What Surrender Charge?

Good Morning Relaxing Retirement Subscriber,

I recently shared a painful story with a new member which I haven’t discussed in some time.  His question about annuities, along with another one I received earlier on the very same day, reminded me of a conversation I had with the brother of one of our members.  Unfortunately, and completely unnecessarily, he experienced some serious pain.

He and his wife retired three years ago and wanted to split time between a new condo in a suburb West of Boston, and a condo in Florida during the winter.

The reason he initially reached out to us was they were confused and completely frustrated with the answers they were receiving from their advisor, and they wanted a second opinion.

Their dilemma, as he explained, was that they both rolled over their 401(k) plans into annuities inside of an IRA because they were told they could earn market returns “without risking their principal.”

Uh-oh!  Does this sound familiar?

Their dilemma was they wanted to temporarily withdraw a chunk of money from their plan to help finance the purchases and moves.  IRAs allow you to withdraw money and re-deposit funds within a 60-day window without any taxes or penalties.

That was the good news.  Now for the bad news….

What they discovered was that they couldn’t withdraw any more money from their annuities without paying a 12% surrender charge to the insurance company!

Uggggghhhh!

On the $325,000 they want to withdraw, that’s a charge of $39,000 that can’t be recovered later.  And, it’s not tax deductible.

Can you imagine being in this predicament?  Frustrating and sad at the same time!

After my extended conversation with him, and after thinking about all of the questions I receive about annuities, I thought I’d take the opportunity to discuss the pros and cons so that you can independently understand and personally evaluate annuities for your own unique situation.

Preliminary Comments

Before we dig in, just a few preliminary comments…

The first is that an annuity is like any other investment vehicle; they’re a tool to put in your toolbox of potential options.

They are not a one-size-fits-all solution.  This is one of my biggest pet peeves.  Agents and “advisers” are out there in droves pushing annuities as THE solution to every financial problem.

Like any investment, there must be a very good reason why you would invest in an annuity.  Hopefully, that comes after you’ve carefully and strategically designed a Retirement Blueprint™, and after understanding all the facts and ramifications first.

The second point is that, while annuities can be a potential option for some to solve a specific problem, I believe they’re grossly oversold.

In my estimation, 99% of the annuities sold are inappropriate.

Given this, my goal is to help you better understand them so that you can make an educated decision for yourself.

What’s An Annuity Anyway?

Let’s begin today by first laying out what an annuity is.

An annuity is simply a savings instrument sponsored by an insurance company.

There are many different classifications and variations, so let’s tackle those first:

Immediate vs. Deferred Annuity

A deferred annuity has two phases to it:

  • Accumulation: funds you deposit grow inside the annuity on a tax deferred basis until you withdraw funds.
  • Withdrawal or Distribution: you choose how you’d like to withdraw funds from your annuity, either by “annuitizing” the value and receiving a guaranteed monthly payment, or by simply taking withdrawals as you see fit. (more on this in a moment)

An immediate annuity has no accumulation phase.  You simply place money into the plan and begin receiving monthly income for life.  If you currently receive a monthly pension from your employer, what you’re receiving payments from is typically a form of an immediate annuity that your employer has placed funds in to guarantee your monthly payment.

Accumulation Phase

During the accumulation phase of a deferred annuity, there are two broad options:

Fixed Annuity:  When you invest in a fixed vs. a variable annuity, what they’re referring to is the “investment” element.  In the case of a fixed annuity, your deposit is credited with interest paid by the insurance company.  How much interest you receive is based on the performance of the insurance company who sponsors the annuity, so in that respect, it acts like a CD at the bank.  Typically, they come with a minimum guaranteed interest rate for the life of the annuity contract.

Variable Annuity: In a variable annuity, in addition to having a “fixed rate” option to choose from, you are also provided a list of subaccounts which act like mutual funds from various mutual fund companies.  There are no guarantees.  The performance of your plan will be based on the performance of the underlying subaccounts.

Withdrawal or Distribution Phase

During the withdrawal or distribution phase, there are also two broad options:

Random Withdrawal:  When you want to begin receiving money from the plan, the first option, within a deferred annuity only, is to simply take random withdrawals subject to the deferred sales charge limitations set forth by your company.  For example, within most companies, you may not withdraw the entire balance of your annuity within the first six to twelve years without paying a hefty surrender charge.  However, prior to the end of that period, many companies allow you to take a partial withdrawal without any charge.

Annuitizing (Guaranteed Monthly Payment): When you “annuitize”, you are choosing to receive a guaranteed monthly payment for a period of time, typically for life.  In this case, it acts like a pension or the social security income you receive.

  • Single Life: When you select the single life option, you choose to receive payments for your life only.  When you pass away, even if that’s in three months, the insurance company keeps the money.  However, if you live to be 156 years old, the insurance company must continue to pay you the guaranteed monthly check.
  • Joint and Survivor or Period Certain: If you have a spouse who you want to protect, or if the prospect of passing away too soon and having the insurance company keep your funds is a problem for you, you may select a joint and survivor or period certain plan.  By doing so, you guarantee payments to your beneficiary either for life or for a certain period of time after your death.  However, in order to compensate the insurance company for this added risk, you receive a smaller monthly payment while you’re living.

Now that we have the basics down, we’ll continue with a discussion of the pros and cons of using annuities so that you can evaluate them for your own use.

Stay tuned.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)