Annuities are one of the most popular retirement investment vehicles, but they are also one of the most debated.
People either love them or hate them (there’s usually no in-between when it comes to annuities).
One particular aspect of deferred annuity contracts, and the one that’s at the root of almost every debate or argument, is the legitimacy and validity of surrender charges.
Annuity contracts are retirement investment vehicles developed, marketed, and maintained by life insurance companies. So, at their core, annuities are insurance products.
Yes, they are specifically designed to facilitate growth and an increasing portfolio value, but these products are actually extremely complicated when you take a look under the hood.
Traditional brokerage accounts containing investments such as dividend stocks are fairly simple to understand and to use in retirement planning efforts.
If the value of the individual stocks goes up, the overall value of the account increases proportionately.
Dividends paid by stocks can either sit in cash within the account, or can be reinvested to purchase additional stock shares.
Companies that consistently pay higher dividends are especially appealing. Dividend aristocrats are one such group, and income investors can view data and analysis on all of these popular dividend growers here.
Simply put, there are a number of reasons to be a dividend growth investor.
Annuities, on the other hand, come in a variety of shapes and sizes, and from a plethora of providers.
There are a number of generic characteristics that make up the common threads among annuities, as well as similarly generic features associated with each of the different annuity types.
Before going deeper, I want to be clear that I’m not advocating for a retiree to buy annuities or dividend stocks exclusively – it largely depends on the individual’s unique income needs, assets, and risk tolerance. There are tradeoffs to both approaches.
Instead, given the popularity of annuities with retired investors, my intention is to review one of the key issues investors need to be aware of if they are considering annuities.
After all, each insurance company puts its own spin on these products in an effort to remain competitive and attract new investors.
Now, we all know that it’s extremely important to actually read a contract before signing it, but making sure you actually understand all the unique features of your chosen annuity is only half of it.
The major aspects — the parts that annuity companies and agents alike often skim over — are called surrender charges, and if you’re not careful they can put a massive strain on your retirement finances.
What Are Annuity Surrender Charges?
To put it simply, annuity surrender charges are penalty fees that will be deducted from your account balance if you choose to cancel your contract (close your account) before a pre-determined number of years have elapsed.
Surrender charges differ from company to company, and also depend on the type of annuity product you purchase, as well as the additional benefits (called “riders” in the insurance industry) that you choose to add on to the contract.
The most common surrender charge on fixed annuity contracts begins at 7% and decreases by 1 percentage point annually.
So, once you have held that fixed annuity for seven full years there is no longer a surrender charge.
However, in this example, if you close your account or make a sizable withdrawal within the first seven years (referred to as the “surrender period”), the amount of money you receive will be reduced by the applicable surrender charge.
For example, if you invested $100,000 in a basic fixed annuity on January 1st of last year, your hypothetical surrender charge right now would be 6%, since you’re currently in the midst of your second contract year.
Now, let’s also assume that your annuity has increased in value to $105,000. If you decided to cancel that contract and move your money elsewhere, you would not receive the full $105,000, but rather $98,700.
Of course, these figures are for illustration only, and your actual contract value and surrender charges may be dramatically different. But, the basic premise remains the same.
Why Annuity Surrender Charges Exist In the First Place
To be clear, insurance companies do not add surrender charges because they are greedy or evil. (Many of them may, in fact, be greedy or evil, but that’s an entirely different topic for another day…)
The purpose of surrender charges is to ensure that the insurance companies providing annuity contracts are not left holding the bag when faced with indecisive or impulsive investors.
Compared to dividend stocks, which you can buy and sell all day long with no residual financial liability left to burden your brokerage firm, establishing an annuity often takes a bit of time and preparation on the part of the insurance company, which translates into a potentially significant outlay of cash.
Because annuities are technically life insurance contracts, there is at least a minimal amount of underwriting that occurs.
It’s nowhere near as in-depth or comprehensive as when you purchase a traditional life insurance policy, as many of the life insurance aspects are merely estimated or assumed, but a certain amount of underwriting is necessary to make contract-specific calculations.
Additionally, the agent who sold you the annuity contract is typically paid a very handsome sum by the insurance company.
On average, independent annuity brokers can often expect to receive a commission that is in line with the first-year surrender charge of the contract.
So, continuing with the $100,000 hypothetical example from above, the agent who convinced you to invest in that annuity would likely receive a commission check in the neighborhood of $7,000.
Some Annuities May Have Longer Surrender Periods
The simple example we’ve been using was a basic fixed annuity, but that is just one type of annuity contract that exists. There are others, each with their own pros and cons, and no one annuity is right for every retirement investor.
As a way to entice more investors, some annuity contracts offer a bonus on the initial up-front deposit.
