Mortality and Expense Fees: A Deep Dive into Annuity Costs
Mortality and expense fees, often abbreviated as M&E fees, represent an ongoing charge deducted from the value of a variable annuity contract. These fees belong to the broader category of Annuity Costs and compensate the issuing insurance company for the various insurance-related risks and administrative services they provide. M&E fees typically cover the cost of the guaranteed death benefit, guaranteed living benefits (if chosen), and the assurance that the insurer's administrative expenses will not increase beyond a stated maximum. They are a core component of the fee structure of a variable annuity, distinguishing them from other investment vehicles like mutual funds.
History and Origin
The concept of mortality and expense fees is intrinsically linked to the development and evolution of variable annuities. Variable annuities emerged as a financial product seeking to combine the tax-deferred growth benefits of traditional annuities with investment exposure to equity markets. However, due to their investment-linked nature, the question of their regulatory oversight became a central legal battle.
A pivotal moment in the history of variable annuities, and thus the fees associated with them, occurred in 1959 with the landmark Supreme Court case SEC v. Variable Annuity Life Insurance Co. (VALIC). The Supreme Court ruled that variable annuities, despite their insurance characteristics, are indeed securities and thus subject to regulation by the Securities and Exchange Commission (SEC) under the Securities Act of 1933 and the Investment Company Act of 1940. This decision brought these complex products under federal securities law, leading to more standardized disclosure requirements for all associated costs, including mortality and expense fees.19 This regulatory framework ensured that insurance companies would clearly outline the various charges, including M&E fees, in the product prospectus.
Key Takeaways
- Mortality and expense fees are charges within variable annuities that cover the insurer's mortality and longevity risks, along with administrative and distribution costs.
- These fees are typically expressed as an annual percentage of the annuity's portfolio value or daily net asset value.
- M&E fees compensate the insurer for guarantees like death benefits and guaranteed living benefits.
- They directly reduce the investment returns within the annuity's subaccount.
- Understanding mortality and expense fees is crucial for evaluating the overall cost-effectiveness of a variable annuity.
Interpreting the Mortality and Expense Fees
Mortality and expense fees are typically presented as an annual percentage of the annuity's account value. For instance, an M&E fee of 1.25% means that 1.25% of your contract's value is deducted each year to cover these costs. This percentage often remains constant over the life of the contract, regardless of the investment performance of the underlying subaccounts.
The "mortality" component accounts for the risk an insurer takes on when providing features such as a guaranteed death benefit, where the payout to beneficiaries might exceed the contract's accumulated value if the annuitant passes away sooner than actuarially projected. It also covers the risk that annuitants live longer than expected, ensuring lifetime income payments can be sustained. The "expense" portion covers various operational and administrative costs incurred by the insurance company, including record-keeping, customer service, and distribution expenses, which may include commissions paid to financial professionals for selling the product.18
A higher mortality and expense fee can significantly erode an annuity's long-term returns. Investors should carefully review the prospectus to understand the exact percentage charged and what specific guarantees or services these fees cover. Different annuity products, and even different share classes within the same product, may have varying M&E charges.17
Hypothetical Example
Consider an investor, Maria, who purchases a variable annuity with an initial payment of $100,000. The annuity contract specifies an annual mortality and expense fee of 1.25% of the account value.
In the first year, assuming no investment growth or withdrawals, the M&E fee would be calculated as:
This $1,250$ would be deducted from Maria's annuity account over the year, typically on a daily or monthly basis. If the account value grows to $110,000 in the second year due to positive investment performance, the M&E fee would then be calculated based on this new, higher value:
Conversely, if the account value decreases, the mortality and expense fees deducted would also decrease, as they are a percentage of the current portfolio value. This example illustrates how mortality and expense fees, as an ongoing percentage charge, can have a compounding effect on the overall cost of the annuity over time, directly impacting the net returns.
