Are annuity surrender charges a good or bad thing? If you want a predictable income steam in retirement, only annuities can provide you with guaranteed payments for life or for a set period. No other financial product can truly do this.
On the other hand, a surrender charge can be a hold-up for someone who might otherwise be interested in an annuity for its guaranteed benefits. Annuities are contracts between someone and a life insurance company.
They are a long-term commitment, and if someone wanted to take out more money than is permitted or exit the contract prematurely, a surrender charge would apply. Of course, surrender charges also help insurance companies maintain their long-term promises to policyholders as well.
So, are annuity surrender charges good, bad, or indifferent? How do they work, and in what specific ways do they work for you? Are there other upsides to annuity surrender charges beyond the obvious benefit of helping the life insurance company?
The truth is, they are more of a necessary feature than a judgment of goodness or badness. In some respects, you can say they are a neutral thing. Let’s break them down into some simpler terms.
What Are Annuity Surrender Charges?
Let’s start with the basics of an annuity. At its most basic, an annuity is a contract between a person and a life insurance company. Now, imagine that you start an annuity with a premium payment to the insurance company. In exchange, the insurance company makes certain contractual promises to you, the contract holder.
Those guarantees can span a number of benefits. The most common is that the insurance company will make regular payments to you over time, including for the rest of your lifetime.
In some annuities, those payouts can start right away. With others, your payments will begin at a later point, often years from when you started the annuity. If you need some liquidity between your annuity contract start date and when you actually turn on your annuity payments, a variety of annuity types let you have some money access via free withdrawals. In other words, you can take out up to a certain percentage of your annuity account value without penalty.
But here is the trade-off for those guarantees: If you decide to take out too much money or exit the contract, you will pay a penalty. That penalty from the insurance company is called a surrender charge.
How Do Annuity Surrender Charges Work?
Annuities have time periods over which they mature. This period can span from 2-14 years. Many annuities have maturity periods of 10 years or less.
During that window, if you take out more money than permitted in a free withdrawal or pull out of the contract before it matures, a surrender charge kicks in. It’s why this period is also called the “surrender period.”
When you are in the surrender period, a schedule of surrender charges applies. They are percentage-based. How much they cost will vary depending on the contract, but typical surrender charges range from 7-10%. Normally they cost a percentage of what you take out of the contract (again, above the permitted withdrawal amounts or cashing the entire contract out).
Most annuity contracts come with a schedule of declining surrender charges over the maturity period. For instance, in year 1, the surrender charge may be 10%. Then it goes down to:
- 9% in year 2
- 8% in year 3
- 7% in year 4
- 6% in year 5
- 5% in year 6, and so on
Surrender Charges Are Neutral, Not Good or Bad
If retirement planning was storytelling, surrender charges wouldn’t be heroes or evil villains. Instead, they are more like rules in a game. Why? Because they help the life insurance company keep its promises to everyone who owns annuities.
With a typical life insurance company, that can be hundreds of thousands of people – or more. The insurer is also managing risks tied to paying steady income streams to these contract holders for as long as they need it or might live. Talk about a lot to take on.
The surrender charge is one way for them to ensure that contract holders stick to that long-term commitment.
Financial Safeguard for Meeting Long-Term Promises
When an insurance company starts an annuity contract with someone, they take the premium dollars and put them into underlying investments so that they can support their promises to the annuity owner. The bulk of the premium money goes in low-risk, long-term investments, such as bonds.
Life insurance companies must maintain dollar-for-dollar reserves for each dollar of fixed-type annuity premium that they gather. The surrender charge schedule also helps insurers maintain their investment timelines and keep up their financial strength. In turn, it lets them meet decades-long promises for many households.
In that way, surrender charges are a kind of “financial safeguard.” If you think about the bank runs of the Great Depression, it also helps prevent runs on insurance companies for annuity premiums. That would otherwise really upset their ability to manage long-lasting promises to contract holders!
Surrender Charges, Snacks, and Cakes… Oh My!
Here is another way to think about this. Owning an annuity isn’t like grabbing a snack. It’s more like putting some elbow grease into a big, delicious cake that takes time to bake.
That cake is your retirement fund. Hopefully it’s part of an overall mix of financial assets that you have for retirement. When you buy an annuity, you are essentially saying, “I’m in this for the long haul.” Once you are retired, you can start serving yourself some of that delicious cake.
The surrender charge encourages you to keep your money in the annuity until it’s fully baked and ready for you to enjoy during retirement. If you take out your money too early, you might have to pay a surrender charge fee. It’s like taking a slice of the cake before it’s finished – perhaps not the best idea.
Are the Trade-Offs Worth It?
The most important question: Is the waiting period during which surrender charges apply worth it for the annuity benefits?
Everyone’s take will be different, and no two people will have the same situation. Nonetheless, many retirees seem to be happy with what they get from their annuity contracts, as a couple of surveys indicate.
In one survey by LIMRA, an insurance industry organization, 900 annuity owners were asked about what factors were most important to them in buying an annuity. Twenty-five percent said that having a guaranteed lifetime income feature with some money access, even as they paid an extra fee for the benefit, was the biggest deciding factor.
In other words, they were okay with the benefit fee, and any possible surrender charge, because of what they got with the lifetime income feature. The annuity’s growth potential, the guarantee of principal protection, and an ability to annuitize for a lifetime income stream were other reasons that were named as primary drivers.
Annuity Owners Happy with What They Get
In a December 2013 survey by Genworth, 78% of annuity owners said that they were happy with the level of access they had to their annuity money. 70% said that their annuity fees were justified by the annuity benefits they received.
In that same survey, 61% of annuity shoppers were willing to pay extra fees for the assurance of asset protection in down markets and growth potential in up markets.
In other words, surrender charges may not be a deal-breaker for those wanting long-lasting financial security. The guarantees of annuities are too appealing to pass up.
Decoding Annuities, Surrender Charges and All
Before you jump into an annuity contract, make sure you understand the terms and conditions. When you are chatting with the financial professional who suggested an annuity to you, ask them about surrender charges.
A good agent or financial advisor will explain them clearly, so you know what you are getting into. They should also be able to cover why a particular annuity is a good fit for your needs, goals, and financial situation. Above all, that annuity needs to cover specific gaps in your financial plan or solve a certain problem. It’s the foundation of your overall strategy.
Understanding the surrender charge – and other annuity features, pros, and cons – will help you with making well-informed choices. It’s not about good or bad. It’s about being aware and making decisions that serve you well in your long-term goals.
If you need help in exploring an annuity for your retirement plan, or you would like some assistance in working through your retirement questions, an experienced financial professional can assist you. Should you be looking for someone to guide you, many independent financial professionals are available here at SafeMoney.com. Top of Form
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