While annuities can make sense in certain circumstances, it's important to be aware of the drawbacks before purchasing any type of investment. And with annuities, the main drawback is the cost. Annuities tend to have higher fees than many other investments, and in some cases, the difference can be huge.
If you couldn't tell, I'm not a big fan of annuities. That said, if you think an annuity could be right for you, here's a rundown of the fees and other costs you can expect to pay.
Types of annuity costs
One major point you need to know is that many annuity fees either aren't disclosed or are difficult to determine. So, just because a certain type of fee isn't listed in your annuity contract or mentioned to you by an annuity salesperson, don't assume you aren't paying it.
With that in mind, here's a list of some of the major annuity expenses you might pay, either directly or indirectly:
- Commission: The salesperson who sells you an annuity gets a cut, and this can be substantial, as you'll see in the next section. However, you can save yourself money by looking at direct-sold annuities, rather than going through salespeople (who may refer to themselves as "investment advisors").
- Management fees: Variable annuities are especially notorious for high management fees. These annuities invest your money in mutual funds, and the fees (known as expense ratios) charged by the underlying mutual funds are passed on to you.
- Insurance charges: These are also known as mortality and expense (M&E) fees and administrative fees. These cover certain guarantees that come with an annuity, as well as administrative expenses.
- Surrender charges: Annuities often have penalties known as "surrender charges" that discourage people from pulling their money out early.
- Other fees: In addition to these common fees, other potential annuity fees include underwriting fees, IRS penalties for early withdrawals in certain cases, fees associated with riders (added features), and more.
How much are we talking about?
Here's the part to pay close attention to: Annuity fees can be astronomically high.
For one thing, annuity commissions often run in the 6% range, and commissions as high as 10% aren't unheard of. As I mentioned earlier, you can avoid paying a high commission by looking at annuities sold directly by companies. Vanguard is an excellent example: Their annuity specialists don't work for commissions and, instead simply charging a one-time 2% fee for income annuities.
You can also end up paying high fees on an ongoing basis if you buy a variable annuity. In addition to the costs of the underlying mutual funds, variable annuities come with insurance charges and other fees that can total 2%-3% per year in many cases. As with commissions, not all variable annuity fees are in the same ballpark. For example, Vanguard's mutual funds are notoriously cheap, so this can save you money on an ongoing basis. And it's not just Vanguard; other companies, such as Fidelity and TIAA-CREF, also direct-sell annuities that could be worth a look.
In addition, a surrender charge can cost you a lot of money if you decide you want to cash out. A typical surrender charge is 7% of the annuity's value after one year, and it declines by 1% per year until it's gone, although much higher surrender charges are possible.
And finally, if you add any riders to your annuity, you can expect to pay an additional charge -- or accept a lower ongoing benefit.
Are annuities ever worth the cost?
It depends. I can't fathom any situation in which paying a 6% commission or paying annual expenses of 2%-plus per year is a smart idea. However, a direct-sold annuity can cost significantly less than this, and if you decide to deal with a salesperson, be sure you get a clear explanation of the fees and other costs you're agreeing to. If you can't get that, walk away.
Having said that, an annuity with reasonable fees can certainly be a smart choice for certain situations. For example, some investors simply don't want to take any investment risk at all, and an income annuity can certainly be a better idea than leaving your money in a risk-free savings account. Just be sure to weigh the pros and cons and take a close look at some of your other options before you sign an annuity contract.