The Real Cost of Annuities: A Look Into What You Pay for What You Get Annuities are a great way to invest, protect yourself from outliving your savings during retirement, and even protect a spouse or dependent from the financial consequences of your death. But,...

Annuities are a great way to invest, protect yourself from outliving your savings during retirement, and even protect a spouse or dependent from the financial consequences of your death. But, as with all financial instruments, annuities come with associated costs. Depending on the characteristics of the contract, an annuity's costs structure can sometimes feel overwhelmingly complex, making it difficult to know if they're a good investment or not.

How much do annuities really cost? What factors come into play when insurance companies calculate premiums? These are important questions we should all ask ourselves before making a $100,000+ disbursement, and I'll answer them in this post.

Factors that affect an annuity's cost

Just as when deciding what mutual fund to choose, comparing insurance policies or even choosing a credit card, for that matter, choosing an annuity is all about comparing its cost with its benefits. In this sense, annuities can have different associated fees and commissions depending on a series of factors. The ones that matter the most are:

• Age.
• Gender.
• Overall state of health.
• Type of annuity contract.
• Contract riders.

Age, gender and the overall state of health affect annuities differently than they do life insurance. In general, the longer your life expectancy, the more you usually have to pay for an annuity (whereas it's the opposite for some insurance products). Consequently, women usually pay more in fees than men, except in some cases where the annuity is linked to a 401(k) fund, which has gender equality requirements.

On certain types of annuities, younger individuals also pay more because of longer life expectancies. On the other hand, having poor medical conditions that increase the risk of life-threatening diseases and reduce your life expectancy can lower the fees you have to pay on some annuities and even increase the monthly payout you stand to receive.

The other two factors, i.e., the type of annuities and the addition of contract riders, deserve separate sections of their own.

Cost of different types of annuities

The type of annuity is one of the most influential factors that affect the cost of entering these contracts:

The costs of variable annuities vs. fixed annuities

Fixed annuities have virtually no fees. Depending on the insurance company and who sold you the annuity, they may receive a sales commission, which you, as the annuitant, ultimately cover. However, other than that, there are usually no other associated costs, provided you go for a simple contract without adding provisions or riders, but I'll get to those further down the post.

In the case of variable annuities, these are subject to several upfront fees and other charges. Variable annuities invest your funds in an investment portfolio so that your account gets market exposure, potentially increasing in value over time. While your money won't be invested in bitcoin or other high-risk investments, investment portfolios will usually include assets like stocks, bonds and indices.

In these cases, there will be administrative fees that aim to cover bookkeeping and other administrative costs associated with opening and maintaining the investment sub-account. You'll also have to pay fees and other expenses related to the underlying fund where your premium is invested, which can reach values of 1% of the invested amount every year or more.

The costs of immediate annuities vs. deferred annuities

Immediate annuities are those that are automatically annuitized the moment you sign the contract. In other words, they don't have an accumulation period during which your investment will grow tax-deferred.

In the case of a standard immediate annuity contract, since the account is immediately annuitized, you begin receiving monthly payments as per the contract conditions (fixed or variable, for example) right away for the rest of your life. In these cases, the insurance company estimates how long you're likely to live based on your particular characteristics when buying the annuity. Once they get a reliable estimate, they'll calculate how much to pay you every month so that the entire value of your original investment, i.e., the one-time premium, is completely exhausted by the time they make the last foreseen payment.

This begs the question, what happens if you outlive your estimated life expectancy? If that happens, you will continue to receive your payments regardless. Insurance companies cover these apparent extra costs by pooling all the funds available for annuitized annuities into a single account. This allows them to pay for people who outlive their life expectancy with the money from people who die before expected, therefore spreading the risk of losing money.

In the case of deferred annuities, things are a little different. You invest a lump sum today, let it grow over time and start receiving income if you decide to annuitize it at a specified date in the future. In these cases, there will be surrender charges that can go as high as 10% if you take some or all of your money out of your annuity early, although the percentage usually decreases the longer you wait.

Costs of adding contract riders or provisions

Riders are simply additions or provisions you add to a standard annuity contract to personalize it to fit your needs better. For example, you usually lose the right to the premium you paid when you annuitize your annuity to start receiving monthly payouts. In other words, you cannot change your mind and tell the insurance company that you want your money back. You also lose the right to pass any unused benefits down to your heirs if you die before exhausting your initial investment's value.

A way around this is to add provisions to the contract that allow you to make withdrawals from your account without actually annuitizing it. The insurance company will take the withdrawals from your account's principal so, by the time you exhaust that, your account will be considered annuitized, and you'll continue to receive your monthly annuity until you die, but there's nothing left for you to pass down or to withdraw from.

For insurance companies to afford to make these payouts, they cover the risk by charging a fee if you want to add that rider.

Riders can be one-time or recurring, and they mainly come in the form of income protection benefits (like the one exemplified above), death benefits and disability income.

Fees for guaranteed death benefits riders, guaranteed income riders, or guaranteed caps on administrative charges riders can be as high as 1.2% each. This implies that the more riders you add to a base annuity contract, the more complex and expensive it becomes.

The bottom line

Annuities are a form of investment that provides a guaranteed retirement income, either fixed or variable. In order to make an informed decision when purchasing one of these investment products, it's important to understand the costs associated with them. Things like age, gender, the overall state of health, type of contract, riders, or provisions can all impact both the benefits you stand to gain and their costs.

While some annuities can become very expensive due to multiple fees and commissions, others are much more affordable. The general rule of thumb is, the simpler the contract and the fewer riders you request, the cheaper the annuity.

After considering the above, you can decide what is more important for you regarding retirement planning. Suppose maximizing the dollar value of your monthly income for life is what you want, and you aren't interested in protecting your principal. In that case, you'll be able to avoid most fees and other costs associated with annuities.

On the other hand, if you're looking for income protection, principal protection and even long-term care protection for a laid-back, easy-going retirement, then you should know that this will come at a considerable cost. In the end, the choice is yours.

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