Typically, these bonuses range from 5%-10%, but some insurance companies have offered even more, particularly during times of stock market volatility.
At first glance, the idea of a bonus on your initial investment sounds extremely appealing. However, when you drill down into the contract and read the fine print, you’ll often realize that the “bonus” is only a hypothetical figure that you may never actually receive.
Another type of annuity product is called an equity indexed annuity, or sometimes simply referred to as an index annuity.
These contracts offer safety by guaranteeing your account value will never decrease, while also offering increases tied to a stock market index such as the S&P 500.
In essence, when the index value increases, your annuity value will increase proportionately, but if the index decreases, your annuity value will remain the same.
The basic premise with all annuities and surrender charges is that the more guarantees, riders and other bells and whistles that you add onto your contract, the higher their surrender charges and the longer their surrender periods will be.
Some bonus annuities and equity indexed annuities come with surrender charges in excess of 10% and surrender periods longer than ten years.
If you are young and can’t touch your retirement investments for a few more decades, then lengthy annuity surrender periods are essentially irrelevant.
However, a decade is a long time to lock up your money if you are planning on retiring in the foreseeable future.
This is why it is extremely important that you read the entire annuity contract before signing or committing any money, paying special attention to the sections that explain the surrender charges.
Purchasing an annuity is not a decision that should be made in haste, nor is it one that should be taken lightly.
There are dozens of annuity providers out there, and countless annuity products for almost any budget and situation. It is not necessary to settle for something less than ideal for your particular situation or goals.
Free Annuity Withdrawals — The One Saving Grace
Almost every deferred annuity contract has a provision that allows the contract owner to withdraw up to 10% of the total cash invested each year. These free withdrawals are not subject to surrender charges.
However, that 10% figure is calculated differently by every insurance company, so it is important that you understand how this amount is determined in your particular annuity contract.
In the simplest form, again going back to our $100,000 example, you would be permitted to withdraw up to $10,000 each and every year, free from penalties or surrender fees, as that amount is 10% of your initial deposit.
Some insurance companies, though, will calculate that 10% on the remaining initial deposit amount, meaning that in the year after your first $10,000 withdrawal you would only be permitted to take out $9,000, as that would be 10% of your remaining deposit.
So, with such a contract, the amount of money you could take without a surrender charge every year would decrease.
Still further, some of the more flexible insurance companies calculate the free withdrawal amount as simply 10% of your overall account value, as opposed to only your initial deposit amount.
This is definitely not the norm, though. It is also worth noting that, when it comes to bonus annuities, the amount of the bonus is never taken into consideration when figuring your free withdrawal amount, regardless of whether the insurance company uses your initial deposit figure or current account balance as the basis.
Subsequent Deposits — A Potentially Sneaky Pitfall
Not all annuities come about as the result of a single lump sum deposit. In many instances, annuity owners make subsequent deposits, sometimes even initiating automatically recurring deposits.
While in most cases this is a sound strategy for dollar cost averaging or accumulating savings, some annuity contracts contain provisions that could further hinder investors who put additional money into their annuity.
It isn’t typically the norm, but enough insurance companies have added additional surrender charge provisions to annuity contracts that it’s worth noting.
With these unscrupulous insurers, every additional deposit into an annuity creates a brand new surrender schedule for that specific amount and based on the exact date of that deposit.
So, multiple deposits will result in a series of surrender schedules, which makes it virtually impossible for the account owner to easily determine how much of his own money is freely accessible at any given time.
Many annuity agreements cease attaching new surrender charges to subsequent deposits upon the expiry of the initial surrender schedule, but this would still serve to — at worst — result in a total surrender charge duration that is double the original one.
Again, this is why really reading the annuity contract before committing any money is an absolute necessity.
Bottom Line on Annuities
Overall, annuities can be an effective and powerful component to a sound retirement investment portfolio.
Notice I say “component,” as it is not typically the best course of action to commit your entire retirement savings to one particular investment vehicle.
But, there are enough reputable insurance companies with reasonable annuity contracts, many of which could serve as a solid cornerstone to a larger retirement investment allocation strategy.
The key, as I’ve explained, is taking the time to actually read the fine print in any annuity contract. It’s easy to get caught up in the hype or sucked in by impressive sales pieces, and even easier when you find yourself face-to-face with a smooth-talking sales agent.
That’s not to say annuity salesmen shouldn’t be trusted, but rather that it’s important to perform your own due diligence.
After all, we’re talking about your retirement money, potentially your life’s savings, so it’s worth the extra effort to make certain you know what you’re getting yourself into.
Income investors can learn more about the overall pros and cons of annuities versus dividend stocks here.