- Clearly identify your investment needs.
- Understand the product and how it may fit into your overall plan.
- Focus on value, including the cost.
- Get familiar with fee types.
In the past, misconceptions about annuity fees may have kept some people from buying these investment products. However, many annuities have come a long way in terms of lowering costs and clearing up confusion among shoppers.
Before making an annuity investment, shoppers could benefit from knowing the rules of the road. By asking the right questions up front, and by having a better understanding of the features you might be paying for, you should be able to gain a much clearer sense of whether an annuity might fit your needs.
Start by following some basic guidelines for evaluating the potential costs of annuities. Then, dig a little deeper into the details of specific fees and determine whether it’s worth paying for added features that may appeal to you.
Understanding the big picture
Different types of annuities, whether variable or fixed, charge different fees depending on the purpose of the contract (see chart below). Generally, variable annuities include an underlying investment (e.g., mutual fund) and charge explicit fees. Fixed annuities offer either a fixed rate of return or a guaranteed income stream, which reflects the company’s expenses and profit margins, rather than having explicit charges that you typically find in variable annuities. Indexed annuities take a different approach by limiting returns through factors such as participation rates, spreads, and caps.
Become familiar with fee types
While you don't have to become an expert on all annuity fees, knowing the most common types will help you evaluate products and ask the right questions. Generally, there are 4 types of annuity fees mentioned in the chart below:
Insurance charges. Also known as mortality and expense (M&E) fees and administrative fees, these charges pay for insurance guarantees that are automatically included in the annuity, and the selling and administrative expenses of the contract.
Investment management fees. These are assessed on the investment options within variable annuities, and are similar to management fees on mutual funds. Check the annuity prospectus for any underlying funds to learn how much you might pay for investment management fees.
Surrender charges. Most insurance companies limit the amount of penalty-free withdrawals one can take during the initial years of a contract, and place a surrender charge on any withdrawals above that preset limit. Be careful, as surrender charges can be significant and can be imposed for an extended time period. Be sure to ask for details on any surrender charges to help ensure that you have enough flexibility.
Rider fee. Riders are optional guarantees available in some annuities. For example, a death benefit rider may be available at an additional cost to ensure your heirs receive at least the principal you invested upon your death (minus any withdrawals). Some riders are not optional and may be a standard cost associated with the annuity contract.
Understanding the fees associated with each type
Deferred variable annuities provide the potential to grow your investment with the advantage of tax deferral. From a fee perspective, deferred variable annuities can include insurance charges, investment management fees, surrender charges, and rider charges, yet they tend to have a significant degree of variability. This makes direct price comparisons more difficult. Deferred variable annuities may also have many different optional riders or guaranteed features. These features may include both death benefits and living benefits, which come at an additional cost. If these are of interest to you, take some time to research how each feature works (e.g., whether it applies when you are alive or if you die) and consider its price tag. Then, evaluate whether that rider works for your specific situation when considering a variable annuity. It’s also important to review the prospectus thoroughly.
Fixed deferred annuities offer tax deferral too, and pay a guaranteed interest rate for a set period of time. This rate reflects reductions for expenses, risks, and profits. The rate is clearly stated in the contract and is easy to compare with other fixed annuities or similar products. Fixed deferred annuities typically have surrender charges. Sometimes the interest rate is reset, up or down, during the surrender charge period, subject to the insurance company's rate setting process. To take the guesswork out of what your future guaranteed interest rate might be, look for a product that guarantees its interest rate at least as long as the surrender fees are in place. Also, consider the creditworthiness of the issuing insurance company to help evaluate the best overall value.
Fixed income annuities provide a guaranteed income stream for life or a set period of time. The income can start immediately or at a date you select in the future. The income amount reflects reductions for expenses, risks, and profits. The good news is that this characteristic makes it easier to research, as you can focus on comparing the income amount. When you compare income amounts, be mindful of the creditworthiness of the insurance company. A higher income amount might sound appealing, but if it’s offered by an insurance company whose financial strength you question, it might not be worth the risk. A common way of researching financial strength is by checking out third-party credit ratings issued by agencies like Standard & Poor's and AM Best. Also, be sure you know which features are included in the income amount such as a Cost of Living Adjustment, so you can compare apples to apples.
Fixed indexed annuities
An indexed annuity is designed for protection against down markets; the potential for some growth linked to an index (e.g., the S&P 500® Index); and, in some cases, a guaranteed level of lifetime income through optional riders.
Indexed annuities typically do not have an up-front sales charge, but there are often substantial surrender charges and in exchange for downside protection, returns are significantly limited by caps, participation rates, and spreads.
Read Viewpoints on Fidelity.com: Indexed annuities: Look before you leap
Pay for only the features and guarantees you need
There are different types of fees that are specific to certain types of annuities. Here are some general guidelines to consider when weighing the costs and potential benefits of annuities.
Know your needs. The fees you pay for annuity features can reduce your overall return, so opt only for those that you need and will use. "For instance, if you want protection from market downturns for your savings or future retirement income while you stay invested in the market for growth, you may want a feature that provides a guarantee*—and some peace of mind—if the cost is fair and reasonable," says Tim Gannon, vice president, product management, at Fidelity Investments Life Insurance Company.
Understand the product. Some annuities can be complex to understand. When you're considering a purchase, it's important to understand how the proposed annuity works, what its benefits may be, and, perhaps most importantly, the role it can help play in your overall financial plan. Be sure to read carefully the marketing materials and prospectus (if applicable). If you don't understand what you’re paying for, make sure you ask questions and receive full disclosure before making a decision.
Focus on value, including the price. It's important to evaluate any annuity's costs versus the guarantees it promises. Not all guarantees are created equal. Some guarantees involve cumbersome restrictions that may diminish their appeal, regardless of the price. Also, keep in mind that when you buy an annuity, part of what you are paying for is the creditworthiness of the insurance company standing behind those guarantees.
Getting good value
There are a few other important considerations before making an annuity investment.
Consider the totality of all costs. Tom Ewanich, a Fidelity vice president and actuary, says this advice is important and often overlooked. "Rather than focusing on any single fee component, it's prudent to look at all the associated costs together," he says. "In some instances, one variable annuity may have a lower charge than another similar product but more expensive investment options, making the entire package more costly."
Invest with someone reputable. Get the facts on the firm's financial strength and business practices by working through an advisor or accessing the 5 major independent ratings agencies either online or by phone. How do the third-party ratings agencies rate the company? Is it known for fair claims-paying practices? How reliable is its customer service? Dealing with a company that's fair and financially sound may help save you from financial headaches in the long run.
Understand hidden costs. For some annuities, you need to be aware of other ways an annuity design can affect its performance. For example, index annuities may offer upside potential, but can actually cap the benefit of market performance. If an index annuity promises upside based on performance of the stock or bond market, ask whether there are caps on how much your annuity can earn.
Take the time to review information on different types of annuities, learn more about annuities in general, and even compare the types of annuities offered by Fidelity.
Remember, it is important to do your homework and comparison shop when it comes to major purchases. Buying an annuity should be no different. It’s easier to understand what you’re buying if you do your homework.
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