Basically, a surrender charge is a fee assessed for withdrawing funds from an annuity during an initial pre-set number of years. Sometimes, for certain kinds of variable annuities, this kind of fee is also called a “contingent deferred sales charge,” or CDSC for short.
How exactly does a surrender charge work?
The pre-set number of years to which a surrender charge applies is called the “surrender charge period.”
For most annuities, the surrender charge period begins at the start of an annuity contract. Some annuities, however, apply a separate “rolling” surrender charge or CDSC period to each purchase payment in addition to the first one.
Surrender charge periods vary in length and typically decrease the fee charged during the period. For example…
- Year 1 – 6 percent
- Year 2 – 5 percent
- Year 3 – 4 percent
- Year 4 – 3 percent
- Year 5 – 2 percent
- Year 6 – 1 percent
- Year 7 – No charge
… if $10,000 was withdrawn in the second year the surrender charge would be $500 ($10,000 X 5 percent). This is just an example. The number of years and the percentages will vary depending on the type and terms of the annuity involved.
It is also important to understand that most annuities offer what is called a “free withdrawal provision.”
This provision allows a contract owner the ability to withdraw a designated portion of their funds, often 10 percent each year, without incurring a surrender charge. Withdrawals will be subject to ordinary income tax and may be subject to an additional 10 percent federal income tax if taken prior to age 59½. (Related: When is the right time to buy an annuity?)
Depending on the type of annuity, there may be circumstances where surrender charges are waived. These typically involve situations where a federally mandated “required minimum distribution” needs to be taken or a death benefit paid out. Certain types of annuitization payment options may involve waiving the surrender charge as well.
So why do annuities have surrender charges?
One reason annuities have a surrender charge is because they are designed for long-term financial goals, such as retirement, and surrender charges act as a deterrent to withdrawing money for short term needs. Having such a deterrent also allows the insurance company to manage annuity funds more efficiently, using the money for longer term investments with traditionally higher returns, and not keeping too much of those funds liquid to cover early withdrawals.
Another reason is due to the initial cost to the insurance company. It costs a carrier a significant amount of money to create and administer an annuity contract, given the various sales, operational, and legal costs involved. A surrender charge helps an insurance company recoup these costs if a client were to withdraw funds early.
While looking at various kinds of annuities there is another term you may come across that can affect withdrawals taken during the surrender charge period called a “market value adjustment” or MVA.
Not all annuities have MVAs. Indeed, they are pretty much restricted to certain kinds of fixed annuities. (Learn about the different types of annuities here).
An MVA adjusts the amount of the withdrawal taken from an annuity, either up or down, based on the interest rate environment at the time. If interest rates are higher than when the contract was put in force, the withdrawal will be reduced. If current interest rates are lower, then the withdrawal will be adjusted up. MVAs can be calculated and applied in many different ways. And again, not all annuities include MVAs, so it’s important to check the terms of any annuity you are considering.
What should you consider?
The surrender charge is a deterrent against investors taking out money from an annuity and as such draws ire from time to time. That’s why it’s important to understand what surrender charges may apply to any annuity you may be considering and weigh certain questions, like…
- Is there a reasonable chance you will need these funds before the surrender charge period is over?
- Are there other more liquid funds available for emergencies?
- Does the annuity offer a free withdrawal amount each year?
The answers to these questions may well depend on the goal you’re trying to achieve with the annuity in the first place. Different annuities are aimed at accomplishing different things, from a hedge against longevity to immediate retirement income. You can learn more about the different types of annuities on the MassMutual website or consult a financial professional about what annuities may be right for you.
Annuities can be a great part of a financial plan and provide some valuable guarantees. But, as with any investment, understanding how they work is critical to making the right choice. With surrender charges it is important to understand how likely it is you will need to access the funds early and the availability of other resources.
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This article was originally published in September 2016. It has been updated.