Annuities are often sold as safe, long-term retirement investments that offer guaranteed income and protection against market losses. The only real caveat is the surrender charges. They can be expensive if you decide to take your money out or move it into a better investment, so it’s vital that you fully understand them before you decide.
What Are Surrender Charges?
Surrender charges are the fees that the insurer will charge you if you withdraw more than the allowed amount during the surrender period. The surrender periods usually run for five to ten years (though they can be longer in some cases).
For example an annuity could have a 7% surrender charge in year one which would then reduce each year until it’s gone.
The Cost of Getting Out
An investor buys a $500k annuity and then takes out the whole thing with a 6% surrender charge.
That decision could result in a $30k surrender charge (if it applies to the full $500k balance).
Some of the annuities will also have market value adjustment provisions, which can reduce the amount you receive. Withdrawals will almost certainly be taxable and may attract an IRS penalty for investors under the age of 59½.
Why Insurance Companies Impose These Fees
Insurance companies use surrender charges to recoup the cost of issuing and selling the annuity contracts (commissions to agents being the most obvious example).
These commissions can create an incentive to recommend annuities with long surrender periods even where a more flexible investment would be better for the investor.
Limited Flexibility During Retirement
Retirement needs are not static. A medical bill, a family emergency or a change in circumstances could at any point lead to the need to access your savings.
Although many annuities will permit a certain amount of annual withdrawals without surrender charges, those provisions are often subject to restrictions. If you take out a large sum, you may well be hit with a very large penalty or a reduction in your guaranteed benefits. It’s worth checking the rules in that respect beforehand.
A More Flexible Alternative
A portfolio consisting of a range of low-cost ETFs, bonds and other liquid investments will generally enable an investor to access their funds without surrender charges.
Investors can change their allocation, strategy, or withdraw their money at any time. There will still be market loss, tax, and transaction costs, but they are not locked into a multi-year insurance contract, so there is a great deal of flexibility.
The Bottom Line
Surrender charges are an important cost to be aware of prior to purchasing an annuity. They can limit your flexibility, discourage you from making sensible changes, and can make it very expensive to access your retirement funds.
Your retirement savings should give you financial freedom, not lock you into an investment that then charges you to get out of it. Knowing what the surrender charges are will give you the confidence and reassurance you need prior to making your decision.
Before you go and buy an annuity, you need to be aware of the surrender schedule, the withdrawal restrictions, and the total cost of getting out of the contract. You need to understand all of that if you’re going to make a proper decision.