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Beware of Surrender Charges and Other Extraordinary 401(k) Fees Charged by Insurance Companies

Eric Droblyen

December 28, 2022


If your retirement plan’s service provider is an insurance company, there is a good chance your investment options are variable annuities and not mutual funds.  If this is the case, it’s important to understand how variable annuities are different than mutual funds – it can be easy to confuse the two.  Not understanding the differences between mutual funds and variable annuities can result in excessive 401(k) fees for participants and fiduciary liability for sponsors – especially when a decision is made to move the plan to a different provider.

What are variable annuities?

Variable annuities are basically mutual funds “wrapped” in a thin layer of insurance that renders the investment earnings tax-deferred. This tax advantage can make variable annuities an attractive alternative to mutual funds for personal investors.

Inside a retirement plan, however, it’s a different story.  Earnings are already tax-deferred inside a retirement plan.  Do variable annuities have other advantages over mutual funds? Not really.  Do they have any disadvantages – generally yes – namely, additional fees and onerous trading restrictions.

An additional layer of fees

When a retirement plan uses variable annuities, participants own “units” of an account that holds mutual funds owned by the insurance company – they don’t own mutual fund shares.  These units generally include “wrap fees.” Wrap fees can include investment management fees, surrender charges, mortality and expense risk charges, and administration fees.  Variable annuities also pay commissions to the broker that sold them.

Wrap fees add an additional layer of fees a plan fiduciary must consider when evaluating an insurance company’s fees for reasonableness – Directly invoiced fees and revenue sharing payments made by the underlying mutual funds may still apply.  Finding wrap fees can be difficult – they’re generally buried in an annuity contract between the sponsor and the insurance company. 

I surrender!

Generally, the most onerous component of a wrap fee is the surrender charge.  The DOL describes surrender charges as “fees an insurance company may charge when an employer terminates a contract (in other words, withdraws the plan’s investment) before the term of the contract expires or if you withdraw an amount from the contract. This fee may be imposed if these events occur before the expiration of a stated period, and commonly decrease and disappear over time.”

Surrender charges can be extraordinary – sometimes as much as seven percent of plan assets in the first year of an annuity contract! They can take a big bite out of a participant’s nest egg.  They can also make it easy for participants to bring suit against plan fiduciaries for imprudent investment selection.

Insurance companies say surrender charges are meant to recover their setup expenses when a retirement plan leaves prior to the expiration of their annuity contract period.  I say surrender charges are a way for insurance companies to hold retirement plans hostage. This can be problematic when a retirement plan wants to leave an insurance company due to poor service.

Variable annuities can be confusing to participants

Variable annuities are often described by insurance companies based on their underlying mutual fund. This can make it easy for participants to think they’re investing directly in a mutual fund, when in fact, they’re investing in annuity units subject to additional fees. This is can be problematic when participants want low cost index funds.  While the index fund itself might have a super low expense ratio, its wrap fee could make the investment high-priced.

No longer the only choice for small retirement plans

Fifteen to twenty years ago, the smallest retirement plans had few, if any, alternatives to high-priced and restrictive variable annuity products.  Today, that has changed. Mutual fund minimums have dropped and recent regulations have helped reduce retirement plan fees through greater transparency. The onus is now on fiduciaries to recognize when plan investments are unreasonably expensive and replace them. When unreasonable investments are not replaced, participant returns suffer and fiduciaries are exposed to liability.

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