What it means
When someone buys an annuity, the insurer invests the money for the long term and pays commission to the seller. If the customer withdrew everything after a few months, the insurer would lose money on those costs and on investments it had planned to hold.
The surrender period compensates the insurer by charging a fee for early withdrawals. The charge is usually a percentage of the amount withdrawn and falls on a schedule.
A common pattern is a charge of, say, 7% in year one, then 6%, 5% and so on until it reaches zero after the surrender period ends. The length of the period varies by product and can range from a few years to ten years or more.
Most contracts allow some free withdrawals each year, often up to a stated share of the account value, and these do not trigger the charge. Others waive the charge in special cases such as death or serious illness.
The detailed terms are in the contract, and they differ between insurers. For a finance professional or a business owner, the key point is liquidity, meaning how easily money can be turned into cash.
Money locked in a product with a long surrender period is not easily available without paying a cost. Anyone planning to need the money within that period should look closely at the schedule before buying.
The nuance is that the charge is not the only cost of leaving. Tax may be due on gains, and there may be extra penalties for taking money out before a certain age.
Comparing products by the length of the surrender period, the starting charge and the free-withdrawal allowance gives a fuller picture of the commitment.
In practice
Real-world examples.
Example
A retired teacher puts $200,000 into a fixed annuity with a seven-year surrender period. In year two she needs $60,000 for a house repair and finds that the withdrawal will cost her a charge of several thousand dollars.
Example
A financial planner compares two annuities. One offers a slightly higher rate but has a ten-year surrender period, while the other has a five-year period, and the planner recommends the shorter one for a client who may need cash soon.
Example
A company owner buys a life insurance policy with a cash value as part of a long-term plan. She expects to hold it for decades, so the surrender period is not a concern, although she still reads the schedule for the first ten years.
Formula
Calculation
Surrender charge = (amount withdrawn - free withdrawal allowance) x surrender charge rate
Suppose an annuity of $100,000 has a 7-year schedule with charges of 7%, 6%, 5%, 4%, 3%, 2% and 1% in years 1 to 7. The contract allows free withdrawals of 10% of the account value each year. In year 3 the owner withdraws $40,000. The free allowance is 100,000 x 0.10 = $10,000, so the chargeable amount is 40,000 - 10,000 = $30,000. The year 3 rate is 5%, so the surrender charge is 30,000 x 0.05 = $1,500, and the owner receives 40,000 - 1,500 = $38,500.Case study
Seen in the real world.
Hartwell Wealth Advisers is an illustrative, fictional firm whose adviser recommended an annuity with a 10-year surrender period to a client who owned a small design business. The client invested $150,000 and expected not to need it.
In year four, a major customer went out of business and the client needed $50,000 to cover the shortfall. The contract allowed 10% free withdrawals, which was $15,000, and charged 6% on the rest, so the charge on the other $35,000 was 35,000 x 0.06 = $2,100.
The firm reviewed its process and added a liquidity check for business owners before recommending long-lock products. In this illustrative case, the lesson was that the surrender period needs to be compared against the client's realistic need for cash, not only against the product's advertised rate.
Watch out
Common mistakes.
- Focusing on the interest rate and overlooking the surrender period, which can make early access to the money costly.
- Assuming the charge is the same each year, when it usually declines over the period.
- Forgetting that tax and age-related penalties may apply in addition to the surrender charge.
Questions
People also ask.
What is a free withdrawal provision?
It is a contract term allowing you to take out a stated share of the account each year without paying the surrender charge.
Does the surrender period apply to all insurance products?
No, it mostly applies to annuities and permanent life insurance, and term life insurance usually has no surrender value or charge.
Can I avoid the charge by waiting?
Yes, the charge normally falls to zero when the period ends, so waiting until then, or using free withdrawals, can reduce the cost.
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