Practical Applications
Mortality and expense fees are a standard component of variable annuity contracts and are applied to help cover the unique investment risk and longevity risk that insurance companies undertake. These fees allow insurers to provide valuable contractual guarantees such as a guaranteed minimum death benefit, ensuring that beneficiaries receive at least the amount invested (or a stepped-up value) even if the market performance is poor. They also fund guaranteed minimum living benefits, which provide a guaranteed income stream regardless of market fluctuations or how long the annuitant lives.16
For individuals engaged in financial planning, understanding M&E fees is critical when evaluating whether a variable annuity fits their long-term retirement goals. These fees are regulated by bodies like the SEC and FINRA, which require clear disclosure in the annuity's prospectus.15 Investors are encouraged to consult these official resources for detailed information on fees and expenses.14
Limitations and Criticisms
Despite the benefits of the guarantees they provide, mortality and expense fees are often a significant contributor to the overall cost of variable annuities, leading to criticisms regarding their impact on investor returns. These fees, when combined with other charges like administrative fees, underlying fund expenses, and rider fees, can result in total annual expenses exceeding 3% or more of the account value.13 Such high costs can significantly reduce the long-term growth potential of the investment.12
Critics also point out that a portion of the mortality and expense charge is sometimes used to cover commissions paid to financial professionals who sell the annuity. This commission structure has led to concerns about "unsuitable" recommendations, where advisors may recommend variable annuities not primarily for the client's benefit, but due to the high commissions involved. FINRA, the Financial Industry Regulatory Authority, has identified variable annuities as a leading source of investor complaints, often related to their complexity, confusion, and questionable sales practices.11 They emphasize that these products are long-term investments and may not be suitable for investors with short investment horizons or significant liquidity needs due to potential surrender charge penalties for early withdrawals.
The financial crisis of 2008 highlighted the fragility that guaranteed benefits (covered by M&E fees) could introduce for insurance companies, leading some insurers to increase fees or reduce the level of guarantees offered in subsequent years to manage their own risk exposure.10
Mortality and Expense Fees vs. Administrative Fees
While both mortality and expense fees and administrative fees are charges levied on variable annuities, they serve distinct purposes. Understanding the difference is crucial for a complete picture of an annuity's cost.
| Feature | Mortality and Expense (M&E) Fees | Administrative Fees |
|---|---|---|
| Primary Purpose | Compensates the insurer for insurance risks (mortality, longevity) and distribution costs. | Covers record-keeping, statements, customer service, and other general operational costs. |
| Coverage | Guaranteed death benefit, guaranteed living benefits, assurance of stable expense charges. | General overhead, processing, and maintenance of the annuity contract. |
| Calculation | Typically an annual percentage of the annuity's account value (e.g., 1.25%).9 | Can be a flat annual fee (e.g., $30) or a smaller percentage of account value (e.g., 0.15%).8 |
| Risk Covered | Risk that policyholders live longer than expected (longevity risk) or die sooner (mortality risk). | Operational risk and the cost of managing individual accounts. |
Mortality and expense fees are fundamentally tied to the unique insurance guarantees embedded within a variable annuity, reflecting the insurer's assumption of actuarial risks.7 Conversely, administrative fees are more akin to routine service charges that cover the basic upkeep and management of an account, regardless of the insurance features provided. Both contribute to the overall expense ratio of the annuity, but they account for different aspects of the insurer's costs and risks.
FAQs
What do mortality and expense fees cover in an annuity?
Mortality and expense fees (M&E fees) primarily cover the costs associated with the insurance guarantees offered by a variable annuity. This includes the guaranteed death benefit, which ensures a minimum payout to beneficiaries, and any guaranteed living benefits that provide income or withdrawal protections. They also cover administrative and distribution costs incurred by the insurance company.6
Are mortality and expense fees negotiable?
Generally, mortality and expense fees are a fixed percentage stated in the annuity contract and are not typically negotiable for individual investors. However, different annuity products or different share classes of the same annuity may have varying M&E charges. For instance, some variable annuities designed for fee-based advisors might have lower internal M&E charges because the advisor's compensation is paid directly by the client outside the annuity.5
How do M&E fees impact my investment returns?
M&E fees are deducted from your annuity's account value, often on a daily or monthly basis, which directly reduces your investment returns. Over many years, these ongoing percentage-based charges can significantly compound, diminishing the total growth of your investment within the annuity.4 It's essential to consider these fees when comparing the potential returns of a variable annuity against other investment options.
Are M&E fees the only fees in a variable annuity?
No, M&E fees are just one component of the overall costs in a variable annuity. Other fees commonly include administrative fees, charges for optional riders (additional benefits like enhanced income guarantees), and the operating expenses of the underlying mutual fund subaccounts where your money is invested.3 Understanding the full scope of all charges is critical for assessing the total cost of ownership.
How are mortality and expense fees determined?
Mortality and expense fees are determined by the insurance company based on actuarial projections of life expectancy, anticipated mortality rates among policyholders, and the projected administrative and distribution costs. Factors like the age of the annuitant at purchase can influence the mortality risk component, though the stated percentage for M&E is generally applied uniformly across the contract value once purchased.2 The fees are intended to cover the insurer's potential losses if payouts exceed premiums, particularly for guaranteed features.1