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
d. 3.56% for all premiums received in the period 1/1/2012 – 12/31/2012
3. Tiered interest rate method: Type one
In this method, the interest rate credited to a contract depends upon the cash value of the annuity.
Example: Ms. Smith’s annuity credits interest according to the following current schedule:
a. 4.00% for the first $50,000 of cash value
b. 4.25% for the next $50,000 of cash value
c. 4.5% for cash value in excess of $100,000
4. Tiered interest rate method: Type two
In this method, interest is credited at one rate if the owner annuitizes the contract and at a lower rate if the contract is surrendered. In these contracts, the value is generally reported as two separate items: (a) the annuity value and (b) the cash value or contract value. The cash value will be reduced, on surrender of the contract, by any surrender charge applicable. The amount payable at the owner’s or annuitant’s death may be either the cash value or annuity value, depending upon contract terms, and a surrender charge may or may not apply.
Interest rate guarantee period
Sometimes the current interest rate of a newly issued fixed deferred annuity may be guaranteed for a specific period. If so, then at the expiration of this period, renewal interest is credited according to the crediting method used for that particular contract — subject, of course, to the guaranteed minimum rate.
Interest rate renewal history
One item that every advisor who is considering recommending a fixed deferred annuity must consider is the history of the issuing insurance company with regard to renewal interest rates. Renewal rates, except for contracts in the interest rate guarantee period, are entirely at the discretion of the issuing insurer and subject, of course, to the minimum rate guaranteed in the contract. Some insurers have a distinguished history of declaring renewal interest at competitive levels. Others, unfortunately, do not. In the 1980s and 1990s, a few insurers offered fixed deferred annuities at initial rates well above the level offered by most competitors and, as soon as the interest rate guarantee period elapsed, renewed these contracts at, or barely above, the guaranteed rate. Fortunately for consumers, most insurance companies did not play this game. Nevertheless, the risk with this sort of “bait and switching” is one that the prudent advisor must take into consideration. The authors strongly advise taking a close look at the published history of the renewal crediting rate of any insurance company whose products you are considering.
A final observation on the subject of interest rate crediting is in order. It may appear to the advisor inexperienced in fixed deferred annuities that renewal interest rates, while they may drop from the initial level to as low as the guaranteed rate, may also rise at that point — even beyond that initial level — if interest rates are increasing at that time. That may appear logical, but it is not likely to happen. In the authors’ experience, insurance companies rarely declare renewal interest rates at a level higher than the initial rate. This may, of course, be due to the fact that, for the past thirty years and more, interest rates have, in general, been trending downward. Nevertheless, there have been short periods, during those decades, during which rates increased. In those periods, the initial rate offered by insurance companies, on their fixed deferred annuities, did increase — but the renewal rates for existing contracts did not.
Bail-out interest rate
Some fixed deferred annuities provide that, if renewal interest is ever credited below a certain specified rate, or the bail-out rate, surrender charges will be waived for a certain time period, allowing the contract owner to bail out of the contract without charges. Of course, the premature withdrawal penalty of Section 72(q) will apply if the owner is under age fifty-nine and a half and no other exception to the penalty is available. Bail-out rate annuities were very popular in the volatile interest environment of the 1980s and 1990s, but are much less common today.
Bonus interest rates
A policy feature that has become very popular in both fixed and variable deferred annuities is the crediting of so-called bonus interest. Typically, bonus interest is interest, over and above the current rate, that is applied to deposits in the first year or first few years, and is immediately vested. That is, the contract owner is not required to keep the contract for a set period, or to annuitize, to earn it. However, it is important to note that generally the surrender charges may be slightly higher on such contracts, the interest guarantees may be lower, or the current crediting rate may be lower — in other words, the general aphorism that “there’s no such thing as a free lunch” still holds true, and the insurance company likely will still find some way to make up the cost of the bonus payment.
A variation on this theme is the annuitization bonus, which provides that a certain interest rate (e.g., five percent) will be credited to the contract, in addition to the regular interest, upon annuitization.
“Bonus annuities,” deferred annuities offering the crediting of an up-front interest rate bonus, have come under considerable criticism in recent years from some financial journalists and from more than a few regulators. Interestingly, it is not the additional interest crediting that has drawn the criticism, but the additional costs of these contracts. This has been especially true of index annuities. Most of the condemnation has been directed at the steeper and longer surrender charge schedules of these contracts. The authors hold no brief either for or against bonus annuities, but we do believe that any assessment of their value or appropriateness ought to balance their negatives against the benefits they offer. Typically, a bonus annuity is very much like a nonbonus annuity offered by the same insurer, except for (a) the additional interest bonus and (b) increased cost factors.
The interest rate bonus
The additional interest rate offered as a bonus is typically credited to contributions made to the contract in the first year or first few years. In some contracts, this additional interest is vested immediately — that is, it cannot be taken back, even if the buyer surrenders the contract. In others, it may vest over a period of years. In some contracts, the bonus is forfeitable if the contract owner does not annuitize the contract over at least a minimum number of years. Some contracts offer as much as a 10 percent bonus to all contributions made during the first several years.
