All about annuity surrender charges
One of the most criticized charges on annuities is the surrender charge an owner incurs if he or she cancels the contract before the expiration of the surrender period. Consumer often don’t understand why they have to pay the insurance company to access some of their money or to get it all back.
The reason is that insurance companies do not charge annuity buyers upfront even though they have to pay agents a commission ranging from 2 percent to 10 percent of the premium paid. The company needs to invest premium for a certain period to recoup the expense of the agent’s commission. That period is the surrender period. As long as you hold onto the annuity for the duration of the surrender period, the insurance company can recoup what it paid for the commission and doesn’t need to assess a surrender charge. Cancel the contract sooner and the company loses the premium it was using to invest.
In addition to commissions, annuities have management costs that make it so that insurance companies may not make a profit on an annuity sale for several years.
Another reason annuities have surrender periods when other investments don’t is that in most cases the insurance company will guarantee a certain amount of income. Investments like stocks and mutual funds offer no guarantees, and it’s possible you could lose money over a given period. Bonds will often pay income, but only for a designated period; annuities can pay this income for life if you choose
If you decide to remove some or all of your money from the annuity before its surrender period, you will likely have to pay a surrender charge. This is typically a percentage of the amount withdrawn. The percentage will decline over time. For example, your annuity may have an 8 percent surrender charge if you withdraw funds in the first year, a 7 percent charge in year 2 and a 6 percent charge in year 3.
The longer the surrender period, the higher the commission paid to the agent. For example, one insurer currently pays 8.5 percent of premium to agents on an annuity with a 14-year surrender period, but only 4 percent on one with a 5-year surrender period. The insurance company can pay a higher commission on longer surrender annuities because it has more time to earn a return on the invested premium. And if the annuity owners surrenders the policy early, the surrender charge assessed will be much higher on the 14-year annuity than on the 5-year product.
Generally, insurance companies will provide better benefits in an annuity with a longer surrender period as a way to entice buyers to hold onto them longer. Annuities will longer surrender periods may have higher guaranteed crediting rates, higher guaranteed payouts and/or premium bonuses. So an annuity with a 10-year surrender period will often provide better interest rates and perhaps other features than one with a five-year surrender period. It’s up to the buyer to determine whether those enhancements are worth having to wait longer to access money from the annuity.
Many companies also recognize that consumers may need to access some of the annuity funds. They have therefore established free withdrawal amounts. This is a percentage of the annuity’s account value that the owner can withdraw without incurring a surrender penalty. A common percentage is 10 percent; therefore, if you have an account value of $100,000, the company would allow you to withdraw $10,000 with a penalty. Anything above that would be subject to a surrender charge.
Some companies also allow you to carry over a free withdrawal amount. For example, if you don’t withdraw any money one year, you may withdraw up to 20 percent the next year. Usually the carryover is only good for one year.
Because of the cost of withdrawing money from an annuity too soon, it’s important to understand the minimum amount of time you will need to keep money in the contract without penalty. You should weigh that with the potential need for liquidity within that surrender period and whether you have another source of funds if that need arises.