Trust That Collects a Management Fee on Principal It Never Disbursed
Imagine depositing $100,000 into an account that charges you 1 percent of the total every year, even if the money never leaves the cash position. No trades, no disbursements, no activity at all—just a fee ticking against the full balance. That is the basic structure of many deferred annuities, and it is written into the contract in plain language that few buyers read.
Annuities are sold as retirement vehicles that offer tax-deferred growth and guaranteed income. But the fee engine runs on a simple rule: the annual charge applies to the account value, not just to gains or to assets that have been put to work. The industry calls this a mortality-and-expense risk charge, and it typically runs between 0.5 and 1.5 percent of the entire balance each year. Add in underlying fund expenses, administrative fees, and optional rider costs, and the total annual tab can exceed 3 percent. On a $200,000 account, that is $6,000 a year—whether the market goes up, down, or sideways.
This article walks through how that fee structure works, where it is buried in the fine print, and what it means for someone trying to build retirement savings. It is not a recommendation to buy or avoid any product. It is an explainer of the mechanics, written for someone who wants to understand the contract before signing.
The Fee That Keeps Ticking on Money That Never Left
The central feature of a deferred variable annuity is that the insurance company collects a management fee on the entire account value, regardless of how much of that value is actually invested in the market. If you allocate your $100,000 to a fixed account that earns 2 percent, the insurer still charges the mortality-and-expense fee on the full $100,000. If you park the money in a money market subaccount yielding near zero, the fee still applies. The charge is not contingent on investment activity.
This is different from a mutual fund, where the expense ratio applies only to assets under management. If a fund holds cash, the management fee still applies, but the fund itself is the investment vehicle. An annuity adds an extra layer: the insurance wrapper charges a fee on the entire account, and then the underlying investments charge their own fees on top. The result is a double layer of costs that compound over time.
Industry advocates argue that the mortality-and-expense charge covers the insurance guarantee—the promise that if you die, your beneficiaries will receive at least the principal, minus any withdrawals. That guarantee has real value, but it is not free. The question is whether the fee is proportionate to the risk. For a 65-year-old in good health, the actuarial probability that the insurer will need to make a death-benefit payout is low. Yet the fee is the same for all ages in the same contract.
Some contracts also include a guaranteed minimum withdrawal benefit rider, which adds another 0.5 to 1.0 percent annually. That rider promises that you can withdraw a certain percentage of the benefit base each year, even if the account value drops to zero. The fee for that rider is charged against the account value, not the benefit base, which can create a mismatch where the fee grows even as the account shrinks.
How the Contract Writes This Into Law
Open the prospectus of any variable annuity, and you will find a section titled “Fees and Expenses.” That section is required by the Securities and Exchange Commission (SEC) and must include a table showing the total annual expenses as a percentage of the account value. For a typical variable annuity, the table lists the mortality-and-expense risk charge, the administrative fee, and the underlying fund expenses. The total often appears in a row labeled “Total Annual Operating Expenses.”
Take the Vanguard Variable Annuity as an example. As of late 2024, its prospectus showed a mortality-and-expense risk charge of 0.35 percent, an administrative fee of 0.10 percent, and underlying fund expenses ranging from 0.10 to 0.40 percent. That puts the total near 0.85 percent for a low-cost option. But many annuities sold through brokers carry charges above 2 percent. A surrender fee can add another layer if you withdraw early.
The fee accrues daily, meaning the insurer calculates the charge each day based on that day’s account value. Over a year, the daily charges sum to the annual percentage. This daily accrual is standard across the industry, and it means that even a short holding period incurs the full daily fee. There is no grace period.
The surrender charge schedule is another key contract term. Most annuities have a declining surrender period, typically 7 to 10 years, during which a penalty applies to withdrawals above a certain threshold (often 10 percent of the account value per year). The penalty starts high—say, 7 percent in year one—and declines by one percentage point each year. After the surrender period ends, withdrawals are penalty-free, but the annual fees continue.
