In this article, we will focus on one of the most controversial — and often misunderstood — aspects of annuities: their costs. The controversy and misunderstanding are chiefly due to two conditions:
- The cost factors can be very complicated and, sometimes bewilderingly so.
- The cost factors are often poorly communicated — both from the advisor to the customer, and to that advisor from the insurance company issuing the annuity contract.
The responsibility for this poor communication is a matter of considerable debate. Some consumerists hold the advisor chiefly, if not solely, responsible for a purchaser’s lack of understanding. Class-action lawsuits have asserted that the onus ultimately lies with the insurance companies, citing confusing, even allegedly misleading, training and marketing materials. The authors believe that, if an annuity purchaser can legitimately state that he or she did not understand the costs of the annuity, there is plenty of blame to go around. The same holds true with respect to the benefits of that annuity.
That being said, the costs of nearly all annuity contracts offered today are often hard to understand and appreciate fully, especially when the benefits derived from those costs are also complicated. Complex cost and benefit structures, however fully disclosed, run the risk of being misunderstood, and even the best explanations can be recalled imperfectly. The annuity advisor must have a very clear understanding of the costs and benefits of those contracts he or she deals with and be willing to spend whatever time is required in perfecting a clear explanation of both.
Cost factors in deferred annuities
The overhead costs of deferred annuities are considerably more complex than those of immediate contracts. Historically, fixed deferred annuities have contained fewer and simpler charges than variable deferred contracts, but, in recent years, the complexity of both types has increased substantially.
Note on Nomenclature: While immediate annuities are always purchased with a single premium, a deferred annuity, of either the fixed or variable type, may be purchased either with a single premium (Single Premium Deferred Annuity, or SPDA) or may permit, but not necessarily require, ongoing periodic premiums (Flexible Premium Deferred Annuity, or FPDA). As if this were not complicated enough, the labels SPDA and FPDA are typically used in connection only with fixed contracts, just as the term SPIA, for single premium immediate annuity is, in common practice, applied only to fixed contracts, even though it is properly applicable to variable contracts as well. To avoid adding to the confusion, the authors suggest using complete terminology (e.g., fixed SPIA, variable SPIA, flexible premium deferred variable annuity, etc.)
Fixed deferred annuities
Charges assessed in fixed annuities may include any or all of the following:
Front-end sales charge
Until fairly recently, an initial sales charge, or load — generally, a percentage of the initial premium — was a common contract expense. Very few fixed deferred annuities offered today assess such a charge, as it was notably unpopular with consumers.
A surrender charge, as its name implies, is assessed upon the surrender of an annuity contract, or upon withdrawal of more than the policy’s free withdrawal amount. Typically, fixed annuities allow the contract owner to withdraw up to ten percent of the account balance, per year, without penalty. There are numerous variations of this provision, such as permitting this penalty-free amount to be cumulative or allowing a penalty-free withdrawal of all previously credited interest, but ten percent per year without penalty is fairly standard. Recently, some issuers of index annuities have pared back the free withdrawal provisions of new offerings to permit a smaller penalty-free withdrawal in the first year or so. This allows the issuer to offer increased benefits such as a higher participation rate and/or a “first year interest bonus” than would otherwise be possible.
Surrenders, or withdrawals in excess of this penalty-free amount, are generally subject to a surrender charge. While the mechanics of this charge vary widely from contract to contract, the usual format is a declining surrender charge schedule — such as six percent in the first contract year, five percent in the second, four percent in the third, and so on — until the surrender charge reaches zero. In flexible premium contracts, the surrender charge schedule may be fixed, terminating at the end of a specified number of years from issue, or rolling, applying the schedule separately to each deposit. This is a moot point with single premium annuities, which, as we have noted, do not allow subsequent deposits.
Many deferred annuities, both fixed and variable, include provisions that waive the imposition of surrender charges in certain circumstances. Most contracts waive the charges upon the death of the owner, or annuitant, if the contract is annuitant-driven. Many also provide a waiver if the owner or annuitant is confined to a nursing home, is disabled, or suffers one of several listed dread diseases.
Considering how much criticism is leveled at surrender charges by many financial journalists and those who simply don’t like annuities on principle, a comment or two may be in order, at this point, on why surrender charges exist in the first place.
A schedule of surrender charges is an alternative to a front-end sales charge. Both exist to allow the issuing company to recover acquisition costs — the costs of putting the annuity policy in force. Even in today’s high-tech world, this cannot be done for free. The most controversial — even notorious — acquisition cost is the selling commission paid to the agent who sells the annuity. Most annuities are sold by commissioned advisors, who are compensated in this fashion. Practically all fixed annuities are of this sort. However, not all variable annuities are commissionable. An increasing number of variable annuities are of the type usually called “low load.” They pay no sales commissions. Not coincidentally, they generally assess no surrender charges.