Often, “bonus” annuities are marketed as having a “first-year yield” equal to the first year guaranteed or expected interest rate plus the bonus. In the authors’ opinion, this is a misleading practice when the “bonus” interest is forfeitable.
The costs of the interest rate bonus
All bonus annuities offer the additional interest in exchange for costs higher than if no bonus were creditable. In variable annuities, this cost is typically a higher contract charge (Mortality and Expense Charge (M&E)) and/or a steeper or longer surrender charge schedule — a schedule in which the surrender charge starts at a higher level and/or persists for a greater number of years. In nonvariable contracts, which typically assess no ongoing contract charges, the surrender charge schedule is steeper and/or longer than for a nonbonus contract; in some cases, the bonus is recouped by the annuity company in the form of a greater interest rate spread.
Many critics of annuities have focused upon contracts with very steep and lengthy surrender charge schedules as though they are, ipso facto, bad for any buyer — but, especially, for a senior citizen. Indeed, regulators in several states have banned the sale to a senior citizen of any deferred annuity with a surrender charge schedule exceeding ten years or with an initial surrender charge exceeding ten percent. Contracts allowable under this rule are known as “ten-ten” annuities. In a few states, ten-ten annuities are all that any purchaser, of any age, may buy. The rationale often given for such a rule is that no one, especially a senior citizen, ought to be subject to a loss of interest and, possibly, principal as well, for more than a decade.
This may appear entirely reasonable to many readers. Why, after all, should one have to pay a penalty for getting to one’s own money, especially when that penalty endures for many years? The authors suggest that one answer to that question would be that the question itself begs another – whether the money in question is, in fact, the buyer’s own. In the case of a nonforfeitable interest rate bonus, we believe that it is arguably not. The issuing insurer can afford to credit such additional interest — over and above the annual interest — only if it can be assured of having the full purchase payment of the annuity to invest, so that the excess of what it earns, above what it will pay to the contract owner each year — or what it will extract in expenses — will reimburse it for that initial bonus credited. This increased liquidity cost is, quite simply, what the buyer must accept if he or she wants that bonus interest.
Let us pose a hypothetical arbitration case, in which the plaintiff argues that the surrender charge schedule of the bonus annuity he bought was unconscionable and the sale clearly unsuitable. It is established that the surrender charge of that contract was both long and steep, declining from a first year charge of nineteen percent to zero only after fifteen years. But it is also established that the bonus paid in the first year of that annuity was ten percent of the purchase payment. The annual interest paid each year on that contract was credited to 110 percent of that buyer’s actual investment.
Was this annuity unconscionable? Would it be arguably suitable for any buyer, especially a senior citizen? The authors believe that a proper answer to both questions must look at the facts and circumstances of the case. Had the advisor established the client’s need for liquidity during that surrender charge period? If so, did the advisor confirm that the client had other liquid assets that could be tapped for reasonably foreseeable needs during that period and that the client fully understood and agreed to the constraints upon liquidity of his investment in that annuity? What was the purpose of the annuity — the job to be done? If the client intended to take distributions of interest only from the annuity each year, it is undeniable that interest computed on 110 percent of a given sum will always produce a greater cash flow distribution than that same rate of interest computed on 100 percent of that sum.
The authors are certainly not arguing that deferred annuities with steep and long surrender charge periods are necessarily good for a client; we argue only that for a particular client, in a particular situation, they ought not to be dismissed out of hand, without a consideration of whether they would meet that client’s requirements, especially if a bonus is involved.
The authors sometimes hear the following complaint from critics of bonus annuities: “If you get the bonus, but the insurer recovers the whole bonus through increased costs anyway, why bother?” The answer is that, for a bonus annuity that differs from its nonbonus cousin only in (a) the bonus, and (b) steeper and longer surrender charges, but not actually higher ongoing costs or a reduced interest crediting rate, the owner of such a contract who does not surrender it early gets the benefit of the bonus without actually paying its cost, or the surrender charges. As noted in the hypothetical example above, for a buyer who intends to withdraw interest each year, the additional interest created by the bonus may well be worth the bother.
A relatively recent development in fixed deferred annuities is the so-called “CD annuity.” This type of contract typically guarantees the initial interest crediting rate for the duration of the surrender charge period, which is typically six years or less. As its name suggests, this product was developed as an alternative to certificates of deposit. While the assurance of receiving a known interest rate for several years, with freedom from surrender charges at the end of that period, is certainly attractive, especially when the tax liability for all the interest is deferred, the existence of the Section 72(q) penalty makes this type of contract a questionable short-term savings vehicle for those who will be under age fifty-nine and a half at the end of the surrender charge/interest rate guarantee period.
Some fixed deferred annuities assess an annual contract charge, though most do not. Some contracts that do assess an annual contract charge will waive that charge when the account balance exceeds a certain amount (e.g., no contract charges for annuities with a balance in excess of $50,000).