Liquidity costs are always comparisons

Owners of annuities typically incur costs if they surrender an annuity prematurely. The penalty for getting out of an annuity can be as high as 25 percent, although a review of annuityspecs.com shows that the first year penalty is 10 percent or less for 70 percent of the annuities out there. However, whether the surrender penalty is an actual liquidity cost depends on what would have been done with the money if an annuity had not been purchased.

Suppose $100 is sitting in a money market account earning 4 percent interest. An alternative is a fixed annuity with a 7 percent surrender penalty that credits a 6 percent rate the first year. If the annuity is bought and then cashed out at the end of the first year a 7 percent penalty is charged, but the actual cost of becoming liquid is less.

If the money market account is cashed out at the end of year one, the owner has an accumulated value equal to $104 – that is $100 (representing the original deposit) plus 4 percent interest. Since it is a money market account there are no penalties and the owner would net out the full $104. At the end of year one the annuity’s accumulated value is $106, but a 7 percent penalty is deducted if the annuity is cashed in, so what the owner is left with is $99. By choosing the annuity instead of the money market the owner has $5 less in pocket. What this means is the actual liquidity cost, based on the original premium, is not the 7 percent penalty because the owner’s choice of the annuity did not mean he or she has $7 less in hand, but is really 5 percent.

Let’s go out four years and then cash in the annuity. Ignoring compounding and taxes, the accumulated value of the money market account would be $116 ($100+$4+$4+4$+$4) and the net cash out value would also be $116. The accumulated value of the annuity is $124 ($100+$6+$6+$6+$6), however, a $7 penalty is charged if the annuity is cashed in, leaving $117 net cash out value. What is the liquidity cost of the annuity? Zero. Actually, it is the money market account that incurs the cost because it cost the owner $1 ($117-$116) to stay in the bank for four years instead of choosing the annuity.

I read an article a while ago wherein a politician was decrying the 15 percent surrender charge that an index annuity product purchased five years before was “costing” a consumer. It is important to note that a surrender penalty is only a charge if the annuity is surrendered. Even so, would the consumer have paid a 15 percent liquidity cost if the annuity had been surrendered? It depends on where the money would have otherwise been.