Why are there penalties? An insurance company incurs costs when it issues an annuity. These costs include policy issue costs, annuity guarantee expenses, and mandated reserve requirements that the state insurance department requires. The insurer needs time to recoup these costs and this usually takes several years. If the annuity is surrendered prior to that time, the insurer will lose money.
One way for insurers to offset that loss is to impose surrender penalties – a “percentage of annuity value” charge on early surrenders which usually declines over time to zero at the point where the insurer has earned back the initial costs. The other way to handle these costs is for the insurer to impose a “front end” sales charge. However, annuity buyers have made it clear that they do not want to have these initial expenses deducted as a sales charge.
The fairness aspect of using a surrender penalty is the loss that results from annuity owners leaving early is born by those leaving and not by the annuity owners that keep their annuities. The annuity buyer needs to determine whether the existence of a surrender penalty presents a problem. As an extreme example, if you’re going to need all of your money in 6 months then any annuity is going to result in a penalty and probably isn’t a good idea. But if you don’t plan on touching the annuity for 10 years then you may never incur the cost of a surrender penalty. The buyer needs to compare the net effect of any possible annuity penalties with risk and returns of where the money might go instead.
What about other fees or costs? If you’ve ever read an article that talked about annuity fees there were probably talking about a variable annuity. A variable annuity has explicit administrative expenses and management expenses for the investment accounts. Fixed rate, fixed index and income annuities don’t have explicit fees. If there are no fees how does the insurance company make its money? The insurer makes its money on the difference between what is earned on their investments and what is used for the interest calculation that is paid out on the fixed annuities to the annuity owner.
The income and principal in fixed annuity, whether it is growing or paying an income, is backed by the full faith and credit of the insurer. It has a fixed value that can never go down due to market risk. Fixed annuities have an incredible track record when it comes to protecting consumers from loss.
Can you lose money in a fixed annuity? Yes! As we said annuities have surrender penalties and if you surrender too early the penalties could dip into the principal. This why an annuity buyer needs to determine whether the existence of a surrender penalty presents a problem. You must make sure that your liquidity needs are met with other assets.
Every annuity product out there is a little bit difference from the other. If you are considering an annuity read the materials and ask questions.