also guarantee your principal. But the rate of interest that you earn in a certain period depends upon an underlying benchmark index to which the annuity is linked. Index gains and losses play into how the interest earnings are calculated, and in periods of loss, the annuity is credited zero percent.
Variable annuities are invested in mutual fund subaccounts, which rise and fall with the markets. Neither your principal nor your interest is guaranteed, but you also have the potential to earn higher returns over time.
What Affects Annuity Pricing?
There are six key factors that play into annuity pricing.
These factors will be discussed below in detail so that you can get a better idea of just how much you are really paying for any annuities that you own or are thinking of owning.
Current bond yields are one of the most important factors when it comes to annuity pricing. They determine the rate of return that life insurance companies earn on their vast cash reserves.
When bond yields are high, then insurers can provide more competitive guarantees and charge fewer or lower fees. People who turn on the income streams with their annuities can get higher payouts when rates are high. When bond yields fall, they will get lower payouts and reduced features or guarantees.
Bond yields generally rise and fall in tandem with interest rates as set by the Federal Reserve Bank. It’s not a bad idea to pay attention to interest rates before you buy an annuity. But just like with the markets, it’s also difficult to time or guess the direction of interest rates as well.
The amount of your initial premium will also help decide the cost of your annuity. Of course, this is factored in on a group basis, as the specific amount of premium that you pay won’t be directly reflected in your annuity.
Life insurance companies will take the gross amount of premium that they collect in a given year and use that number in their cost calculations. When insurance companies collect higher annual premiums, they can offer more competitive guarantees. In lean years, they must offer lower guarantees.
The premiums collected determine the amount of money that insurers can place into their cash reserves. So, the higher the amount, the more interest they can earn.
Mortality rates (or a measure of the number of deaths that happen within a certain time period) are another factor that life insurance companies must consider when assessing costs and fees on annuities.
When mortality rates rise, the financial obligations of life insurers decrease, because there are fewer people left to receive payments. When mortality rates fall, the opposite occurs.
Because of that, life insurance companies pay very close attention to current mortality rates in order to price their products in the most efficient manner. An actuary will tell you that a great deal of statistical information is needed to compute an accurate measure of mortality for a certain demographic of the population. Age and gender are key factors in determining these numbers.
Mortality statistics can vary from one country or even one region to another, so where you live may be a factor.
Business overhead expenses are another item that factors in determining the cost of an annuity.
Insurance companies must pay for reinsurance protection, employee wages, costs of business with their agent salesforce and/or product distribution partners, utilities, rent or mortgage payments, income taxes, and office fixtures, along with a list of many other expenses.
Insurance companies that can run lean and efficiently can keep more of their money in their cash reserves, so their profit margins are higher. This can translate into lower costs and enhanced features and guarantees in their annuity products.
Annuity payout options also play a major role in annuity pricing.
For example, if you decide to receive a life-only payout, then you will receive the highest possible payout from the range of payout options that are available. This is because the insurance company gets to keep any money that hasn’t been paid out when you die. Most annuity owners don’t choose a life-only payout for this reason.
If you choose a joint and survivor payout, then the payout will continue after you die and last for as long as your spouse lives. This option has a lower payout because of the additional income that is paid after your death.
You can also add a period certain to your annuity that guarantees a minimum number of payments regardless of how long you and/or your spouse lives.
For example, say that you opted for a joint and survivor payout with a 20-year period certain. Your beneficiaries will get 20 years’ worth of payments if you and your spouse passed away before receiving any payments. But this additional guarantee will further lower your actual payout because of the reduced risk that you are taking.
Finally, the amount of cash reserves that a life insurer has also plays a role in the insurance company’s annuity pricing.
Companies with larger cash reserves can offer more competitive benefits and lower prices. They are more established.
For that reason, the industry giants can offer more competitive features in their annuity products than many smaller insurers. However, some smaller insurers also offer more competitive features in order to lure buyers. So, be sure to shop around before deciding on which annuity to buy.
A B-rated insurer may be willing to pay higher rates for their products in an effort to build their cash reserves. Just be aware that an insurance company with at least an A rating generally has higher financial strength than one with a B rating.
Different Kinds of Annuity Costs
Now, let’s get back to various types of annuity costs, insofar as the different fees and expenses you may find across annuity types.
Some Annuities Have Costs ‘Built’ into the Contract
In a few cases, you won’t “see” annuity costs in some kinds of annuities, particularly fixed and fixed index annuities.
That is because for these annuity types, these costs are usually built directly into the contracts. Your annuity might have some limits on growth potential, for example, but you also benefit from principal protection.
Annuity Rider Benefit Fees or Costs
However, some fees are visible, such as fees for income riders, guaranteed minimum living benefits, or guaranteed minimum death benefits.
