Surrender Charge

For a variable annuity, the surrender charge is a type of transaction fee that applies if a person withdraws some or all of the person's money from the variable annuity within a certain period of time, such as six to ten years, following each premium payment invested in the contract. This is known as the surrender period. The fee decreases each year until it becomes zero, although a new surrender charge period will begin with each new premium payment. Surrender charges will reduce the value and the return of the investment.

Among the fees a variable annuity may carry, the surrender charge is charged if a person withdraws money from the variable annuity within a certain period after a purchase payment. It is generally calculated as a percentage of the amount withdrawn or purchase payments made.

The Surrender Period

The surrender period is a set period of time after the purchase of an annuity during which the owner cannot surrender the annuity without penalty. The surrender period will be detailed in the annuity contract.

The surrender charge on a variable annuity often declines gradually over a period of several years, known as the surrender period. Variable annuities can feature surrender periods of eight years or more, and during this time an owner can be assessed penalties if the annuity is liquidated.

For an indexed annuity, the indexed annuities bulletin describes the surrender period as a set period of time that typically lasts six to ten years, or even longer, after the purchase of the annuity.

For annuities generally, many annuities charge a fee if the owner takes part or all the money out of the annuity within a certain number of years of purchasing or contributing money to the annuity. Generally, these fees decrease over time.

A variable annuity may offer different share classes with different fees and expenses and different surrender periods. The factors to consider include how long the owner expects to own the variable annuity and the owner's need to access funds when weighing any tradeoff between fees and length of surrender period.

How a Surrender Charge Applies to Withdrawals and Surrenders

Many deferred annuities let an owner withdraw money during the accumulation phase. If the owner takes all of the money out at once, this is often called a surrender and terminates the annuity. The owner may also be able to take out part of the contract value.

There may be adverse consequences to taking money out of an annuity, and the first one listed is surrender charges. If an owner takes a withdrawal of some or all of the contract value within a certain number of years of purchasing or contributing money to the annuity, the amount withdrawn may be subject to a surrender charge. Surrender charges will reduce the value of, and the return on, the investment.

The other adverse consequences listed are taxes, contract adjustments, and reducing certain benefits. On taxes, withdrawing money from an annuity may be a taxable event, and if the owner withdraws money before age 59½, the owner may have to pay tax penalties. On reducing certain benefits, withdrawing money may reduce the value of benefits, such as death benefits, and the value of the benefit may even be reduced by more than the amount the owner withdraws.

One of the questions to ask before buying an annuity is whether the owner intends to keep the money in the annuity long enough to avoid paying any surrender charges, tax penalties, or any contract adjustments.

Surrender Charges in Different Types of Annuities

The types of annuities compared on the Investor.gov annuities page are fixed, fixed indexed, registered index-linked, and variable. For fixed and fixed indexed annuities, the potential for the loss of money is generally none, other than a surrender charge for withdrawals or surrenders taken during the surrender charge period.

For a registered index-linked annuity, there is a potential for loss of the investment, with three items: if the index performs poorly, often subject to limits; if amounts are withdrawn from an investment option before the end of the term, and sometimes if amounts are withdrawn from the contract before the end of a specified period; and a surrender charge if the owner takes withdrawals or surrenders during the surrender charge period.

For a variable annuity, there is a potential for loss of the investment, with two items: unlimited loss, based on the performance of the mutual funds selected; and a surrender charge if the owner takes withdrawals or surrenders during the surrender charge period.

The indexed annuities bulletin has a heading titled Can you lose money buying an indexed annuity? with a paragraph on the surrender charge. If an owner takes all or part of the money out during the surrender period, the owner may have to pay a surrender charge. Surrender charges will reduce the value and the return of the investment. The bulletin also describes a loss under a floor or a shield as measured before considering any adjustments imposed by contract terms such as surrender charges.

Surrender Charges in Variable Life Insurance

A surrender charge might also apply upon a full surrender, lapse, or decrease in face amount value of a variable life insurance policy. Unlike variable annuity surrender charges, a variable life insurance policy surrender charge is not tied to premium payments. Instead, it is calculated based on individual characteristics of the policy holder, such as age and other characteristics.

Contract Adjustments That Come With a Surrender Charge

Contract adjustments are a separate item from the surrender charge. Some annuities earn interest over a specified term. If money is withdrawn or transferred from an investment option before the end of the term, the owner may forfeit any interest that may have been earned during the period. The insurer may also adjust the value of the annuity through a Market Value Adjustment or an Interim Value Adjustment. These contract adjustments are often negative and may significantly lower the value of the annuity. They are in addition to any surrender charge that applies. Both registered index-linked annuities and registered Market Value Adjustment annuities contain contract adjustment features.

In the list of transaction fees, the point is repeated. Some annuities adjust the value of the contract if the owner withdraws or transfers money before the end of a specified period. These adjustments, also known as Interim Value Adjustments or Market Value Adjustments, are often negative and can result in significant loss in the value of the annuity. These adjustments are in addition to any surrender charge that may also be applicable.

The Free Look Period

The free-look period is a set time period within which the purchaser of a new annuity contract can cancel the contract without having to pay surrender charges.

State law gives the buyer a set number of days, usually 10 to 30 days, to change the buyer's mind about buying an annuity after receiving the annuity contract. This often is called a free look period. The contract should prominently state how long the free look period is and how to return the contract. For a variable annuity, the right is described as the ability to cancel the contract within a short period, usually 10 to 30 days, of receiving it, without a penalty fee called a surrender charge.

Surrender Charges and Taxes

An owner does not have to pay taxes on any growth in an annuity until the owner starts making withdrawals, and if the owner withdraws money before turning 59½, the owner may face a 10 percent tax penalty. Many annuities have set holding periods and surrender charges for those who want to withdraw their cash early. Even if the owner manages to skip the surrender charge, the owner still may face a steep tax penalty for certain withdrawals made prior to age 59½.

