Features Of A Fixed Index Annuity: Surrender Charges

Fixed index annuities can be complex financial products, and I will conclude this chapter* by discussing some of the other various features one may come across when investigating FIAs.

We begin with surrender charges or, more formally, contingent deferred sales charges. FIAs are meant to serve as long-term tools and surrender charges help the insurance company to invest in longer-term bonds with higher yields and to recover its initial fixed costs for setting up the contract. Surrender charges will only apply to excess distributions in the early years of the contract. As one example, surrender charges might apply during the first seven years of a contract. These charges could start at 8 percent and decrease until they are eliminated entirely after year seven.

There are numerous exceptions that allow one to avoid a surrender charge, including a 10 percent free withdrawal from the contract value for each term. Surrender charges can also be exempted for death benefit payments during the surrender period, or if it is necessary to take required minimum distributions from the contract. As well, there could be exceptions for terminal illness or a nursing home stay, and the allowed benefits for an optional income benefit rider are exempt from surrender charges. Note also that because the government provides special tax treatment for annuities to be used for retirement, a federal income tax penalty may apply for distributions taken before age 59.5.

Someone intending to use the FIA for its long-term income provisions and who has sufficient liquidity elsewhere in the financial plan may even prefer a contract with higher surrender charges. Higher surrender charges, which will not be paid, could support more favorable features elsewhere in the contract.

For distributions subject to surrender charges, a market value adjustment is also applied to protect other annuity owners from capital losses if the insurance company is forced to liquidate bonds at a loss to cover the distribution. The adjustment is based on interest rates and is a way to transfer interest rate risk to the annuity owner. Annuities are meant to be long-term investments, allowing the insurance company to purchase longer-term bonds with higher yields. With excess withdrawals, the insurance company must sell bonds and could realize losses on these sales if rates have risen. The market value adjustment shifts such potential losses to the annuity owner making the withdrawal. Market value adjustments will reduce the contract value further for distributions taken if interest rates have risen, but they could increase the contract value relative to the amount of the distribution if interest rates have declined at the time of the distribution.

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An FIA contract will also include a minimum surrender value that overrides surrender charges and market value adjustments if those factors would have resulted in less. An FIA is a fixed annuity instead of a variable annuity because it pays a guaranteed minimum interest rate in this way. The minimum interest rates paid by an FIA may not always be stated explicitly but gets reflected through the minimum guaranteed surrender value of the annuity should one wish to close the annuity contract.

The minimum surrender value implies a guaranteed interest rate that is different from the 0 percent annual floor. This guaranteed minimum surrender value is payable upon a full withdrawal, death, or if the contract value is to be annuitized. As an example, it may be 87.5 percent of the purchase payment at the start. This value then accumulates at a guaranteed minimum surrender value interest rate, but it is reduced for withdrawals and optional rider costs. This minimum surrender value reflects an underlying minimum interest rate that is part of the contract and that is distinct from any floor on credited interest applied on an annual basis. If the floor return was repeatedly realized because of a string of negative index performance, the contract value could be less than this minimum surrender value, and the insurance company would have to credit additional interest to apply retroactively at the time of surrender to meet this obligation. However, with the annual reset design, with just a couple positive index returns, it is likely that the contract value will exceed this minimum guarantee.

To summarize this discussion, for someone seeking to take a full distribution of the contract value, after the surrender period ends the amount is the larger of the contract value or the guaranteed minimum surrender value. During the surrender charge period, the distribution amount is the larger of the guaranteed surrender value (which is not affected by a market value adjustment) and the contract value net of surrender charges and the market value adjustment. The market value adjustment is only applied during the surrender period. These matters could vary slightly if the full distribution is triggered either by death or by annuitizing the contract. To be clear, annuitizing the contract is different from turning on the guaranteed lifetime withdrawal benefit, and most owners would choose the latter.

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*This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon AMZN .

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