For example, an insurance company may charge 0.95% annually for an income rider with a hypothetical income value that grows at a certain rate, such as 7% per year. This type of rider is common in both fixed indexed and variable annuities.
These add-on benefits may range from 0.25% to 1.25% per year or sometimes more, depending on the rider benefit you are paying for.
All annuities come with a back-end surrender charge schedule. This feature helps insurance companies maintain underlying investments supporting the annuity and also make good on their promises to you and thousands of other contract holders. Surrender charges apply to excess money that is taken out of the annuity before the schedule has ended – or in other words, when the annuity has matured.
Many annuities come with “free withdrawal” provisions, or where they let you take out up to 10% of the contract value without any penalty. Most contracts permit free withdrawals after you have been in the contract for a year. Withdrawals that are in excess of the 10%, however, would be subject to a surrender charge.
Surrender charges tend to apply anywhere from three years to 15 years. A typical contract situation may be that an annuity has a 10-year surrender schedule, and in year 1, the surrender charge is 10%. Each year that you are in the contract, the surrender charge goes down (9% for year 2, so on) until the annuity has matured.
Be sure to find out what your surrender charge schedule is before signing on the dotted line. If your annuity is funded with pre-tax retirement money, most annuities won’t assess surrender charges for required minimum distributions.
More Growth Potential at a Cost with Fixed Index Annuities
Fixed index annuities may give potential for higher interest earnings in exchange for an additional fee. For example, an annuity might let your money earn interest based on a certain percentage of an index’s growth for a certain period.
It may also offer you the chance to earn well over 100% of what the index does – but an annual fee will be required to take advantage of that. For example, one option with one fixed index annuity allows the potential to earn up to 220% of what the index does, but for a 3% annual fee.
In some cases, this fee may be worth it, and in other cases it won’t be. Ask your financial professional for an objective analysis and explanation of the potential pros and cons of this option.
Fees and Charges with Variable Annuities
Variable annuities usually assess more charges than any other type of annuity.
In addition to guaranteed income riders, most variable contracts also offer a guaranteed minimum death benefit of some sort. This rider will guarantee the beneficiary that they will get at least a certain amount when they inherit the contract from the annuity owner.
The amount that is guaranteed may be the highest value the annuity ever grew to or at least the initial purchase amount. The better the guarantee, the more expensive the rider.
Variable annuities charge other types of fees, such as mortality and expense fees, which apply annually and are taken directly from your contract value. This fee pays for the insurance features built into the annuity. A typical mortality and expense fee costs 1.25% per year.
This fee must be assessed because the contract value of the annuity can fall below your initial premium amount if the markets perform poorly. The insurance company must ensure that it can continue to make payments to contract holders if this happens.
Variable annuities also charge investment management fees for the mutual fund subaccounts inside your contract. Individual funds charge these annual fees to pay the portfolio managers of the funds for their services. Investment management fees can range from 0.25% to 2.00% per year.
Annual administrative fees are charged so as to cover the costs assessed by the custodian of your money. A range for administrative fees might be 0.10% to 0.30% per year.
Variable annuities often have annual fees of around 2-3% per year (or higher), while fixed index annuities can have lower fees and/or charges – or even none at all. Fixed annuities generally don’t have explicit fees as part of them, but they also pay the lowest rates of interest of any annuity type.
Other Things to Keep in Mind
In the end, the amount of money that you pay for an annuity will depend upon the number and level of guarantees that you want.
If you want to start a fixed index annuity and get the highest growth potential that is calculated based on a given index’s gains, then it will cost you a rider charge. If you want to invest in a variable annuity in order to get higher returns over time, it will cost you.
The more guarantees and annuity benefits that you add to the mix, the more that you will be looking at in annuity fees and charges. You can talk with your financial professional about your options and what might make sense (and not so) for your situation.
Questions to Ask When Considering Different Annuity Options
Here are a few questions that you should ask your financial professional before committing to any type of annuity:
- Does this annuity have any rider charges built into it, and how much are they?
- If a fixed index annuity, is it worth it to pay an annual fee to get a potentially higher percentage of growth?
- (Variable annuities only) How much are the maintenance fees and mortality and expense charges?
- How long does the back-end surrender charge schedule last, and how much money can I take out without penalty before it expires?
- Which payout option is best for me?
- What is this company’s financial rating?
- How much does it have in cash reserves?
- Why are you recommending this annuity for my situation?
- Please tell me the downsides or cons of this annuity, and why the pros outweigh those.
Your financial advisor can help you find the right type of annuity for you. Don’t be afraid to ask questions and seek clarity until you understand what you are getting into. These are your hard-earned life savings, you deserve to make the most of them.
Are you looking for a financial professional to help you find effective annuity options for your financial goals? Perhaps you want a second opinion of your existing financial strategy or have some questions about your current financial progress for retirement.
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