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.
Every fall I get actual return data from most of the index annuity carriers for the preceding five years. The average total interest credited by the reporting carriers for the last five-year period was 35 percent. By contrast, the average total interest earned by CDs over the same five-year period was 13 percent.
If the consumer had placed $100 in the average CD they would have had $113 net cash in pocket at the end of the five years. If the consumer had bought an average index annuity their $100 would have grown to $135. Even after paying a $15 (15 percent) penalty the consumer still has $120 left in pocket. Which choice would have cost the consumer more?
Behind the concept of liquidity cost is the realization that financial decisions are not made in a vacuum, but are always a choice between alternatives. Comparing the net after-penalty yields determines the true surrender cost
*For further information or to contact this author, please use the forum below.