Some annuities offer a “bonus credit” of 2 to 5 percent of the initial premium, but that bonus often vests over several years. If you withdraw early, you forfeit the unvested portion. The bonus is also subject to the same annual fees, so the insurer collects fees on money it gave you as an incentive.
The Tax Tail That Wags the Withdrawal Dog
Annuities are tax-deferred, meaning you do not pay taxes on gains until you withdraw money. That sounds attractive, but the tax treatment of withdrawals has quirks that can magnify the effective cost. Under the Internal Revenue Code, withdrawals from a non-qualified annuity (one funded with after-tax dollars) are taxed under a LIFO rule: last in, first out. That means every withdrawal is treated as coming from earnings first, not from principal.
If you invest $100,000 in a non-qualified annuity and it grows to $150,000, the first $50,000 you withdraw is fully taxable as ordinary income. The remaining $100,000 is considered a return of principal and is tax-free. This rule can create a tax surprise for someone who needs a large withdrawal early in retirement. The earnings portion is taxed at your marginal income tax rate, which could be as high as 37 percent federally, plus state taxes.
For a qualified annuity—one held inside an IRA or 401(k)—the entire withdrawal is taxable because the contributions were pre-tax. The LIFO rule does not apply; instead, all withdrawals are taxed as ordinary income. The annuity adds no tax benefit beyond what the IRA already provides. In fact, the annuity’s fees can erode the tax deferral advantage.
If you withdraw before age 59½, the IRS imposes a 10 percent penalty on the earnings portion of the withdrawal. This penalty applies on top of ordinary income tax. The combination of tax and penalty can consume a large share of the withdrawal. For someone in the 22 percent bracket, a pre-59½ withdrawal of earnings faces a 32 percent total hit (22 percent tax plus 10 percent penalty).
After age 73, qualified annuities are subject to required minimum distributions (RMDs) under the SECURE Act. The annuity company must distribute a certain amount each year based on the IRS life expectancy tables. Those distributions are taxable and reduce the account value, but the annual fees keep running on the remaining balance. The RMD can force withdrawals at a time when the market is down, locking in losses.
Why the Industry Calls It a Feature, Not a Bug
Insurance companies argue that the mortality-and-expense charge is not a fee for nothing—it pays for real guarantees. The death benefit guarantee ensures that if you die before annuitizing, your beneficiaries receive at least the principal (minus withdrawals). The guaranteed minimum withdrawal benefit, if you buy it, promises a lifetime income stream. These guarantees require the insurer to hold reserves and hedge against market risk, which costs money.
A 2018 report from Cerulli Associates estimated that the average variable annuity fee, including all layers, was roughly 2.3 percent. That is in line with other industry data. The report noted that fee levels had declined somewhat from the early 2000s, when average fees were closer to 3 percent. But the decline has been slow, and many annuities sold through commissioned brokers still carry fees above 2.5 percent.
Proponents also point out that annuities offer professional management and rebalancing, which can be valuable for someone who does not want to manage their own portfolio. The underlying subaccounts are managed by the same firms that run mutual funds, and the annuity wrapper provides tax deferral on the gains. For someone in a high tax bracket, the deferral can be worth something.
But the counterargument is that the fee structure creates a conflict of interest. The insurer earns the same fee regardless of investment performance. There is no incentive to minimize costs or to encourage the policyholder to move to lower-cost options. In fact, the insurer has an incentive to keep the account value as high as possible, because the fee is a percentage of that value. That can lead to aggressive investment options that carry higher underlying expenses.
Some states have considered legislation requiring clearer fee disclosures, but as of 2025, no federal rule mandates a simple dollar-cost summary. The prospectus table is the closest thing, and it requires some math to convert percentages into actual dollar amounts over time.
The Arithmetic of Never Disbursing
To see how the fee structure compounds, consider a hypothetical $100,000 investment earning a gross annual return of 5 percent. Assume a 1 percent annual fee on the entire account value, charged at the end of each year. After one year, the account grows to $105,000 before fees. Subtract 1 percent of $105,000 ($1,050), and the net value is $103,950. The fee consumed about 21 percent of the year’s gain.
