Annuity Riders

Additional Costs

Adding annuity riders comes with additional costs. In addition to the rider fee, there are base contract charges and other costs that could amount to several percentage points per year. The rider fee itself might seem small in isolation, but when combined with base contract fees, costs of holding underlying investment products (like mutual funds in the case of a variable annuity) or a contract that already limits your growth potential like an indexed annuity, your account’s growth may be severely limited. Riders are normally only available upon issue date and cannot be added after the contract is issued.

So, while riders may sound comforting, it’s always important to think carefully about the costs of any rider added to an annuity contract and be clear about the total fees and additional costs. Calculating all the fees and costs of an annuity contract can help the investor assess whether the potential returns are worth the costs. Too often, investors don’t do their research and end up paying too much for too little benefit. This can have dire consequences on their retirement lifestyle or their ability to leave a financial legacy.

Tax Consequences of Death Benefit Riders

Annuity death benefits are not treated as life insurance. Any gains from a non-qualified annuity your beneficiaries inherit would be taxed at ordinary income tax rates. This is because the gains of an annuity aren’t taxed until they are withdrawn. If a qualified annuity is inherited, such as an IRA or Roth IRA, the assets follow traditional IRA tax rules for inheritance purposes.

For income tax purposes, gains on an inherited non-qualified annuity are considered income when the beneficiary receives it. If the beneficiary chooses to receive a lump sum, the tax is payable on everything above the original cost basis; the original cost basis amount is excluded from taxable income.

The Risks of Riders

Many investors look at annuities as a way to mitigate the risks associated with stock market volatility, but annuities and annuity riders come with risks of their own.

In an attempt to receive guaranteed income for life, investors often forget about inflation, which can erode your purchasing power over time. When buying an annuity, five percent of the contract value may seem sufficient to cover your expenses, but that percentage may not account for inflation.

A common restriction associated with living benefit riders is a waiting period before you can receive a cash flow, which creates liquidity risk. Waiting periods can be detrimental if unexpected costs arise, such as hospital bills or urgent home repairs. In these cases, you may incur surrender fees in order to access your money, further adding to your total costs. Moreover, taking withdrawals before the income rider allows can also reduce your future guaranteed income.

One of the most detrimental risks associated with riders is the additional fees on top of existing annuity fees. This effect is exacerbated for those annuities that are structured to provide CD-like returns. Adding a 1.25% fee to a product that might optimally produce a 2% to 4% annual return can have a demonstrably negative impact over time.

Excessive fees affect you in the short term with out-of-pocket costs and in the long term, because every dollar spent on fees is money that’s not earning a return. These fees reduce the effect of compound interest and can further inhibit your ability to meet your long-term goals. For example, consider the fees of an average variable annuity with a common rider:

• Annual M&E and administrative fees generally are 1.21% on average.¹
• Many variable annuities invest in subaccounts which are similar to mutual funds, which will also charge an annual fee averaging 0.98%.²
• Income rider fees typically range between 0.35% and 1.60% annually.³

In the above example, the hypothetical variable annuity fees with one rider could amount to 3.79% annually!⁴ When compared to other investments, these fees can be excessive and make it difficult to achieve your long-term goals. When considering an annuity, understand that annuities may not be the best way to limit risk or create ongoing investment income.