How Much Does That Annuity Really Cost?

Costs Always Affect Performance

There really is no such thing as a free lunch and there is no such thing as a financial product, annuity or otherwise, without some costs to produce and provide that product to you, the consumer. The question is, What is the impact of that cost and what is a reasonable cost to bear?

So, what costs are associated with a fixed annuity? Some folks will try to tell you that you don't bear any costs with a fixed annuity, the insurance company pays the agents commissions and any costs related to bringing this wonderful annuity contract to you. While it is true that the insurance company bears those costs, where does the insurance company get the money with which to bear those costs; from you, of course. So, you do have some costs that you should be aware of. This doesn't mean you wont buy that annuity, it just means you will go in with your eyes open and know what the costs are that you are bearing in order to buy the insurance company's guarantees.

Fixed annuities don't have explicit fees, like variable annuities, but they do have implicit fees, which the industry refers to as "spreads."

Consider a person nearing retirement earning 2.5% in a fixed annuity during a period when short term interest rates are 5%. That person would not be getting a good deal since there is an implicit fee (i.e., the difference between the 5% interest rate and the 2.5% annuity rate) of 2.5%. I think that any economist worth his salt would call that (i.e., the spread of 2% to 2.5%) a "cost," and so would any investor if it were disclosed to the investor in an understandable way.

As for the apparent lack of an up-front commission sales charge, do you seriously believe that a fixed annuity is sold without the insurance company paying the agent who sold it? In fact, the insurance company recovers those "phantom" commissions via the series of surrender charges imposed by a fixed annuity. The fact that an investor "technically" doesn't pay up-front commissions in a fixed annuity is merely a distinction without a difference.

So, what can you accomplish with this information? If you are considering purchasing a fixed annuity, compare the current interest rate paid by the annuity company to the interest rate of the short term bonds. Are you really going to get a good after-tax return (only the returns after taxes count) or are the costs of the annuity eating up your returns?

Variable Annuity Costs

• Explicit Costs

Explicit costs include:

1. Mortality and expense fees (M&E) of 1.25%-1.45% of the value of the annuity annually (this is the industry average)... M&E is supposed to cover mortality and expense, but it mostly covers profit. This becomes obvious once you realize that the insurance company actuaries all use the same numbers for mortality. The high cost providers charge 1.25%-1.45% for M&E while the low costs providers charge about .25%-.30%.

Explicit costs also include 2. A mutual fund (in an annuity it is technically a "variable account") annual expense ratio of about 1.50% (this is the cost of the average mutual fund; it includes, for example, investment management fees and 12-b(1) fees). The explicit costs associated with a variable annuity on the low side are, therefore, 2.50% (the M&E fee of 1.00% plus the fund annual expense ratio of 1.50%). The high side is 3.35% (the M&E fee of 1.85% plus the fund annual expense ratio of 1.50%). Both the low side and high side of explicit costs can increase if riders for living benefits are elected--which is being done more and more now. And that is a good subject for another article - more than I can include here.

• Implicit Costs

Implicit costs include:

1. Internal brokerage commissions paid on transactions of .45%. This cost is not included in a fund's annual expense ratio but instead in a separate, obscure document called a "Statement of Additional Information." Implicit costs also include,
2. Bid-ask spread costs (these costs provide a "market maker" with a profit for providing liquidity in a market) of .40% (for the most liquid stocks) to 10.00% (for the least liquid stocks), and
3. Market impact costs of .40% (these costs arise from the impact on the market price of a stock when it is bought or sold). The implicit costs associated with a variable annuity on the low side are therefore 1.25% but can all the way up to more than 10.00%. Let's not forget that many of the mutual funds used in annuities are actively-managed and, therefore, have much higher costs than passively managed mutual funds (i.e., index funds and asset class funds).

The Bottom Line

The total is: Explicit costs of 2.50%-3.35% plus implicit costs of 1.25% (I'll ignore the 10.00%, since that's just too scary) for a grand total of 3.75%-4.60%. Oh by the way, did I mention the

1. Cost of surrender charges,
2. The cost of additional investment advisory services that are included in many arrangements,
3. Commissions received for selling to retail buyers (which being explicit costs are different than the implicit brokerage commissions earned on transactions internal to a mutual fund), or
4. The cost of the increasingly negative compounding effect caused by lost money?

Since some people will claim these costs are exaggerated, therefore let me quote from a randomly selected company, directly from the prospectus of Ohio National Variable Account A of the Ohio National Life Insurance Company ONcore Series of Variable Annuities Supplement to the Prospectuses dated May 1, 2009 in which, on page 8, Summary of Maximum Contract Expenses the Maximum Possible Total Separate Account Expense is listed as 5.45%. This does not include any of the implicit costs referred to above. It also does not include the fund operating expenses listed on page 9 with a range without waivers of .35% to 26.26%!

When you consider that the long term stock market returns are in the neighborhood of 10.5%, how can you really do well in a variable annuity with these high costs dragging down any possible market returns? Income tax deferral won't make up the difference in lost earnings for many many years and maybe never.

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This article was adapted from "Forewarned is Forearmed: How to Make an Annuity Purchase (or not) You Will Never Regret!" To take advantage of Charles Stanley's two decades in the financial advice business, read "Forewarned is Forearmed: How to Make an Annuity Purchase (or not) You Will Never Regret!". Do not become victimized by an unprincipled annuity agent!

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