After 20 years, the account would grow to roughly $219,000 without fees. With the 1 percent fee, it would be about $179,000. The difference—$40,000—is roughly one-third of the total growth. The fee consumed not just a portion of each year’s gain, but also the compounding on that portion. Over 30 years, the gap widens to roughly $90,000 on the same assumptions.
Compare that to a low-cost index fund with an expense ratio of 0.03 percent, held in a taxable brokerage account. The same $100,000 earning 5 percent would grow to about $265,000 after 30 years, assuming no taxes on gains until sale. The annuity’s after-fee value would be around $175,000. The difference exceeds $90,000, even before accounting for the annuity’s higher tax burden on withdrawals.
This arithmetic is not a secret. The SEC requires annuity prospectuses to include a fee table that shows the cumulative effect of expenses over time, typically using a $1,000 investment and a 5 percent return. The table shows that after 10 years, the total fees paid can amount to hundreds of dollars per thousand invested. But few buyers read that table.
The same logic applies to the surrender charge. If you need to withdraw a large sum during the surrender period, the penalty can wipe out years of gains. For example, a 7 percent surrender charge on a $100,000 withdrawal costs $7,000, which is more than a year’s worth of fees on the same balance. The combination of annual fees and surrender penalties can make annuities very expensive to exit.
Three Contractual Traps That Magnify the Cost
Beyond the basic fee structure, three specific contract features can increase the total cost significantly. The first is the bonus credit that vests over time. Some annuities offer an upfront bonus of 2 to 5 percent of the initial premium, but that bonus is not available until you hold the contract for a certain number of years—often 5 to 7. If you surrender early, you forfeit the unvested portion. Meanwhile, the insurer charges fees on the full account value, including the bonus amount. So you pay fees on money you do not yet own.
The second trap is the step-up feature found in some variable annuities. When the account value reaches a new high, the guaranteed minimum death benefit or living benefit basis resets to that higher value. That sounds good, but the fee for the rider is often based on the benefit base, not the account value. If the market drops after a step-up, the fee remains high relative to the actual account value. The insurer collects a fee on a promise that may never be used.
The third trap is the guaranteed living benefit rider, which can add 0.5 to 1.0 percent annually. These riders promise a minimum income stream regardless of market performance. But the fee is charged against the account value, which can decline even as the benefit base remains fixed. In a prolonged bear market, the fee can consume a large percentage of the shrinking account. Some contracts allow the fee to be waived if the account value drops below a certain threshold, but that is rare.
These features are not inherently bad; they can provide valuable protection for someone who prioritizes income guarantees. But they add cost, and the cost is not always transparent. A policyholder who buys a rider for peace of mind may end up paying more in fees than they receive in benefits.
What to Look For Before You Sign
Before buying an annuity, ask the agent or company for a fee table that shows the total annual cost in dollars, not just percentages. The prospectus will have a table titled “Annual Expenses” that lists the mortality-and-expense charge, administrative fee, and underlying fund expenses. Add them up. Then ask for a projection of what the account would be worth after 10, 20, and 30 years under a reasonable return assumption, with and without fees.
Check the surrender schedule. Most annuities have a declining penalty period of 7 to 10 years. If you might need access to the money before then, an annuity is probably not the right vehicle. A prospectus clause in some annuities also allows the insurer to delay payments under certain conditions, adding another layer of illiquidity.
Compare the annuity to a simple brokerage IRA invested in low-cost index funds. The tax treatment is the same for qualified annuities and IRAs. The IRA has no insurance wrapper and no mortality-and-expense charge. The only difference is the annuity’s guarantee features. Decide whether those guarantees are worth the extra cost.
Finally, read the fee section of the prospectus yourself. Do not rely on a summary from a salesperson. The prospectus is a legal document, but the fee section is usually written in plain language. Look for the words “mortality and expense risk charge.” That is the fee that never disburses.
This article is for informational purposes only and does not constitute personalized financial advice. Consult a qualified professional before making investment decisions.
