Surrender charges are probably responsible for more annuity sales complaints than any other factor. Partly, this is because they are not properly disclosed by some agents; but even when they are fully explained, surrender charges
are perceived as a disadvantage by most buyers — and many sellers. That’s inaccurate and wholly unnecessary.
Buyers will often prefer a deferred annuity with surrender charges to one without them, once they understand the alternatives.
An insurance company incurs acquisition costs when it issues an annuity. These costs (including printing and issue costs, commission expense, annuity guarantee expense and mandated reserve requirements, exceed the initial premium received. The insurer will invest those premium dollars and profit thereby, but only if it retains them long enough. This usually takes several years. If the annuity is surrendered prior to that time, the insurer will lose money.
One way for insurers to offset that loss is to impose surrender charges — a “percentage of contract value” charge on early surrenders which declines over time to zero at the point where the insurer has “earned back” the acquisition costs. Another way is for the insurer to impose a “front end” sales charge. A third way is to reduce the interest it would otherwise credit each year (perhaps by imposing annual contract fees).
All three methods work, and an insurer must use one or more if it intends to make a profit (and stay in business) because early
will — absent some loss prevention method — produce financial loss to the insurer.
No prudent investor wants that, so the question becomes, “Which loss prevention method do I want the issuer of my annuity to use?” The front-end sales charge and annual fee/reduced annual interest methods apportion the cost of offsetting that potential loss to all buyers, whether they surrender their contracts early or not. By contrast, the surrender charge method imposes the burden of repaying unrecouped acquisition cost losses only upon those annuity buyers who caused those losses.