Annuities are one of the most confounding and controversial products in the “investments” world. I put investments in quotation marks, since annuities are actually life insurance products, and not strictly investments. You may find these definitions helpful.
What is a surrender period?
The surrender period is the term during which surrender charges may apply. This is kind of a “substantial penalty for early withdrawal” usually designed to reimburse the insurance company for the commission it paid an agent to “produce” the contract. Typically surrender periods last for years, and sometimes longer than a decade.
Surrender charges typically apply for years – sometimes many years – after policy delivery. Again, this is called the surrender period. Again, surrender charges generally reimburse the insurance company for commissions paid to agents who market these products by convincing consumers to buy the annuity.
Often the percentage of the surrender charge – which is applied to the total of your deposits in the annuity – declines over a period of years as the insurance company is able to recover the commission cost by the internal charges, fees and other profit sources in the annuity product.
What are Surrender Charges?
These charges are often imposed by insurance companies on withdrawals which occur before the surrender period has elapsed. They are designed to reimburse the insurance company for costs associated with the new annuity business, chiefly sales commissions paid to agents.
Agents are often reluctant to disclose the compensation they receive on annuity sales, and some even deny that a purchaser pays a commission to the agent. This may be technically true, since the company pays the agent out of the buyer’s premium, but it can be very misleading, especially since the buyer is on the hook to pay any surrender charges if they change their mind and want to move the money.
An important rule of thumb to remember: the agent commission is often close to the first-year surrender charge. If that is 8% and a buyer puts $1,000,000 in an annuity, the commission would be estimated at $80,000. Since this money comes out of the buyer’s pocket, however indirectly, this is important to bear in mind.
What are the types of fees associated with annuities?
Most fixed annuities don’t have declared charges, aside from surrender charges. The insurance company profits from the difference in interest it earns from investing the money you give it, and what it credits to your account. Besides surrender charges, identifying specific fees and costs can be difficult in fixed annuities, and especially in equity index annuities.
Variable annuities often disclose specific costs, like mortality charges – which are essentially life insurance charges, and can often seem excessive at around 1% when the only “insurance” is the return of your cash value as a death benefit instead of a withdrawal. Other charges can include policy fees, sub-account management and expenses charges (“mutual fund” fees), and rider charges for additional insurance features. On the worst of these, we’ve seen total charges pushing 6% a year, that are often invisible to consumers because they can be so cumbersome to dig out of the many pages of disclosure.
What happens to my annuity when I die?
Annuities in the accumulation phase generally pay a death benefit related to the cash value. For annuities in the payout or annuitization phase, insurance companies generally make no death benefit payment after payees die, so if you die before receiving all of your money back plus a reasonable return, the insurance company keeps the difference. In fairness, some annuitants live longer than expected, and the insurance companies are obligated to pay for life, even if they lose money.
When should I buy an annuity?
This is an intensely personal decision, and should be based on lots of factors, including:
- What your total asset and retirement income situation looks like.
- Your age, health and life expectancy.
- Your spouse’s age, health and life expectancy.
- Your current and future tax profile.
- Current and expected interest rate and inflation expectations.
- Total costs and charges for given annuity products.
- Commissions, level of training, and fiduciary status of advisors recommending annuity purchase.
The decision to buy an annuity is complicated and can leave you “stuck” in a product that does not fit now, or may not in the future. Consumers are strongly advised to seek the opinion of an advisor with deep expertise and without a commission agenda.
To get such an opinion from this author’s firm, just request one of the many free offers on this website.