For the most part, the IRS doesn’t have limits on how much money can be placed inside an annuity, giving people more opportunity to take advantage of the contractual guarantees. And if you want more growth potential for your money, fixed annuities and fixed index annuities can earn higher interest while protecting your principal.
However, one limitation that annuities have is their liquidity. Annuity owners give up having complete liquidity in exchange for these benefits, and if their money is in fixed-type annuity contracts, that is a very safe place with the dollar-for-dollar reserves that insurance companies must maintain.
So, are annuities a liquid asset? Yes, they offer some liquidity, but not as much liquidity as you might find in other types of assets in today’s markets. It’s a trade-off for those rock-solid, guaranteed benefits that they provide.
Even so, there are some provisions for liquidity in annuity contracts. You might access your money in a variety of ways: free withdrawals, cumulative free withdrawals, and waivers of surrender charges (where you get your money back in a qualifying situation) are a few.
Let’s talk about the liquidity of annuities in more detail.
How Do Surrender Periods Affect Annuity Liquidity?
The vast majority of annuity contracts that are issued today come with a back-end surrender charge schedule. This schedule is also called a surrender period, or a specific timespan that someone commits to staying in an annuity contract.
During the surrender period, the policyholder agrees to not exit the contract and has certain limits on how much money they can withdraw. Part of this is to help the insurance company maintain its long-term commitment in the underlying investments it holds for its contractual promises.
If someone does exit the contract or makes withdrawals above that limit during the first few years of the contract, they incur a penalty – a surrender charge.
Most deferred annuity contracts have surrender periods that last for 3 to 10 years. However, a couple of contracts go up to a 15-year span. What about surrender charges? Generally, many fixed contracts begin at 10% and have a declining schedule from there.
The surrender charge diminishes over time until it finally reaches zero after a certain number of years. As for the upper range of surrender charges, some contracts go up to 15% in their first year.
The surrender charge depends, in large part, on how long the commitment is to hold the annuity contract.
Does This Make Annuities a No-Go?
This disadvantage can make people hesitate before buying an annuity. After all, they will effectively be tying up their money for a period of time.
While deferred annuities (contracts that start payouts in your later years) may have this “waiting period” of a few years to a decade, it’s different with an immediate annuity. If you buy an immediate annuity (SPIA), then you lose control of your principal and become irrevocably locked into a predetermined stream of income for the rest of your life.
Other types of assets may pay lower rates of interest. But some assets can also be liquidated with little or no penalty if you need to get your hands on some money quickly.
Annuities Have More Liquidity Than Many Might Think
How do you factor this limitation into your overall retirement strategy, then? For that matter, does that mean that annuities should be off the table for you?
The good news is that most annuities offer more liquidity than many people think. Most annuity contracts carry what the insurance company calls a “free withdrawal provision.”
This is a part of the contract that specifies that, as long as certain conditions are met, you can take out a certain amount of your contract value without any penalty being put on you by the insurer.
Keep in mind you will have to pay income taxes on the withdrawn balance. The 10% early withdrawal penalty will also be applied to your withdrawn amount if you are under age 59.5.
How Much Liquidity Can Free Withdrawals Provide?
Many free withdrawal provisions allow for taking up to 10% of your contract value each year on a penalty-free basis. Some contracts only allow you to take out 5%. Meanwhile others allow you to take out as much as 20%.
Hence, you can have as much as 5-20% of your contract value available for liquidation as you need it. Many insurance companies require you to stay in the contract for some time, in many cases one year, before the free withdrawal provision applies.
All annuity contracts also have a free-look provision that allows people to cancel the purchase of their annuity within a certain amount of days if they change their mind. This provision is built into every annuity contract that is issued, per state law.
Keep in mind that you will have to pay income taxes on this balance. If you are younger than age 59.5, there may be a 10% IRS-imposed penalty along with your tax bill.
Annuity distributions are always taxed as ordinary income, which means that they are taxed at your top marginal tax bracket.
Why Do Insurers Have Annuity Surrender Charges?
Insurance companies levy surrender charges because it helps them to fulfill their contractual guarantees and promises to you. It also helps them maintain those same assurances to thousands of other annuity policyholders.
When you buy a fixed or index annuity, the insurance carrier puts the bulk of your premium dollars into low-risk, longer-term, fixed-income assets. For example, these underlying investments are often the 10-year Treasury or investment-grade bonds with an extended maturation date.
Insurance companies will also devote 3 to 5 cents of every dollar put into an index annuity to buy call options on the underlying financial benchmark to which the contract is linked. For many fixed index annuities, the underlying benchmark is the S&P 500 price index.
This is one reason why that fixed index annuities can earn more interest than other fixed annuity types.
So, what happens when you take out more money from your contract value that is permitted? Or when you leave the contract entirely? It disrupts the “schedule” of the investments that the insurance company has committed to for its obligations to you.
Surrender periods are a way that help insurance companies keep their annuity contracts intact and prevent “runs” on annuity premium dollars.
More Annuity Liquidity with Cumulative Free Withdrawals
Interestingly, if you don’t take a free withdrawal for some years into your contract, some insurance carriers will “bump up” the amount you can take from your annuity without penalty.
This sort of benefit is called a “cumulative free withdrawal.” Currently, there are some insurance companies that permit as much as 30%-40% cumulative free withdrawals. However, keep in mind this benefits applies only when contract value withdrawals aren’t taken in the first few years of the contract.
You can think of this as a bump-up incentive in exchange for all of the money remaining in the annuity.
Qualifying Health Situations Can Give You Access to Your Money
Not only that, most fixed-type annuities provide a complete liquidity benefit in a qualifying health situation. This benefit is called a “waiver of surrender charges” provision.
While most insurance carriers have a provision that lets you access all of your money, a few companies are different. In those cases, this provision will give access to most of your money. Again, this isn’t typical for most insurers.
Now, what events can trigger this benefit? Generally, an unexpected health or long-term care situation or an event involving terminal illness. This can range from physical impairments to stage-four cancer. Some contracts also include nursing home confinement stituations in their qualifying events.
Your contract will clearly spell out which events and how it defines them. In that case, you will receive most or, in many cases, all of your contract value back. The details matter, so be sure to carefully review the annuity’s certificate of terms with your financial professional.
You want to be fully up-to-speed on what emergency situations are covered.
Annuities, a Powerful Lynchpin in a Retirement Strategy
The relative illiquidity of annuities can be a major disadvantage in some cases. But for those seeking a predictable stream of guaranteed lifetime income, an annuity can be the perfect vehicle.
You might also consider an annuity if you are looking to preserve your retirement money. It could also be attractive if you want to earn more interest than you would with a CD or other fixed-interest instrument.
Between the free withdrawal provision, the free-look period, and the declining surrender charge schedule, it’s possible to get a fair amount of money out of an annuity in many instances.
Ultimately, it’s about the purpose. What role will the annuity provide in your retirement strategy? What problems will it solve? Those benefits are a trade-off for not having complete liquidity.
So long as your annuity’s role is clear, and you have strategies for liquidity in other parts of your retirement portfolio, an annuity can be a great solution indeed.
Is an Annuity Right for Your Retirement Goals?
Consult your advisor if you are considering an annuity and unsure whether it’s right for you. There are many factors that are used to determine the appropriateness of an annuity in a portfolio.
Your financial professional can help you sort them out and arrive at a well-informed, confident decision. If you don’t have a financial professional to guide you — or you want a second professional opinion of your retirement strategy — then no sweat.
Help is a click away at SafeMoney.com. Use our “Find a Financial Professional” section to connect with someone directly. Should you need a personal referral, call us at 877.476.9723.