With baby boomers beginning to enter retirement, it's no surprise variable annuity sales were up 16.7% in 2006, according to Insurance Information Institute. And it's a good indication that these types of products are becoming increasingly popular tools to manage personal wealth.
On the other hand, insurers are being challenged to offer more competitive products such as living benefits, while lowering costs to attract more sales. Although the market is improving its product diversity, there are a few basic things you should consider while shopping around.
All variable annuities, regardless of whether purchased through a bank or mutual fund, are essentially an agreement between you and an insurance company. This means the financial security of the insurer cannot be ignored. A financial rating can give a good indication of an issuer's financial health and is an important factor to consider.
Although variable annuities are placed in separate accounts from an insurer's general account and are not subject to claims by policyholders, a company with financial troubles can still impede policyholders from recovering their investments. This alone is a good reason to select a financially strong company.
Once you have found a well-rated company, you need to consider the costs, such as front-end loads, back-end loads (also known as surrender charges), mortality and expense risk charges, annual contract fees and optional feature fees.
Hit on the Front End
The front-end load is the commission you pay out of your investment contribution. It goes to cover sales costs, especially the fee paid to the salesperson who sells you the policy. For example, when you buy a variable annuity with a 4% front-end load, $4 of every $100 you put into the policy goes to the sales costs. Only $96 is actually credited to your account.
That's why TheStreet.com Ratings recommends only no-load annuities where there is no upfront reduction in your principal. You do, however, pay a slightly higher cost built into the mutual fund expense or insurance expense, which comes out of your earnings over time.
But since every penny you invest gets credited to your account, all your funds start working for you immediately. Good news: More than 97% of the variable annuities sold today have no front-end loads.
Just like the government will penalize you a 10% fee for withdrawing from your IRA before age 59½, insurance companies may attach a surrender charge representing a percentage of the contributions to the account or account value. Most surrender charges are designed to discourage you from making withdrawals during the first few years after you purchase an annuity.
The typical charge starts at 7% in the first year, declining 1% annually over the course of the first seven years of the policy. This means that if you make a withdrawal or cancel the policy in the first year, the insurance company will keep 7% of your total investment.
In the second year, the charge drops to 6%, and so on until it reaches 0% after seven years. In the last two years of the contract, many annuity issuers have altered their surrender charges so that they do not decline to 0% but only decline to 1%-3%, a setback for unaware consumers. Moreover, each time you contribute new money into your policy, this "seven-year clock" starts afresh for the newly invested portion.
Some variable annuities also carry "rolling surrender charges," meaning that even your investment gains, as they accrue to your account, are subject to the surrender charge. Under these contracts, a certain amount of the value of your policy will always be subject to a surrender charge no matter what. The only way to get out of this trap is to annuitize the policy.
Ideally, the best kind of variable annuity to own is one without any surrender charges. This may be somewhat difficult to find on your own, as about 75% of variable annuities contain some type of surrender charge.
Mortality and Expense Risk
Mortality and expense risk charges are usually a percentage of the account value around 1.2%. This charge compensates the insurance company for the risks it assumes on your behalf and expenses associated with the contract. One exception is
Jefferson National Life Insurance
, currently rated D-minus, which charges $20 a month regardless of your account value.
The Annual Contract Fee
Most variable annuities assess an annual contract fee of $25 to $35. This flat-rate fee guarantees the issuing insurance company an annual stream of revenue regardless of the size or performance of your personal variable annuity. Unfortunately, there is very little you can do to avoid this charge. Still, it's not a factor you can ignore when comparing variable annuities with one another and with other types of investments.
Optional Feature Fee
This fee is associated with benefits that include minimum income benefits (GMIB), guaranteed minimum accumulation benefits (GMAB) and guaranteed minimum withdrawal benefits (GMWB). The industry average fee is 0.4% to 0.45% annually, according to Annuity FYI, an annuity information and education service.
It definitely pays to shop around and compare variable annuities based on their costs and performance. But when comparing costs, remember that you must factor in the insurance costs and loads associated with the annuity to get the full picture. For starters you may want to compare with some of the top-10 rated life and health insurance companies with the greatest volume in their separate accounts as of year-end 2006.
Melanie Dufour joined TSC Ratings as a life and health insurance analyst in February 2007. She has an actuarial background with a BS degree in Actuarial Mathematics and Finance from Concordia University in Montreal, QC. Melanie has most recently worked as an actuarial analyst with Aequicap Insurance Company in Ft. Lauderdale, FL and prior to that as a senior analyst with Watson Wyatt Worldwide in Montreal, QC.