Understanding surrender costs and other annuity fees

Q. I’m thinking of an annuity. I know they have large surrender charges, but if I’m not planning to sell the annuity, does it matter? What am I not thinking of?

— Trying to learn

A. Before we get to the costs of an annuity, let’s make sure you’re clear on how different annuities work.

In general, annuities fall into two categories.

First, there are immediate annuities. For these, funds are invested in exchange for immediate guaranteed income for a specified term or lifetime(s), said Gerard Papetti, a certified financial planner and certified public accountant with U.S. Financial Services in Fairfield.

The said this type of annuity is appropriate for those who have the primary objective of maximizing current income and do not have a need for liquidity from the capital invested.

Then there are deferred annuities. For these, funds are invested and will grow tax-deferred until you take a withdrawal, Papetti said. Any gain withdrawn prior to age 59 ½ will be subject to a 10 percent penalty in addition to the ordinary income tax on the gain.

Deferred annuities can be sub-divided into several following types.

For fixed annuities, the insurance company will provide a fixed interest rate for a specified period. Upon expiration of the term, there is a guaranteed rate that is contractually provided.

Then there are indexed annuities.

“This type of deferred annuity allows you the ability to direct your investment into an index, typically the S & P 500 Stock Index, in which your annual return is based,” Papetti said. “Indexed annuities are complex as they have a participation rate as well as a cap on how much of the index gain you can earn.”

They also provide a minimum rate that you will earn and may guarantee your principal from loss, Papetti said.

Finally, there are variable annuities.

These allow you to direct your investment into various sub-accounts in the bond, stock, real estate and alternative investment asset classes.

Papetti said variable annuities can provide capital protection that can guarantee your principal from loss of value to you and/or your beneficiaries.

For this principal protection, you will pay an additional fee which is called mortality expense.

“In addition to the mortality expense, an extremely popular rider that you can add to a variable annuity is called a Living Benefit Rider, which provides for a minimum annual accumulation rate and a minimum annual withdrawal rate based on your age at the time you take your first withdrawal,” Papetti said.

The accumulation rate is based on your original investment and will increase regardless of investment performance; however this accumulation value, also called an “Income Base,” is not a cash value and cannot be liquidated, Papetti said.

This value is used to calculate how much income you can withdraw annually. The cost for a Living Benefit Rider can range from 1 to 1.8 percent a year.

On your question specifically about surrender charges, Papetti said, these are really only a concern if you plan to sell the annuity early on.

He said you should review your personal financial situation and see what other liquid assets you have to determine if an annuity and what type may be appropriate.

The mention of surrender charges indicates the type of annuity you are referring to is a deferred annuity not an immediate annuity, Papetti said.

If that’s the case, realize that fixed or indexed annuities have no fees deducted from your investment value.

“The insurance company usually restricts your access by imposing a penalty called a surrender charge if you cash the annuity in prior to the surrender period, which typically range from seven to nine years,” he said.

Variable annuities also have the typical seven to nine year surrender period, however, many variable annuities allow you to shorten the surrender period to as little as one year if you are willing to pay a higher mortality and expense percentage, Papetti said.

“One-year surrender variable annuities called Class C annuities and Class L, which typically have a four-year surrender period, may be more appealing if flexibility and liquidity are important,” Papetti said. “Note that most annuities, both fixed and variable, allow a 10 percent penalty/surrender charge-free annual withdrawal if you needed to access part of the annuity value so that does provide some flexibility during the surrender period.”

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Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.