Understanding Annuity Costs

There have been enough written and said about annuities to know that they do include certain costs that you wouldn’t ordinarily encounter with other types of investment products. Still, it is interesting that annuity critics try to illustrate cost disparities by comparing them with the other products. It’s not a fair comparison considering that annuities include many features and guarantees not found in other products, so there really is no equivalency. People buy annuities because they are looking for more guarantees, more safety, less taxes and, generally, more assurance that their savings or income will be there even if all heck break loose around them.  There is significant economic value and psychic value to that proposition which, for many people, far outweighs the additional costs.

Value vs. Cost

Volumes have been written in attempts to define “value” in the context of consumer decision-making.  While no standard definition emerges, the consensus among consumer behaviorists is that it is formed individually as a perception based on a personal frame of reference.  Perceived value is enhanced when a person feels that the benefits he or she receives exceed the monetary sacrifice in terms of money, time, and energy.  Most experts agree that perceived value equates to an emotional payoff for the consumer, which, if it is high, will lead to an entrenchment of favorable attitudes toward a product or service.

 

As with any type of product, investment or otherwise, it is always important to weigh annuity costs against the value received.  Annuity costs are transparently presented to prospective buyers through sample annuity contracts and prospectuses. It is up to the prospective buyer to determine whether these additional costs are a fair exchange of value for the additional benefits they receive in their annuity investment.  Essentially, prospective buyers need to determine how valuable annuity features are in addressing their own concerns, preferences and priorities. Specifically:

How important is it that my principal be protected for my family? Survivors of the market crash of 2008 may be asking themselves, “what if I had died and my family received just a fraction of my investment?” Annuity owners are assured that their family survivors will receive at least their principal investment, and in most cases, the gains in the account value regardless of the market performance.

How important is it that I can rely on a minimum amount of growth on my investment? Investors who struggled through the lost decade of 2000 to 2010 in which stocks returned an anemic 1.5%, probably wished they had a fixed annuity that returned, on average, 3.8%, or an indexed annuity that returned, on average, 4.6%.  And, looking into the uncertainty of the current market, they may be wishing for more stable returns.

How important is it for me to sleep at night knowing my principal is safe?  If you ask any of the customers of the more than 500 banks that failed in the economic crisis how well they slept, you may get stares from bloodshot eyes.  Life insurance companies are still the strongest and most financially stable of all financial institutions, and the regulations that govern their financial management are much stricter than those that apply to the banks.

How important that is it that I can count on an income that I can’t outlive? Just ask three out of four Baby Boomers who, by their own admission, are very concerned with the possibility of outliving their income.

Weighing the Costs

The perceived value of an annuity can only be measured by the individual addressing these concerns.  With that, the costs can be considered in the context of the value received.

Mortality and Expense Charges,

All annuities are essentially insurance contracts. They include a death benefit, and, in the case of an immediate annuity, a lifetime income guarantee. The mortality is the risk cost to the insurer in guaranteeing these benefits.  Additionally, the insurer deducts a portion to cover its administrative and marketing costs. The total mortality and expense charge typically ranges from 1 to 1.5 percent.

Investment Management Fees

With variable annuities, the accumulation account is comprised of separate investment accounts, similar to mutual funds. Fees are charged for the professional management of the accounts. As with mutual funds, the fees are higher for more actively managed accounts such as growth stock accounts. Fees range from .5 percent for bond accounts to 1.5% for aggressively managed accounts. These fees are generally in line with the fees charged in mutual fund accounts.

Surrender Charges

Even though investors look to annuities as long term investments, they take comfort knowing that, should their circumstances change, they can still access their funds if necessary. Deferred annuities include provisions which allow for annual withdrawals without charge if they don’t exceed 10% of the account values. Excess withdrawals are charged a surrender fee of 5% to 10% initially. The fees decline by one point each year of the contract, so that, at the end of the surrender period, there is no charge.  Most long term investors can live with this, but there is value in knowing their funds are available.

Optional Features and Guarantees

Annuities offer additional options that can enhance the guarantees, such as inflation riders, or principal step-up options. Generally, these options come at an additional cost. Consumers are used to evaluating extra features to determine if their value outweighs the costs.

Summary

Yes, annuities have costs, more so than other investment products. But they also provide economic value and psychic value not available in some of the other products. Consumers today are looking for greater emotional payoff in their investment products, and they are savvy enough to measure the costs versus the long term payoff.  Some won’t perceive the value as great enough to outweigh the costs, while others will. That’s what the free market is all about.