With annual expenses often in excess of three to four percent, indexed and variable annuities are already seen as high-cost insurance products by some. Nonetheless, some investors may still be paying even more for certain contract features than they expect to be.
Many annuities are sold with income riders that offer owners some guaranteed income in retirement. Depending on contract performance, the income floor on such riders can grow after contract purchase, and can include bonus features like annual income "step-ups."
However, the fee mechanics of these riders are often misunderstood.
"I think it's widely misunderstood," said Scott Witt, a fee-only insurance adviser. "In general, there is shock once they discover how it works."
The confusion comes from how insurers calculate a client's income stream. They use a shadow account, aka income base or benefit base, rather than the client's actual account value, to determine their monthly income.
A shadow account often grows faster than a client's actual account value, according to advisers. And, it’s true if the product offers a six percent guaranteed increase in value each year, or a similar feature. What makes things particularly difficult to understand, is how Insurers assess the overall cost for the income rider — maybe 1% — based on the shadow account, but subtract that fee from the actual money invested in the client's account.
Because the shadow account can be larger than the underlying account value, the fee ends up being upwards of one percent.
For example: A client has $50,000 in a variable annuity. The income base of the contract has grown to $75,000. The income rider costs 1%.
The client would pay $750 (1% of the $75,000 income base) — so the true cost to the client would be 1.5% of the account value. That's a 50% greater cost than investors and advisers may realize.
The difference would only grow larger after the investor tapped the income benefit. Most insurers maintain the same rider-fee level, even as an investor's account value drops in tandem with income payments. So, if that same investor has an account value of $40,000 after a period of income withdrawals, the annual rider fee would still be $750 — which, by virtue of a reduced account value, is really almost a 2% annual fee.
"Instead of 1% of account value, it can end up being 3% or 4% of your account value as your account value plummets to zero," said Mr. Witt, owner of Witt Actuarial Services.
Witt also added that the rider fee ends up being a large "headwind" — during accumulation and especially during withdrawal — to account performance.
According to the Limra Secure Retirement Institute, half of the $21.3 billion in second-quarter retail variable annuity sales had an income rider. That was true for 39% of the total $19.6 billion in indexed annuity sales over the same period.
In practice, rider fees don't really matter if an investor holds onto the annuity and uses the income benefit. That's because an investor receives the same amount of income even after the underlying account value dips to zero, making the fees essentially meaningless.
"You're paying that charge for the guarantee," said Jacob Soinski, an annuity planner at ValMark Financial Group. "So I think it's probably a reasonable expectation" that the fee be assessed based on the income base underpinning the guarantee, he added.
The situation could catch investors by surprise, nonetheless.
