Annuity Fees and Expenses

Just like other investments -- good and bad -- annuities have fees and expenses. What distinguishes them from most good investments, however, is that annuity fees are quite high. For this reason alone, annuities generally receive heaps of bad press -- and at least in this limited regard, we're siding with the mainstream conventional press. To be fair, we'll mention that costs do vary from product line to product line and company to company, and that variable annuities have more features than fixed annuities, so fees and expenses within a variable annuity are generally higher than those found in fixed annuities.

A shopping list of the types of fees that go into annuities is as follows:

1. Mortality and Expense Charges
   The first fee typically imposed by an annuity will be what's known in the industry as a "mortality and expense" (M&E) charge. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the contract. In general, these fees in a variable annuity will be charged as a percentage of the average value of the investment and will probably be quoted in terms of "basis points." A basis point is 1/100th of 1%. Thus, an M&E charge of 115 basis points means a fee of 1.15% will be assessed against the value of the investment. According to the National Association of Variable Annuities (NAVA), the industry average M&E in 1997 was 1.15%. In a fixed annuity, these charges are usually incorporated in the insurance company's determination of the periodic interest rate or the annuity payment amount during the distribution phase.
   
2. Surrender Charges
   The existence of surrender charges should alert many a Fool that annuities are something to be treated with skepticism. Many annuities will impose a surrender charge if the annuity is cashed in before a specific period of time. That period may run anywhere from 1 to 12 years. A typical surrender charge is one that starts at 7% in the first year of the contract, and declines by 1% per year thereafter until it reaches zero. The charge is made against the value of the investment when the annuity is surrendered, and its purpose (other than simply to make money for the insurance company) is to discourage a short-term investment by the purchaser. For that reason, an annuity should always be considered a long-term investment. In the typical fixed annuity, though, this charge will not apply provided no more than 10% of the investment is withdrawn per year.
   
3. Management Fees
   Management fees on subaccounts are assessed by variable annuities, and they are the same as an investment manager's fees in a mutual fund. These fees will vary depending on the various subaccount options within the annuity. In general, they will be somewhat less than those charged by a managed mutual fund within the same investment category -- though not necessarily. According to NAVA, the 1997 industry average for subaccount management fees was 82 basis points, or 0.82%. That's somewhat lower than many managed stock mutual funds, but it's over four times that of an unmanaged stock index fund like the Vanguard Index 500, which only charges 18 basis points. Also, just as an aside, the returns published by an insurance company for its annuity subaccounts will be the net returns after all management fees have been deducted. So, just as a mutual fund's stated return does not reflect the impact of any sales commissions, the subaccount return does not reflect the impact of M&E charges that have been assessed against the investment.

Conclusion

The fees and expenses imposed by annuities indicate they are undoubtedly costly to own, and they absolutely are not meant for the short-term investor. Get out early, and the surrender fees could swallow a large hunk of cash that would take years to recover in a taxable alternative. Additionally, of the over 11,000 mutual funds in existence in 1999, expenses exclusive of loads average between 1.2% and 1.5% (depending on which study you use) compared to the nearly 2% in management and M&E fees charged by the typical variable annuity. For no-load funds, expenses average only 90 basis points, less than half that of the average variable annuity.

Assume you are a long-term, buy-and-hold investor who wishes to invest $20,000 in either a taxable S&P 500 index fund or a similar S&P 500 index subaccount with identical expenses within a tax-deferred variable annuity. Assume the investment in either option will earn an average annual return of 11.2%, of which 4.5% comes from dividends. In the taxable account, you will pay income taxes on dividends as received. The annuity will impose an M&E charge of 1.15% each year. Which investment will give you the most money after taxes at the end of 20 years?

After paying income taxes at a marginal rate of 28% on your annual dividends, the taxable account would have a net annual return of about 9.9%. At the end of 20 years, the investment would have grown to $132,125. Your long-term capital gain would be $112,125 taxable at 20%. After paying your tax of $22,425, you would be left with a total of $109,700.

The annuity would have a net annual return of 10.05% after the M&E charge (11.2% -- 1.15%). At the end of 20 years the investment would grow to $135,778, or some $3,600 more than the taxable account. Your gain would be $115,778. All of that gain, though, is taxable at ordinary rates. If taxed at a marginal rate of 28%, your tax bill would be $32,418. That means you would net $103,360, or about $6,300 less than that of the taxable account.

Hmmm... Maybe the tax deferral in the annuity wasn't everything that it was hyped to be. It seems as though those M&E charges coupled with ordinary income taxation on annuity gains offset the tax advantage during the annuity's accumulation phase. Indeed, your income tax rate would have to drop in 20 years for the annuity to come out on top in this case. Will it? Only you can answer that.