Annuities are typically considered illiquid, long-term investments. In general, I don’t think anyone would disagree with that view. After all, annuities are designed to be lifetime contracts. However, it would be wrong to assume all annuities are created equal when it comes to liquidity. Instead, it’s important to recognize the differences.
Why Are Annuities Considered Illiquid?
It’s not hard to read statements from both the Financial Industry Regulatory Authority and the Securities and Exchange Commission and conclude that they view annuities as illiquid, long-term investments. In multiple variable and indexed annuity Investor Alerts, both regulatory bodies list liquidity as a consideration and emphasize the long-term nature of these investments.
In addition to the regulators’ views on annuities, these considerations make annuities illiquid too:
- Commission-based annuities with surrender charges will carry a cost to get out of the contract in the first 5 to 10 years.
- Nonqualified annuities will carry tax consequences if liquidated early.
- Optional living and death benefits may be too valuable to surrender the policy.
Can Annuities Be Liquid?
Even with these instances of illiquidity related to annuities, viewing all annuities as automatically illiquid is simply an invalid assumption. Consider the following circumstances:
- Nonqualified annuities beyond the surrender charge period: Without surrender charges, the policy owner can receive the entire value of the annuity at any time. Therefore, the annuity is as liquid as any other investment asset that would create taxable gains upon liquidation.
- Qualified annuities beyond the surrender charge period: Since these investments are taxed the same as other assets in a qualified account, the annuity is as liquid or illiquid as any other investment within the account. If the client truly needs liquidity, there is no advantage or disadvantage to liquidating the annuity as opposed to another asset in the qualified account.
- C-Share and advisory annuities: These carry no surrender charges. Therefore, these annuities can be liquidated by the policy owner at any time at no cost.
- Fixed annuities with a return of premium guarantee: With a fixed annuity guarantee of premium, surrender charges cannot decrease the initial amount invested. At most, the policy owner will sacrifice interest. While this is never a desired outcome, it’s similar to a Certificate of Deposit.
While each client situation is different, the above examples show the potential liquidity available from some annuities.
Why Does This Matter?
Why not just accept the fact that annuities are not a great source of liquidity and, for simplicity sake, categorize them all as illiquid? It matters because suitability rules are built around the concept of concentration.