If an owner surrenders an annuity and does not exchange it for another annuity, the surrender amount may be taxable and the owner may face a 10 percent federal income tax penalty if the owner is under 59½ years old.

Exchanges, Replacements and Buyout Offers

The Internal Revenue Service allows an owner to exchange one variable annuity contract for a new one without paying tax on the income and investment gains earned on the original contract. Governed by Section 1035 of the Internal Revenue Code, these types of replacements are called 1035 exchanges.

Surrender charges are one of the points to consider when deciding whether to exchange a variable annuity for another. Surrender charges are typically higher in the early years an owner owns an annuity. If an owner exchanges an annuity, the owner may be subject to a surrender charge on the existing annuity and a new surrender period on the new annuity.

Variable annuities may impose a variety of fees, and fees generally include surrender charges, which the owner owes if the owner withdraws money from the annuity before a specified period. The exchange or replacement of insurance or annuity contracts generally is not a good idea if the owner thinks the owner might need money from the annuity in the short term. Another way of saying this is to know the impact of surrender charges, which can be very expensive if the owner withdraws money early or decides to sell the annuity. 

The owner should check when surrender charges expire with the current annuity, and consider how comfortable the owner is with a potentially longer surrender period that may come with the new contract. Some variable annuity contracts include a free withdrawal provision, up to a certain percentage, or offer a rider to waive surrender charges, but these are generally not standard features.

Exchanging one contract for a new one may involve additional costs and fees, including surrender charges, and usually means the clock restarts for purposes of early withdrawal penalties.

A buyout offer is an offer by the insurance company that issued the annuity to increase the contract value in exchange for giving up a contract benefit, or to increase the cash surrender value in exchange for surrendering the annuity or exchanging it for a new annuity that may have different terms and conditions. Transferring cash surrender value to a different financial product, which may be another annuity, may trigger a new sales charge or subject the owner to a new surrender charge period. For an owner who considers accepting a buyout offer with the intention of moving into a new annuity, the financial impact could include a new surrender charge period, less favorable benefits, and higher fees and expenses.

FINRA Rule 2330 and Surrender Charges

FINRA Rule 2330 is titled Members' Responsibilities Regarding Deferred Variable Annuities. Rule 2330(b)(1)(A)(i) provides that one of the items a member or person associated with a member must have a reasonable basis to believe is that the customer has been informed, in general terms, of various features of deferred variable annuities, such as the potential surrender period and surrender charge; potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of 59½; mortality and expense fees; investment advisory fees; potential charges for and features of riders; the insurance and investment components of deferred variable annuities; and market risk.

Rule 2330(b)(1)(B) provides that, in the case of an exchange of a deferred variable annuity, the exchange also must be consistent with the suitability determination required by paragraph (b)(1)(A) of the rule, taking into consideration whether the customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), or be subject to increased fees or charges (such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements).

The content outline for the Securities Industry Essentials examination lists surrender charges among the items under Topic 2.1.4, Packaged Products, in Section 2, Understanding Products and Their Risks, in the group that begins with the words Knowledge of. Candidates should check the current outline before the examination.

Common Misunderstandings

The corrections below come from the FINRA annuities page, the FINRA page titled Should You Exchange Your Variable Annuity?, FINRA Rule 2330, the Investor.gov pages and glossary entry, the indexed annuities bulletin and the buyout bulletin.

A surrender charge lasts for as long as the owner holds the annuity. For a variable annuity, the fee decreases each year until it becomes zero, and the surrender charge often declines gradually over a period of several years, known as the surrender period.

A surrender charge applies only to a full surrender. If an owner takes a withdrawal of some or all of the contract value within a certain number of years of purchasing or contributing money to the annuity, the amount withdrawn may be subject to a surrender charge.

A surrender charge is the only cost of taking money out early. Taxes, contract adjustments and reduced benefits are listed among the other adverse consequences of taking money out of an annuity, and contract adjustments are in addition to any surrender charge that applies.

Skipping the surrender charge avoids every penalty. Even if the owner manages to skip the surrender charge, the owner still may face a steep tax penalty for certain withdrawals made prior to age 59½.

Surrender charges are the same for variable annuities and variable life insurance. Unlike variable annuity surrender charges, a variable life insurance policy surrender charge is not tied to premium payments, and it is calculated based on individual characteristics of the policy holder.

An exchange removes the surrender charge. If an owner exchanges an annuity, the owner may be subject to a surrender charge on the existing annuity and a new surrender period on the new annuity.

Cancelling a new annuity always costs a surrender charge. The free-look period is a set time period within which the purchaser of a new annuity contract can cancel the contract without having to pay surrender charges.

Key Points

The surrender charge, sometimes referred to as a contingent deferred sales charge, is the penalty fee owed by a contract owner who sells or withdraws money from the annuity during the surrender period.

The surrender period is a set period of time after the purchase of an annuity during which the owner cannot surrender the annuity without penalty, and the surrender period will be detailed in the annuity contract.

If an owner takes a withdrawal of some or all of the contract value within a certain number of years of purchasing or contributing money to the annuity, the amount withdrawn may be subject to a surrender charge.

Contract adjustments are in addition to any surrender charge that applies.

The free-look period is a set time period within which the purchaser of a new annuity contract can cancel the contract without having to pay surrender charges.

Rule 2330(b)(1)(A)(i) lists the potential surrender period and surrender charge among the features of which the customer has been informed, and Rule 2330(b)(1)(B)(i) lists surrender charges and a new surrender period among the factors for an exchange.