Add up your variable annuity's layered fees in actual dollars

Open a variable annuity statement and you will probably not find a line that says "fees: $6,040." The charges are real, but they are scattered. Some are taken daily from the value of the investment units, some are deducted once a quarter by cancelling a few of those units, and some sit inside the funds you chose, reflected only in the price per share. Each is quoted as a percentage, often of a different base, so the totals rarely get added up in one place.

This worksheet does the adding. It converts each percentage into dollars on an illustrative balance, shows the total as a share of the account, and ends with a set of blanks for your own contract. All figures are hypothetical and rounded for clarity; they are not any product's actual charges.

The layers, one at a time

The guide to annuity fees, explained lists the standard layers. Here is how each one behaves in arithmetic terms, and what base it applies to, which is the detail that causes most surprises.

The first four are annual and happen whether or not you do anything. The surrender charge is different: it is a cost of leaving early, so it belongs in a separate calculation, which the last section covers.

The illustrative contract

Say a hypothetical owner has $200,000 of account value spread across three subaccounts, and a lifetime withdrawal rider with a benefit base of $250,000. The Mortality and expense (M&E) charge is 1.10% a year. There is an administrative charge of 0.15% and a flat contract fee of $50 a year. The rider charges 1.00% a year of the benefit base. The subaccounts are:

Each line is the amount times the percentage: $100,000 × 0.0020 = $200, $60,000 × 0.0055 = $330 and $40,000 × 0.0115 = $460. Dividing the $990 by $200,000 gives the blended fund cost of 0.495%.

The worksheet, filled in

Two observations. First, the rider is the largest line, at $2,500, and it equals 1.25% of the account value even though it is quoted as 1.00%, because the base ($250,000) is bigger than the balance. Second, the rider charge does not fall if the account falls. If the markets drop and the balance is $150,000 while the base stays at $250,000, the same $2,500 is 1.67% of the account.

Converting to a daily figure is a useful reality check. Sixteen or seventeen dollars a day is the price in this illustration for everything the contract provides: the investment platform, the standard death benefit, the account administration and the income guarantee. Whether that is fair value depends on what you use.

What the total does to growth

A yearly dollar figure is more meaningful when set against growth. Take the same $200,000 and a gross investment return of 6% a year before any of these charges, an assumption chosen for round numbers and not a forecast. To keep the arithmetic simple, treat every charge as a constant percentage of the starting balance. In practice the dollar amounts change as the balance and the benefit base change, so this is an approximation.

• Net return with every layer: 6% − 3.02% = 2.98%. After ten years: $200,000 × 1.0298¹⁰ = about $268,300.
• Net return without the rider: the total is $3,540, which is 1.77% of the balance. 6% − 1.77% = 4.23%. After ten years: about $302,700.
• A plain low-cost index fund at 0.10%: 6% − 0.10% = 5.90%. After ten years: about $354,800.

The gap between the first and third lines, about $86,500, is what the variable annuity's features cost over ten years in this setup, before considering taxes. The gap between the first and second lines, about $34,400, is the cost of the rider in particular. These are not predictions. They show how a few percentage points of annual charges compound.

They also leave out the other side of the ledger, which is what you receive for the cost:

• The income guarantee pays you for life even if the account runs out, and its value depends on how long you live, how markets perform and whether you take the income. A rider that is never used still charged its fee every year; a rider that supports a long retirement may be worth much more than it cost.
• The death benefit may return at least your premiums, less withdrawals, if markets have fallen.
• Tax deferral postpones tax on growth, which matters most when other tax-advantaged room is used up. The index fund in the comparison is shown before tax, and in a taxable account it would have a tax cost that the annuity postpones until withdrawal. In an IRA the deferral is already present, as covered in Should you put an annuity in an IRA?.

A fair reading is that the cost is certain and the benefit is conditional. The worksheet helps you see the certain part clearly so that you can weigh the conditional part honestly.

What happens to the total when the balance moves

Percentage charges rise and fall with the account, but a charge on a benefit base does not. To see the effect, keep the same contract and change only the account value, holding the benefit base at $250,000. This is a simplification, because bases can step up or grow by a roll-up, but it isolates the point.

After a market decline, the owner pays fewer dollars but a higher share of what is left, and the rider's share of the account grows because its dollar amount stays put. This is the structure of the product: the guarantee is most valuable when the account has fallen, and the fee on it is most burdensome in the same situation. A rider with a charge on account value instead would behave differently, and some riders allow the charge to rise to a stated maximum. Check which design you have.

When the guarantee might earn its cost

No arithmetic can say whether the rider is worth $2,500 a year without knowing what happens next. It is useful to think through the cases.

• The account grows well and you never need the guarantee. You paid the fee each year and received nothing from it directly, other than peace of mind. This is the same way you pay for home insurance in a year with no fire.
• The account is depleted early by withdrawals and poor markets. The rider continues paying the guaranteed income for life, and its value to you is large.
• You die early. The guarantee may never have been used, though a death benefit may pay something to your beneficiaries.
• You never start income. A contract held only for growth, with a rider you do not use, pays the fee for a benefit that stays unused. Some owners drop the rider at an anniversary if the contract allows, and that decision belongs on a calendar.

