Variable Annuities: Breaking Down the Cost

Physician's Money Digest, September 2006, Volume 13, Issue 9

Variable annuities offerbenefits such as tax-deferredgrowth, protectionfrom creditors invarious states, and livingand death benefits. The beneficiaryof a variable annuity never receives lessthan the cost basis of the annuity lessany withdrawals. But these benefits donot come without a price, and thereare costs associated with owning avariable annuity.

First, you have several types ofexpenses associated with a variableannuity. You have the mortality andexpense fee, administration fee, distributioncharge, front-end load, annual contractcharge, surrender penalty, and subaccountexpenses. You want to reduce—and in some cases eliminate—as manyof these charges as possible. Keep inmind that the IRS imposes an additionalpenalty for early withdrawal from anannuity prior to age 591/2. The annuitycontract may also impose penalties forearly surrender. Unless you are a disciplinedinvestor and have several yearsbefore you will need to take money fromthe annuity, it is not wise to purchaseone. However, if you happen to live in astate where creditor protection is affordedthe cash accumulation in an annuity,you are a disciplined investor, you havea need for tax deferral, and you've madethe maximum contributions allowed toyour qualified retirement plan, an annuitycan be a good investment vehicle.

Owning a Variable Annuity

As of May 31, 2006, Morningstar, Inchad 873 variable annuities in its database,and there were 33,248 individualsubaccounts, with the average annuityhaving 54 subaccounts from which tochoose. At that time, the average fundexpense was 1.03%, the average mortalityand expense risk was 1.21%, and theaverage administration expense was0.15%. The average total subaccountexpenses were nearly 2.4% annually,plus there may be additional contractcharges and surrender charges for earlywithdrawal—both annuity charges andIRS early withdrawal penalties for distributionstaken prior to age 591/2.

You want to select an insurance companywhose annuities offer a wide arrayof investment subaccount choices withdifferent money managers. In addition,you must also try to minimize the mortalityand administration expenses, asthese expenses alone average 1.25% to1.65% annually. More importantly,there are annuities out there that do notimpose surrender charges for early withdrawal.These are more commonlyreferred to as no-load annuities, andmany insurance companies offer them.No-load annuities offer much more liquidityand are cheaper.

Difference in No-load Annuities

Going back to the Morningstardatabase and selecting annuities thatimposed no front-end loads, no surrendercharges, and had insurance chargesof no more than 0.5% produced 30variable annuities and 831 individualsubaccounts, with the average annuityhaving 51 subaccounts from which tochoose. The average total expensesequaled 1.53%. Selecting contracts thatimpose no loads, surrender penalties,and reduced mortality and insuranceexpenses can reduce the costs of owningan annuity by nearly 35%, or0.86% annually. Now 0.86% may notsound like much, but for someone whocurrently has $400,000 in variableannuities, assuming an annual net rateof return of 7%, this would translateinto a savings of more than $50,000over a 10-year period.

There are also other living and deathbenefit options available with annuitycontracts that have not been discussedhere. These additional options will driveup the costs of the annuity, as theyhave additional fees. Before you commityourself to purchasing an annuitycontract, study the annuity prospectusso that you know exactly what the realcosts are of purchasing it.

Thomas R. Kosky and his partner, Harris L.Kerker, are principals of the Asset Planning,Group, Inc, in Miami, Fla. The companyspecializes in investment, retirement, andestate planning. Mr. Kosky also teaches corporatefinance in the Saturday Executive and Health CareExecutive MBA Programs at the University of Miami in CoralGables, Fla. Mr. Kosky and Mr. Kerker welcome questions orcomments at 800-953-5508 or e-mail Mr. Kosky directly atProfessorKosky@aol.com.