Variable, indexed annuities may cost more than you think

Variable and indexed annuities are lambasted in some circles as being high-cost insurance products, with all-in annual expenses often exceeding 3%-4%. Yet investors may be paying even more for certain contract features than they think.

Many of these annuities are sold with income riders that offer owners a minimum level of guaranteed income in retirement. The income floor on such riders — a guaranteed living withdrawal benefit, for example — often grows after contract purchase, depending on contract performance and can include certain bonus features like annual income “step-ups.”

However, the fee mechanics of these riders are often misconstrued, according to some advisers.

“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.”

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The confusion is due to how insurers calculate a client’s income stream. They use a theoretical shadow account, known as an income base or benefit base, rather than the client’s actual account value to determine their ultimate quantity of monthly income.

This shadow account typically grows faster than a client’s actual account value, advisers said. That’s especially true if the product offers a 6% guaranteed increase in value each year, or a similar feature, as many do. Here’s the confusing part: 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 is typically larger than the underlying account value, the fee — in practice — ends up being more than 1%. Sometimes, the difference can be pretty stark, as was the case with many variable annuities following the financial crisis.

Here’s an example: A client has $100,000 in a variable annuity. The income base of the contract has grown to $150,000. The income rider costs 1%.

The client would pay $1,500 (1% of the $150,000 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.

And the discrepancy would grow even larger once the investor taps 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 $75,000 after a period of income withdrawals, the annual rider fee would still be $1,500 — which, by virtue of a reduced account value, is really 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.

The rider fee ends up being a large “headwind” — during accumulation and especially during withdrawal — to account performance, Mr. Witt added.

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Other fees, such as administration, mortality and expense, and investment costs, aren’t assessed the same way.

Half of the total $21.3 billion in second-quarter retail variable annuity sales had an income rider, according to the Limra Secure Retirement Institute. 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.

However, the situation could catch investors by surprise in certain circumstances. For example, if an investor needs to surrender a policy unexpectedly for cash, due to a health emergency, or if a broker does a 1035 exchange from one annuity to another. In these cases, the investor only receives back the account value, not the value of the shadow account.

Also, for those investors expecting to leave a death benefit for heirs, an account value that falls faster than anticipated would leave behind a smaller inheritance.