Annuities and their Associated Costs

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Another Look at Expenses

By Rick Kahler MS CFP™

Rick Kahler MS CFPAnnuities are popular investments; almost every new physician or other client I see has one. Part of any investment adviser’s due diligence is to understand the history and intentions of the investments in a portfolio.

When I ask why someone purchased an annuity, the most common responses are: “We didn’t have to pay any fees or commissions.” “There are no ongoing expenses.” “All my money is working for me.” “The principal is guaranteed.”

Warning … Warning!

Any time you read or hear “no fees,” “no commissions,” “no expenses,” “free,” or “guaranteed” used in conjunction with an investment, it’s a red flag. All investments, including annuities, have costs associated with them. You need to ask some probing questions about those costs before proceeding.

Fixed Annuity Example

Let’s look at the costs for one popular type of annuity, the fixed annuity. This simply gives you a stated rate of return that often can change annually, similar to a bank certificate of deposit.

Suppose Investor A is sold a fixed annuity with a guaranteed return of 3.5%. Investor B invests her money in a plain vanilla portfolio of mutual funds holding 60% stocks and 40% bonds, which has a long-term projected return of 6%.

The insurance company selling the annuity must earn enough of a return on Investor A’s money to cover their expenses, pay commissions, and return something to Investor A. There is no magic formula on how that’s done. The insurance company invests the money in the same asset classes available to anyone. For the sake of this example, it’s reasonable to assume the insurance company would hold the same 60/40 portfolio as Investor B.

The annuity incurs internal costs for administration, managing the money, insuring the return of principal, and commissions paid to salespeople. While these vary somewhat from company to company, a cost of 2.5% isn’t unreasonable.




If the company earns 6% and deducts 1% to recoup the upfront commission paid to the salesperson, 1.0% for management costs, and 0.5% for administrative fees, they pay out the remainder as a “fixed” return of 3.5%. Investor A only sees that 3.5% fixed return. If Investor A wants out of the policy before the cost of the up-front commission is fully recovered (usually 4 to 15 years), he will also incur a “surrender penalty” that is approximately equal to the remaining amount of commission paid to the broker selling the policy.

Investor B’s 60/40 portfolio will have the same 6% gross return as the insurance company’s portfolio. If Investor B purchases index funds from a company like Vanguard, her costs could be as low as 0.10%, leaving her a return of 5.9%.

Suppose Investors A and B each accumulates $1 million in retirement funds. The difference between Investor A’s guaranteed 3.5% return and Investor B’s average and unguaranteed 5.9% return is potentially an extra $2,000 a month in retirement income. Guarantees come with a cost.

Why Bother?

Given these numbers, you may wonder why anyone would purchase a fixed annuity? Why bother?

One reason is that many buyers don’t have the confidence that they can invest the money wisely or the stomach to watch the portfolio’s inevitable peaks and valleys.

Another reason is that most buyers don’t fully understand the costs.


Unlike stocks, bonds, and mutual funds, most annuities are sold, not bought. I have never had a new client who independently purchased a no-load annuity. The annuities I typically see were sold by someone who received a commission. Commissions are not inherently bad, but in most cases they do inherently create a conflict of interest.

There are always fees associated with any investment. In my experience, the less transparent those fees are, the higher they are.


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5 Responses

  1. Some Insights on Variable Annuities

    The “benefits” of a variable annuity usually cost around 1.4 percent of your balance each year, plus money management averaging around .60 percent. If you invest in the average mutual fund at 1.4 percent per year, you would save .60 percent per year. The issue you need to decide is if the .60 percent provides enough benefits to be worth the cost.

    Most studies focus on an analysis comparing tax deferral versus mutual fund investing, not on the other features. This has become more of an issue with the reduction in capital gains rates to a maximum of 20 percent versus the ordinary income from the annuity.

    Unfortunately, this analysis is subject to the variability of mutual fund taxation from fund to fund, as well as how long you hold your fund without selling. One often ignored advantage of variable annuities is the ability to make changes in your investments without incurring any additional tax.

    According to a Morningstar Study of January 2001, the average domestic equity mutual fund lost 21% of its return to taxes over the prior 15 years.

    Using this example, $10,000 growing for 20 years in a taxable mutual fund at 10 percent (7.9 percent net) will be worth $45,754 while the annuity would be worth $60,304 (9.4 percent net). In 5 years, the taxable fund would be worth $14,625 versus the annuity at $15,670.

    No matter how you analyze this, here are some general rules:

    1. You might consider variable annuities with after tax money after you’ve completely funded your qualified plan and IRA options.

    2. Look for contracts with minimal surrender periods, meaning you can take your money out without penalty in a short time.

    3. Consider the value to you of the additional features, such as riders, and only buy those you feel are worthwhile. Every additional feature adds cost to your annuity. As in all investments, watch your expenses.