If, at this point, you are thinking that the purpose of surrender charges is to pay the sales commission, you are basically right. The insurance company pays that commission when it issues the annuity and it needs to recover that cost. But the surrender charge almost always declines over time — after a few years, to zero. Why is that? It is because the insurance company knows that if the annuity owner keeps the policy in force for long enough, it will recover its acquisition costs from other moving parts in the annuity contract. In the case of a fixed annuity, the interest rate spread (i.e., the difference between what the company earns on invested annuity premiums, and what it credits to those annuities) will, in time, not only make up the commission cost, but make the annuity contract profitable to its issuer. In the case of a variable annuity, there’s no interest rate spread, and thus it is the insurance costs that bring about this same result. A front-end sales charge would do the job, too. But front-end sales charges are unattractive to buyers, which is why most annuities no longer impose them.
So, if the sales commission is an acquisition cost, surrender charges, in lieu of an initial sales charge, pay that cost, right? Yes, for our purposes, though it’s slightly more complicated than that. Essentially, if the annuity pays no sales commission, there’s no need for surrender charges.
That seems simple enough, but sales commissions are not the only acquisition costs. Even when an insurance company markets a particular annuity contract through fee-only advisors as a commission-free product, it cannot produce that product for free. Not only are there development costs that any prudent company will expect to recover, but also costs of issue and administration as wells as the need to make a profit. The insurance company expects to make money selling the annuity, and prices it with that expectation. In the case of a fixed annuity, profit — and cost recovery — come from the interest rate spread. In a variable annuity, which has no such spread, they come mainly from insurance charges. Thus, insurance companies attempt to make up for the fact that there are not any surrender charges on such low load or commission-free products through other costs, or by the attempt to generate additional sales with the marketability of a low load or commission-free label.
Market value adjustment
There may be a Market Value Adjustment (MVA) upon surrender of the contract or upon a partial withdrawal. If so, then the surrender value or withdrawn amount is usually decreased if a benchmark interest rate — a specified, well-recognized external index — is higher when the contract is surrendered than it was at the time of issue. The surrender value will be increased if the reverse is true. The purpose of this adjustment is to compensate the insurance company for the risk that contract owners will withdraw money when the market value of the investments backing the annuity is low. In the case of fixed annuities, this generally means bonds. Since bond prices are inversely related to interest rates, the market value of the investments backing the annuity will generally be lower when interest rates have risen. Generally, this is the exact time that investors may want to withdraw their money to re-invest in a new contract with higher-than-current rates — thus the need for the insurance company to protect itself from this risk. However, MVAs are a risk-sharing feature, because, if the external index is lower at the time of withdrawal or surrender than it was at issue, and the value of the underlying bonds is correspondingly higher — again, because bond prices are inversely related to interest rates — the contract owner benefits from the adjustment. Generally, an MVA is assessed only on withdrawals in excess of the penalty-free withdrawal amount, and usually does not apply after the expiration of the surrender charge period.
Interest rate spread
In a fixed deferred annuity, the issuing company’s profit derives chiefly from the interest rate spread, or the difference between what the company can earn on invested annuity premiums and what it will credit to the cash value of those contracts. In a sense, this spread is a cost of the contract, if one assumes that the annuity investor would otherwise be able to earn the same rate as the insurance company. And in fact, some annuity companies will forego many of the previously mentioned costs and simply drive most of their cost indirectly from interest rate spread.
Of course, it’s worth noting that in nearly all fixed deferred annuities, this spread is not guaranteed for the annuity company (nor is it often even revealed directly to the contract holder), and thus represents an uncertainty at best. It may be calculated, provided one knows both the rate credited to an annuity during a certain period and the rate the insurance company earned during that same period. However, not all insurers credit interest in the same manner, or even credit interest in the same manner to all fixed annuities they have issued, and annuity investments in one contract may be pooled with the annuity company’s other investments and contracts.
To understand how interest rate spread works as a contract cost, we must understand how interest is credited to fixed deferred annuities.
Guaranteed interest rate
All fixed deferred annuities guarantee a minimum interest crediting rate. Regardless of future conditions, interest will be credited each period to the annuity at a rate at least equal to this guaranteed rate. In addition, every deferred annuity of which the authors are aware also provides for the crediting of current, nonguaranteed interest at a rate, which may be higher, but cannot be lower than the guaranteed rate.
Current interest rate crediting methods
There are four basic methods of crediting current interest to conventional nonindex fixed annuities.
1. Portfolio method. For an annuity that uses this method, all contracts will be credited each period with the same current, non-guaranteed interest rate, regardless of when annuity contributions (premiums) were received, except for contracts that are still within an initial interest rate guarantee period.
2. New money or pocket of money method. For an annuity using this method, the rate of interest credited to all contracts will depend upon when the premiums were received. For flexible premium annuities, this can mean that a particular annuity contract might receive, on any given interest crediting date, several different rates, each applied to the pocket of money received during the time period specified for that pocket.
Example: Mr. Jones’ flexible premium annuity was issued June 30, 2009. Interest is credited each year, at a rate determined annually. On June 30, 2012, the contract is credited with the following:
a. 4.00% for all premiums received in the period 1/1/2009 – 12/31/2009
b. 3.89% for all premiums received in the period 1/1/2010 – 12/31/2010
c. 3.80% for all premiums received in the period 1/1/2011 – 12/31/2011