More Insurers Raise Fees on Variable Annuities

Pacific Life and The Hartford have joined the ranks of insurers who are raising prices and fees on some of their most popular investment products: variable annuities that promise to provide market gains with no risk, and a lifetime stream of income.

The moves suggest a problem that critics have long suspected: Many insurance companies radically underestimated the cost of hedging their guarantees in a market meltdown. Now that the markets have crashed, some investors will find they’re paying a lot more for the same product.

As SmartMoney has reported, this is one way that annuities are failing to live up to their big promises. The guarantees attached to the products – minimum returns of 6% per year or better, market upside, no chance of loss and a lifetime income stream – were designed to attract people in retirement or close to it.

And it worked, attracting $650 billion in assets in the last five years. But the guarantees are only as good as the insurance company’s ability to hedge them, and even when the markets were rising, some insurance company executives admitted their strategies hadn’t been tested by real-life crisis conditions. Now some estimates suggest that hedging costs have doubled in the last year, and insurers are passing those costs along to their customers.

Every annuity is wrapped in layers of fees, which are typically expressed as a percentage and charged annually. Investors usually pay annual fees for the underlying investments, for the insurance wrapper, and then for additional benefits, such as the all-upside, no-downside guarantees. Fees in that last category cover what are technically called Guaranteed Minimum Withdrawal Benefits; they’ve been driving the recent boom in sales, and this is where prices are rising.

For example, an investor might purchase a $100,000 annuity that pays a guaranteed 6% annual return for 10 years, or market returns — whichever is better. The fees for a product like that might look something like this:

The fees now rising are all in that last category — charges that cover guarantees. At the Hartford, the fees of three different kinds of guarntees are rising, from the current charge of 0.35% to 0.75%. At Pacific Life, the fee on its Foundations 10 product, which guaranteed a 10% annual return for 10 years, will go up from 0.85% to 1.35%; costs on three other kinds of guarantees are rising, too. Pacific Life is also restructuring a number of its annuities to make them less generous and limiting investors to more conservative investment options.

Both companies say existing policyholders won’t pay more until their accounts recover, because the higher fees are structured so that they kick in after a so-called step-up, which means essentially a reset of the purchase price to reflect market gains.

Even so, Pacific Life’s fee increase from 0.85% to 1.35% is particularly egregious, says John McCarthy, vice president of Advanced Sales, an annuity research company. "I’d be mad about that one,” he said. “It might not kick in this year, but it will eventually." And because most annuities levy steep penalties for cashing out early, investors who want out could pay a fine of up to 10%. And new policyholders will pay the higher fees from the get-go. Pacific Life didn’t return calls for comment.

Even annuity investors whose fees are not officially rising may find they’re paying more than they thought. Logic would dictate that because the cost of these benefits is expressed as a percentage, when account values drop, so should the fees.

But it isn’t that simple. Even though the cost of these benefits is always expressed as a percentage, it won’t drop this year. Here’s why: The basic annuity typically costs around 2.3% of the account balance (like an expense ratio on a mutual fund). But the all-upside, no-downside guarantee is usually calculated as a fraction of the original investment, even if the account value drops. So if you put $100,000 into Pacific Life’s Foundation 10 product, for example, the guarantee costs 0.85% of the original amount. You’ll pay $850 even if your account balance dropped to $75,000.

Insurance companies have to charge this way, industry experts say, because they’re hedging the benefit based on the initial account value. A spokesman for the Hartford says it is raising prices because the volatility in the markets has driven up the cost of hedging the benefits.

But the increased fees make an already expensive investment even pricier. A variable annuity already costs almost 3% per year. As the prices go up and the balances go down, as a percentage, the cost rises to closer to 4%.

To some, it’s worth the higher prices. “Given all we’ve been through, I’d rather pay the higher price and still have the guarantee,” said Scott Demonte, Director of Variable Annuity Markets at market research firm Financial Research Corporation. Shell-shocked investors may not care, either.