Why Do Annuities Have Surrender Charges?

Every year consumers put over 300 billion dollars of their savings into annuities. While annuities can provide specific guarantees that are unavailable elsewhere, part of what consumers don’t like about them are their surrender charges. A surrender charge is what a consumer with an annuity has to pay if they want to withdraw their money early.

Let’s look at an example to illustrate how this works. Say a customer buys a Multi-Year Guaranteed Annuity (this is the insurance industry’s equivalent of a certificate of deposit or a CD). In this case the consumer gives the insurance company some money and the insurance company promises to pay the customer back their original savings plus some interest over a term (let’s say 10 years). The way many annuities work is that the first 10% of withdrawals can be taken out without any penalties, but then for any further withdrawals they have to pay a surrender charge. The surrender charge is typically the highest towards the beginning of the term and decreases over time. This is an unpopular feature with consumers because they may not realize that their annuity is not a liquid investment. In this post will examine why the surrender charge exists in the first place.

Why Surrender Charges Exist

To understand why surrender charges exist we have to understand how insurance companies make money. With a Multi-Year Guaranteed Annuity, the insurance company generates revenue from an investment spread and has a number of costs associated with creating and distributing a product. Lets say the insurance company offers you a 3.5% interest rate every year on your savings. In reality they are taking your money and investing it in bonds that return more than 3.5% a year, but are keeping for themselves any returns above what they have promised you. That explains the revenue side of the equation. On the cost side, the insurance company pays a commission to an agent or broker who sells you an annuity. The commission for a Multi-Year Guaranteed Annuity can be anywhere from 1% to more.

Recovering Expenses

If you were to invest in a Multi-Year Guaranteed Annuity and then try to pull all your money out immediately afterwards the insurance company would incur a loss. The reason is because they have already paid the agent or broker their commission for selling you the product and have already incurred costs for issuing the product for you, such as raising capital to hold as reserves against the policy. Part of the surrender charge compensates the insurance company for the expenses they have already incurred on your behalf.

Interest Rate Risk

The second reason for the surrender charge is a little harder to get your head around. Let’s say you bought a Multi-Year Guaranteed Annuity with a 10 year term and an interest rate of 2.5% a year. If after one year, interest rates in the economy increased sharply, you might be able to buy a new 10 year annuity that credits you 3.5% a year. In that case, if your original annuity had no surrender charge you would be tempted to surrender it and buy a new one. If you did this, the insurance company would incur a large loss, as the bonds they had bought on your behalf to be able to credit you an interest rate would now be worth less and would have to be sold at a loss. This is premised on the fact that when interest rates increase, the prices of existing bonds decrease. The insurance company needs the surrender charge to ensure that if interest rates go up, you will be indifferent between surrendering your policy and buying a new policy.

Conclusion

These are the main causes of annuities having a surrender charge. It is something that is worth paying attention to and understanding when you think about purchasing an annuity. It is often hard for consumers to know whether they will need their retirement savings before they retire, and surrender charges can be extremely expensive if you happen to need your money before you had originally planned.