    4. Look for additional expenses: Contract charges as well as Mortality & Expense charges are added to your annuity.

    5. Internal fund expenses need to be monitored.

    6. Sometimes there are limitations how many times you can make inter fund transfers.

    7. Strength of the issuer and rating.

    Dr. David Edward Marcinko MBA


  2. Know your annuity costs

    Rick – One way to keep your annuity costs low is to consider a Vanguard Variable Annuity, issued by Transamerica Premier Life Insurance Company and, in New York State only, by Transamerica Financial Life Insurance Company.

    With an average expense ratio of 0.56%, the Vanguard Variable Annuity’s costs are more than 70% below the annuity industry average of 2.25%. That difference can save you an average of $1,700 a year in fees for every $100,000 you invest.

    The Vanguard Variable Annuity offers a diverse lineup of stock, bond, and money market portfolios, many of which are index-based. The low expense ratios of the underlying investments help to keep your costs down.

    You’ll also save on commissions and surrender charges. The Vanguard Variable Annuity is sold directly to you, so there are no commissions or purchase fees. You can exchange money tax-free among portfolios without incurring transaction fees, and there’s never a surrender charge if you decide to move your contract. This combination of factors helps keep your annuity costs far below the industry average, and keeps more of your money working for you.



  3. Guaranties?

    My first at bat in Little League baseball didn’t go well. I was hit in the head with an errant pitch. Every at bat thereafter, I would close my eyes and flinch when the ball came whizzing by. Needless to say, my baseball career was short-lived.

    Today, I have a similar internal flinch whenever I mention annuities or whole life insurance in a column. I know that comments from insurance salespeople casting aspersions on my IQ and my character will start whizzing into my inboxes.

    Admittedly, I am no fan of most “investment” products sold by life insurance companies. I believe most life insurance companies do a great service providing low-cost term life insurance and a big disservice promoting high-cost, low-return investment products. Life insurance salespeople disagree with me about my views, and they let me know it.

    Recently I wrote a column with the premise that, outside of a FDIC guaranteed bank account of up to $250,000, there is no “guaranteed” investment. My point was that only the Federal Reserve Bank, which owns the ability to create dollars at will, can be the ironclad guarantor of any dollar based investment. I flinched when I included annuities and whole life insurance in my list of non-guaranteed investments.

    Predictably, commenters told me I was wrong, that insurance companies routinely guarantee their returns on fixed annuities and cash value life insurance. Knowing that a guarantee is only a good as the company behind it, I dismissed the comments until one brought up a point I had not considered.

    This person wrote, “If an insurance company goes bankrupt the South Dakota Guaranty Association guarantees payment up to $250,000.” He is right; any annuity licensed to be sold in South Dakota is guaranteed for up to $250,000 per company by the South Dakota Life & Health Insurance Guaranty Association (SDLHIGA). If you own three annuities, each worth $200,000, issued by the same company, only $250,000 is covered by the SDLHIGA.

    What is the SDLHIGA? It’s a private association created by the SD legislature comprised of every life and health insurer licensed in South Dakota. All 50 states have similar associations. The SDLHIGA is not a state agency, nor does is have the power to access any state funding.

    If an insurance company that sells annuities or any life, health, disability, or long term care insurance files for bankruptcy, the SDLHIGA can ultimately take over funding the obligations of the policies. Payments are subject to a cap of between $100,000 and $500,000, depending upon the type of policy. You can view a complete list of the types of insurance covered and the limits at or call the SD Division of Insurance at 605-773-3563.

    While not a government guarantee, the SDLHIGA guarantee is certainly strong, as it is backed by all the member insurance companies. The downside to the guarantee is that your money will be “locked up” while the bankruptcy and receivership process wends its way through the courts. It could take at best months and often years before you would be able to receive your proceeds.

    You may wonder why you’ve never heard of the SDLHIGA. That is because SD law prohibits insurance agents and their companies from using the guarantee in any advertising or as an inducement to buy life insurance products.

    Despite the guarantees offered by the SDLHIGA, it’s still important that you protect yourself by researching potential investment products and only buying from financially sound companies. Guarantees are no substitute for doing your own due diligence as part of taking responsibility for your own financial well-being.

    Rick Kahler MS CFP™


  4. Annuity Payouts Decline

    Did you know that insurance companies are now [finally] adopting new mortality tables that show people are living longer (three additional years for men, to 88.5 years; and two additional for women, to 90.3 years).

    This requires insurers to offer guaranteed lifetime payments for a longer period overall, and that means they have to offer lower lifetime income streams to remain profitable.

    Dr. David Edward Marcinko MBA CMP


  5. FEES

    Each 1% in investment fees reduces an investor’s end-return by approximately 8% over ten years and 17% over twenty years. At fees between 3%-4% a year, investors would be facing losses of 24%-32% over ten years and 51%-68% over twenty years.

    Since variable annuities come within the SEC’s new Reg BI, wonder how the potential loss of over one-half to two-thirds of an investor’s end-return fits within Reg BI.



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