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.
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.
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 If so, then the surrender value or withdrawn amount is usually decreased if a benchmark interest rate — a specified, well-recognized external index — is higher when the contract is surrendered than it was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.
Current interest rate crediting methods
There are four basic methods of crediting current interest to conventional nonindex fixed annuities.
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.
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.