On the surface, annuities seem like a simple investment. The investment generally entails paying an insurance company a lump sum with the expectation that, at some point, the insurance company will begin making a string of payments to you from that lump sum plus any investment growth. While the fundamental idea of an annuity is fairly straightforward – you invest your lump sum and we’ll give you a stream of income – as with most financial products designed by Wall Street, annuities can become extremely complex.

The simplest type of annuity is a fixed annuity, which earns a fixed rate of interest and can be converted to a stream of payments at the investor’s request. Slightly more complex are variable annuities, which allow the purchaser to invest in “sub-accounts”, which are mutual fund-like investments into which funds can be directed. Finally, many annuities offer various add-on options, or riders, including  guaranteed lifetime withdrawal amounts, minimum guaranteed growth and so on.

As you might expect, the more complex an annuity, the greater its cost and it’s helpful to understand the various layers of cost involved. The main expenses that every annuity includes are the M&E charges.  The M&E, or mortality and expense charge is a fee which pays for the insurance guarantee, commissions, selling and administrative costs of the annuity. If you opt for a variable annuity, you’ll also pay a fee to the managers of any sub-accounts you use. Finally, those add-on options, or riders, that many annuities now tout come with yet another additional fee.

When you add it all up, it’s not unusual for the total cost of an annuity to exceed 2%, and 3% isn’t unheard of for a variable annuity in which a rider or riders were added. Further, if you try to cash out of many annuities before a specified amount of time has lapsed, and the annuity company will often levy a surrender penalty. Compare all those costs to a cost of less than 1% for a carefully chosen portfolio of mutual funds, and it’s clear that before investing in annuity, an investor should clearly understand the total cost and confirm that for the investor’s particular situation, the annuity makes more sense than a traditional portfolio.