Components of Annuity Pricing

The first thing that retirement plan sponsors need to know about the prices of annuities they might offer in their plans is that in-plan annuities should be less expensive than out-of-plan annuities available on the retail market because there are far fewer salespeople servicing them, says Dan Keady, chief financial planning strategist at TIAA.

Plan sponsors looking to offer an in-plan annuity should “look for low cost annuities—but also for a high-quality firm with financial strength,” Keady says.

Doug McIntosh, vice president of investments at Prudential Retirement, agrees: “The SECURE Act points out that the provisions for a sponsor examining the financial capability of a guarantor require them to first focus on their financial strength. There is no requirement for plan sponsors to find the lowest payer possible.”

When it comes to pricing an annuity, it depends on the type of annuity being purchased—variable or fixed, immediate or deferred, and what types of guarantees it offers, says Ephie Coumanakos, managing partner of Concord Financial Group. Then, “as a whole, their price is affected by interest rates and the ability to earn a return on the portfolio by investing in fixed instruments like bonds,” she adds.

Essentially, there are four basic components to the price of an annuity, says Sri Reddy, senior vice president of retirement and income solutions at Principal. “There is the cost of distribution, which is baked into the pricing,” Reddy says. “Through a plan sponsor, that is close to zero.”

“The second is the administration and service charges, or the operational charges. The third is tied to the investments. In a fixed product the insurance company needs to earn a return above the guaranteed rate, so that is the spread. In a variable product, the fees are for the underlying investments,” he explains.

“The fourth is the capital charge the insurer will charge due to their risk of capital cost.” Reddy explains, “You might live too long or the market may not perform as well as projected.”

The Insured Retirement Income Council website, iricouncil.org, is a good resource for plan sponsors, McIntosh says. But in general, “most guaranteed vehicles price in around 100 basis points, over and above the cost of the underlying funds in a variable product,” McIntosh says. “That number can go up or down.”

For example, Prudential had one client that wanted a fee lower than 100 basis points. “We were able to pull back on the equity exposure and increase the efficiency of the hedging we do in an index, so we were able to reduce the fees to 80 basis points, but to do that, it needs to be a large plan sponsor.”

As another example, “What if a plan sponsor said, ‘I like your off-the-shelf deferred annuity paying 5% at age 85, but we want a 5.75% payout.’ Because we are adding risk to our books in the form of, perhaps that money paying a higher return runs out a little faster, we might charge a higher fee, say 1.2%,” McIntosh says.

With fixed products, sponsors and participants need to realize that “they do not charge any explicit fee, no expense ratio,” McIntosh says. “It is just the exchange of money for a promise. Their payout is massively affected by what interest rates are doing right now and how long the participant is willing to wait for the money. The longer they wait, the more they should receive per unit contributed.”

Another important factor is whether the annuitant requires flexibility, McIntosh continues. The most risk that is asked of the guarantor, the lower the payout in a fixed annuity or the higher the fee in a variable annuity, he notes. For example, is the annuitant asking for a payout for the rest of their life or a period certain? Do they want to leave benefits to their spouse or relative?

“Any additional flexibility that the participant asks for adds to the fee in a variable product and reduces the payout in a fixed product,” McIntosh says. “We have found that, overwhelmingly, individuals like flexibility, and they want some assets left when they pass. The vast bulk of in-plan annuities are guaranteed variable products.”

The guaranteed riders on fixed income and variable annuities add to their costs, says Mark Charnet, founder and CEO of American Prosperity Group. “Living benefit rider fees are typically less than 1% on indexed annuities and 1.35% in variable annuities,” Charnet says.

However, like McIntosh, Charnet says that most people want those guarantees and are willing to pay for them. “The wisdom of purchasing these guarantees was underscored in 2008,” Charnet says. “Should an annuitant have bought a fixed index annuity without a rider just before a market period like 2008, when the S&P fell 39%, it would have seriously skewed their life. It is vitally important that people protect their money for their future.”

Sponsors and participants also should understand that all annuities, except for immediate annuities, have what is called a “surrender period,” typically seven to 10 years, during which withdrawals are limited to 5% to 10% of the assets each year, Coumanakos says. Any withdrawal above those caps will be subject to a penalty, she says. Once the surrender period is over, the annuitant can withdraw as much of the remaining balance that they want, she says.

Thus, “it is important for people to realize that they are not completely restricted from accessing their money, and that any profits from their investments are tax free,” Charnet says. “And some companies offer cumulative withdrawals, so, if you don’t use the 10% withdrawal cap in one year, you can take a 20% withdrawal in the second year. However, this is not standard.”

In sum, Keady suggests that sponsors consider “something that is simple and academically supported, like a fixed annuity or a plan variable annuity. They should then look at the financial strength of the company. It should be highly rated because the participants will be relying to make good on their payments over a long period of time. And third, they should make sure the annuity company can provide appropriate advice for people so that they can understand how annuities work and how they could fit into their portfolio.”

McIntosh reports that since the passage of the SECURE Act, “interest among plan sponsors in annuities has gone through the roof.” He says this encourages him, because he would like to see “many more working Americans get access to guaranteed income.”