The question for the buyer is not whether the guarantee is good in the abstract but how likely this household is to need it, and whether a cheaper way to get the same protection exists. A plain income annuity can provide guaranteed lifetime income without layered charges, at the price of access to the money; the trade-offs are laid out in an income rider on a deferred annuity versus a plain income annuity. The guide to guaranteed lifetime withdrawal benefit riders describes how the rider rules work.

Ways owners lower the total

Not every variable annuity charges at the levels in this illustration. Options that exist, with their own trade-offs, include:

• Lower-cost contracts. Some variable annuities sold through fee-only advisors have lower insurance charges and no surrender schedule, because no commission is paid. They often charge an advisory fee instead, which belongs in the total.
• Different share classes. The same contract may come in classes that trade a longer surrender period for a lower annual charge, or the reverse.
• Cheaper subaccounts. Fund expenses are the layer you control most directly. In the illustration, moving the $40,000 from the 1.15% fund to a 0.20% fund would cut $380 a year, since $40,000 × (1.15% − 0.20%) = $380.
• Dropping or skipping a rider. If the guarantee is not needed, a contract without it saves the whole rider line.
• Reallocating the money. For a contract in an IRA, the deferral is not an additional benefit, so the question of whether the contract belongs there at all is worth asking; see Should you put an annuity in an IRA?.

Lowering cost is not the same as improving value. A cheaper contract with less protection may not be the right one. The point is to compare the net cost against the benefits you will use.

Where to find each number in the prospectus

Variable annuities are registered with the SEC, so the numbers are in the prospectus, which every buyer should receive. Many contracts also offer a short summary prospectus. Use these places.

1. The fee table. Near the front of the prospectus, the table typically separates charges paid when you buy or withdraw (such as the surrender charge, shown as a percentage by year) from charges paid periodically (the annual contract fee, the separate account charges that include the M&E and administrative amounts, and the optional benefit charges). Use the current and maximum columns, and note which one your quote uses.
2. The fund expense table. A separate table shows the minimum and maximum annual operating expenses of the investment options. Your blended figure comes from the expense ratio of each fund in your own allocation, which is also in the fund's own prospectus.
3. The example of costs. The prospectus usually includes a table showing the dollar cost on a sample investment over one, three, five and ten years. It uses the highest and the lowest cost cases, so your result will fall in between.
4. The rider section. The description of each optional benefit states the charge, what it is a percentage of, whether the percentage can increase and the maximum it can reach. This is where you find out whether 1.00% is the current charge or the ceiling.
5. The charges section of the contract. The contract repeats the amounts that bind the company, which may differ from the current charges stated in the prospectus. The more important number is the maximum.

If the prospectus is hard to follow, the SEC's investor education site has a bulletin on variable annuities, and FINRA publishes an overview of annuity costs. The guide to variable annuities: how they work, what they cost, who they suit summarizes the structure.

Reading your statement against the worksheet

Annual or quarterly statements show some charges and hide others. As a rule:

• Rider and contract fees often appear as a line item or as a reduction in units.
• M&E and administrative charges are frequently built into the unit price, so you may see no dollar line at all.
• Fund expenses are never itemized on the contract statement; they are reflected in each fund's performance.

If a statement shows less than your worksheet total, the difference is probably charges you cannot see. Ask the company for a written breakdown of every charge in dollars for the last year. Companies can produce it, and asking is reasonable. The walkthrough in reading your annual annuity statement line by line looks at the other lines on a statement.

The surrender charge is a separate calculation

The annual total above ignores the surrender charge because it applies only if you take out more than the free amount during the surrender period. Add it when you plan an exit. For example, say the charge in year three is 6% and the free amount is 10% of the balance. On a full withdrawal of $200,000, the charge applies to $180,000, so it is $10,800. Together with the annual charges, the cost of exiting early can be large. Run this calculation for the next several years, and note the year in which the schedule ends. The details of schedules are covered in reading a surrender charge schedule before you need the money.

Your worksheet

Fill in each line from your prospectus and contract, using the balance you actually hold.

Check the total against the cost example in the prospectus, and against whatever the agent told you. If the agent quoted an all-in cost much lower than yours, ask which charges were left out.

Questions for the agent or the company

1. What is my total annual cost in dollars on this balance, with and without the rider?
2. Is the rider charge a percentage of the benefit base or of the account value, and can it increase?
3. Are there lower-cost share classes or contracts, including no-commission versions, and what do they give up?
4. Which fund choices are required by the rider, and what do they cost?
5. What are the surrender charges in each of the next several years?
6. How would the total change if the account fell by a third?

Sellers are expected to meet best-interest and suitability standards, described in best interest rules for annuity sales. If the answers to these questions are unclear, a fee-only planner can run the worksheet with you, and FINRA and your state insurance department take complaints.

Key takeaways

• A variable annuity's charges are quoted in percentages on different bases, so add them up in dollars: M&E, administrative, flat fees, fund expenses and rider charges.
• A rider charged on a benefit base costs more as a share of your account than its stated percentage whenever the base exceeds the balance, and it does not shrink when the account does.
• In this illustration, about 3% a year in total charges compounds to tens of thousands of dollars over ten years against a low-cost index fund, which the guarantees must justify.
• The prospectus fee table, fund expense table and cost example hold every number, and the current and maximum charges are different columns.
• Surrender charges are a separate, exit-time cost, so calculate them for each of the next several years before committing.