Surrender charges and commissions on FIAs

A commonly misunderstood connection between surrender charges and commissions is the belief that fixed index annuities pay higher-than-usual commissions. Currently the average commission on FIAs is about 7.2%.

Common misstatements regarding “high commissions” imply that they are used as inducement to sell very elderly people annuities that are inappropriate for them. The fact of the matter is that commissions are commonly reduced, generally by as much as 50%, for annuities sold to older individuals. This is very dissimilar to MFs or other market risk products that do not waive surrender charges or guarantee certain minimum positive returns in the event of death, nursing home confinement, terminal illness, RMDs, creation of a lifetime stream of income, etc. I am unaware of any other financial instrument that reduces surrender charges (or contingent deferred sales charges) due to age.

Commissions for FIAs were higher in the early years of the products than they are today. As the products have gained in popularity, surrender charge periods and commissions have been significantly reduced and are now quite similar to the duration and commissions for other fixed and variable annuities.

A no-surrender charge product with a typical 1% annual asset fee as opposed to say a 7-year surrender charge product with a 7% street level commission will actually have a higher cost to the client and will thus reduce the potential return to the client, not increase it. This is as true of mutual funds and other vehicles as it is true of fixed and variable annuities. An asset based trail must recover an increasing cost over time from the spreads and since the spreads cannot be increased (in most cases), they start out higher at the outset than spreads on products with traditional stacked front end commissions and contingent deferred sales charges. Just as a typical “A” share mutual fund will actually cost a client less if the asset is held for a longer duration than a “B” share mutual fund will, so will a stacked front end commission on the annuity cost less than the asset based trail over the same duration.

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.

Short versus long-term surrender charges

As with any insurance product, an annuity must be selected to fit the particular needs of the person buying it. As with any financial product, they will be suitable for some, but not all people, and for some, but not all, of their financial assets.

Like most insurance retirement products, annuities are designed to be held for a number of years. Accordingly, annuities—whether fixed or variable—may not suitable for persons, regardless of age, who could not be expected to keep their product in force for the long term.

Early termination or withdrawals above a specified amount may be subject to surrender penalties as well as potential tax penalties.

Surrender charges are waived in many circumstances: death, terminal illness, nursing home confinement, RMDs, conversion to a stream of income, unemployment and most annuities have a specified annual free withdrawal amount such as 10% of the accumulated value. And all without the potential loss associated with market risk.

Longer surrender charge durations afford the insurance carrier to the ability to invest longer term which generally offers higher interest returns to the client. This means that those who surrender early are not being subsidized by those who stay the course.

No other financial instrument offers the ability to avoid surrender charges under so many circumstances and market risks as well.