An expense ratio is one of the many fees you might have to pay when you buy certain kinds of investments, such as annuities. It's not an out-of-pocket expense, but a fee that is deducted from your account earnings. Fixed annuities don't have an expense ratio, but that doesn't mean that these products are without cost.
You pay an expense ratio when you buy shares in a professionally managed portfolio of investments, such as a mutual fund. A fund manager has to make investment decisions on behalf of the fund and part of this fee covers the manager's wages. The remainder of the fee is used to cover costs, such as the printing of quarterly statements and other basic operating costs. When you buy a variable annuity, your funds are invested in a variety of mutual funds. The annuity expense ratio is comprised of the fees associated with the underlying funds.
When you buy a fixed annuity, you basically lend an insurance firm a sum of money for a certain period of time. The insurance firm deposits your cash into an interest-bearing account and you receive interest until the contract reaches maturity. Fixed annuities are not actively managed since no stocks, bonds or mutual fund shares are involved. Your annuity contract includes the interest rate, so it isn't necessary for the insurance firm to send you quarterly statements. This means there's no need for an expense ratio.
Fixed annuities are not always free of fees. Typically, annuity contracts include surrender fees that you have to pay if you cash in your contract before it reaches maturity. Annuity contracts usually last for at least five years and you could lose some or all of your interest if you surrender the contract prematurely. Normally, you get your initial investment back, but some firms offer the highest rates on annuities that do not have a money-back guarantee. Fees vary between insurance firms but you could end up with less than you started with if you buy one of these contracts and end up cashing it in sooner than expected. You also have to pay a 10 percent tax penalty and ordinary income tax on your earnings if you cash in the account before you are 59 1/2.
If you buy an annuity and then realize that you need your cash sooner than expected, you might be able to avoid both surrender fees and the expense ratio if your contract has a freelook provision. In many states, including Texas and Florida, annuity companies can't assess any fees until a freelook period lasting for between 10 and 30 days has elapsed. This period begins on the day you sign the contract and you get your money back penalty-free at any time before the contract ends.