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By Adam Beaty

At its very core, an annuity is a contract between you and an insurance company where you turn over a large sum of money in exchange for a series of income payments. Typically, these payments will last until you or your spouse passes. Think of them as a form of longevity insurance.

Annuities can be polarizing. Some think they are the worst insurance product to ever grace this earth, and others think everyone needs an annuity in their retirement portfolio.

Regardless of what you think, annuities can have their place in a portfolio. Guaranteed payments and longevity insurance are both strong positives for a lot of retirement accounts.

There are a few types of annuities on the market: fixed, indexed, variable, deferred, and immediate. Some of these annuities are going to be better products than others, while some of these products are going to have a lot more fees than others. The type of annuity with the greatest fee structure is the variable annuity.

Variable annuities can have a ladder of fees embedded and hidden in them that make them poor insurance products. The fees benefit only the insurance company. The commission payout on a variable annuity product will be the highest for the salesperson, which makes them attractive to sell. Even though we are fans of having annuities as retirement tools, we try to avoid using variable annuities due to the fees and complexities that come with them.

How Variable Annuities Work

There are two phases for a variable annuity. The first phase is the accumulation phase. This is when you make the purchase of the annuity in a lump sum or with periodic payments. The insurance company will put your money into an investment account and you can pick the investments (mutual funds) to grow that portion of your money. The investment choices are usually limited so you cannot make extremely risky investment choices.

Once the money has grown through its investments, you can move to the next phase. The payout phase is when you stop the money from growing and choose to start receiving income. This income can be in the form of a lump-sum payment or periodic payments over your lifetime.

Most variable annuities have a significant time period between the accumulation phase and the income or annuitization phase. These types of annuities are deferred annuities. There are some variable annuities that start immediately after a lump-sum payment, these are immediate annuities. Immediate annuities will payout based on the performance of the underlying funds and investments selected. Typically, you are going to deal with deferred variable annuities because you want the investments to grow over time.

The Fees Hidden in Variable Annuities

When looking over an annuity, you want to study the prospectus to understand exactly how the annuity is structured. An insurance company is required to give you access to the prospectus. If you don't have one, you can typically find a copy on the insurance company's website or you can request it from your agent.

The first fee to understand is the Surrender Charge, also known as the CDSC. Variable annuities pay large upfront commissions to their salespeople. To help offset this commission structure and to make sure the insurance company doesn't get stuck with the bill, they will charge you a fee on money you withdraw in the first few years. Most surrender charges last 7-10 years and the surrender fee can be as high as 10% of the money you withdraw. The surrender charges will reduce every year during the surrender period until it finally arrives at 0%.

If you bought a variable annuity for $100,000 with a 10% surrender charge, it would cost you $10,000 if you change your mind in the first year and try to get your money back. It would take 10 years for there to be no surrender fee attached to your annuity.

It pays not to invest into annuities without really considering your options. Once you make that choice it can be difficult or expensive to change your mind.

The next level of fees to look out for is the Mortality and Expense Risk Charge, or the M&E charge. This fee is usually 1-2% of your account balance and is used to cover the insurance company's risk. This is not always called a mortality and expense charge. Some big box brands will simply call this an insurance charge.

The next level of fees is the Administrative Fees or Account Maintenance Fees. These fees are usually not a percentage of assets but a fixed dollar amount and usually range from $25-$100 a year. This covers any record keeping or other administrative expenses that the insurance company incurs.

As you can see, these fees are already starting to add up and chip away at your account value.

The next level of fees is the Fund Expense Ratios. For a variable annuity, you will select mutual funds for your investments to be placed in. These mutual funds have their own set of administrative fees that you will be forced to pay. With some variable annuities you can find low-cost fund options but most of these expense ratios will range from 0.50% - 1%.

Variable annuities are rarely plain vanilla. A lot of times they will have riders attached to them. Think of the riders as added options you can purchase along with your annuity. Like most options, these riders can come at a price. It is best to go through each rider and figure out exactly how much you are being charged for it.

You will also want to look through the prospectus and tally up any transfer fees for your investments. A lot of times you cannot simply trade one investment product for another. There will be a fee attached to making that switch to get you to pick one investment and stick with it.

Let's look at an example of breaking down a real-life variable annuity.

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To understand how the different percentages affect your overall fee structure, we need to start with the current value of the annuity. You should be able to log into your account online and get the current value.

As you can see, our surrender value is 4% less than the current value. If we decide to opt out of the variable annuity, that is our quick haircut. This annuity started with a 7% surrender fee but over three years, it has been reduced to 4%. It will take another 4 years before that surrender fee goes to 0%.

The insurance charge or M&E on this product is 0.85% a year, which is approximately $1,400. The annual maintenance fee is $50, and the premium based charge is 0.50%, or $800.

There are two riders on this product, and both have their own fee. The first is the market value adjustment rider which is a standard rider in this insurance company's products. That is only a $50 annual fee. The next rider is for a lifetime income benefit and that fee is more substantial at 1.10%

The variable annuity is invested into two products, both with high expense ratios. The first investment has an expense ratio at 0.88% and the next at 0.94%.

Once we have recorded all the fees, we can add up the total to see that it is going to cost $5,402.04 a year to maintain this variable annuity. That equates to a 3.33% annual fee on the current value. In terms of fees in a variable annuity, a 3.33% fee is about average.

Understand the Fees Before You Invest

This is but a small part that makes up the confusion surrounding variable annuities. Once you understand the fee structure you can begin to see how a variable annuity is stacked against you. If you are already invested in a variable annuity take a good look at your prospectus to understand how much you are paying in fees every year.

If you have yet to invest in a variable annuity, make sure you understand what the fees are and how they will impact your annuity performance. Make sure a variable annuity is right for you before you make the investment because once you do, it can be difficult and costly to change your mind.

To understand more about variable annuities, read the SEC's Guide to Variable Annuities.

About the author: Adam Beaty is a certified financial planner, specializing in pre-retirees/retirees, at Bullogic Wealth Management.