Surrender charges—why are they necessary?

Costs associated with developing, administering and marketing annuities, especially at the outset and during the early years exceed the “spread” or differential on what the carrier earns versus what it pays out or credits in returns.

Assets and liabilities must be effectively matched…thus long-term (generally higher yielding) assets cannot be used to back a low or no-surrender charge product (which would be a short-term liability). The longer the surrender charge period, the further the carrier can go out on the yield curve to invest premium dollars. In a normal yield curve environment, this results in a higher net investment return for company to work with.

If the purchaser holds the annuity for the longer term, the insurance company recovers their costs and profits from the annual spread. If the client, however, elects to terminate the contract early, the surrender charges are used to offset their un-recovered costs. Thus, earlier terminators are not being subsidized by those client who hold their contracts to the end of the surrender charge term.

The company could price a product to recover all of its costs early, but this would result in lower benefits for all clients, not just to those who elect to surrender early. Thus, surrender charges protect the returns of the clients to stay and impose those costs on the persons who would otherwise not bear their fair share of these expenses.