Beware if your financial advisor is trying to sell you an annuity with a shortened (3-4 year) surrender period. They cost you more and pay your advisor a higher commission. Read this before investing
First, let’s review annuity surrender charges. Most annuities have a surrender charge — a penalty for making an early withdrawal above the free withdrawal amount. The average surrender charge on the typical broker-sold variable annuity is 7 years, and the surrender charge typically decreases over the 7-year period. For example, suppose you invest $100,000 in an annuity with a 7-year surrender period and a surrender schedule of 7%,6,5,4,3,2,1,0% (this means that in the first year the surrender charge is 7%, in the second year 6%, etc.). If you withdraw more than 10% in any year (10% is the typical amount you can withdraw without any penalty), you will pay the corresponding percentage penalty to the insurance company (you may also have to pay the IRS a 10% federal excise tax on top of that if you are under the age of 59 ?). So if you withdraw $15,000 in the first year, you would pay the insurance company a 7% of $5,000, or $350 in surrender penalties (the first $10,000 is penalty-free). But if you wait more than 7 years in this case, there would be no insurance company-imposed surrender charges.
Many insurance companies offer what they call ?L-Share? annuities ? annuities with shortened surrender periods. Typically these L-Shares have 3-4 year surrender periods. They are attractive to many investors because 3-4 years is a lot shorter than 7 years, and many financial advisors promote them on this basis. But Annuity FYI believes that L-Shares are generally not good investment choices for investors. Here is why.
With an L-Share Annuity, You Will Pay a Higher Mortality, Expense and Administration (MEA) Fee & Likely Get a Lower Return
Let’s take a hypothetical, but typical, scenario:
- $100,000 investment
- Assumed growth rate of 10% over 10 years, after sub-account fees (but not including MEA fees)
- You have the choice of:
- Variable Annuity ABC Standard — a 7-year surrender product with a 1.15% MEA fee. This is the MEA fee for the typical 7-year surrender variable annuity recommended through Annuity FYI (without a bonus). Typical surrender schedule: 7%,7,6,5,4,3,2,0%
- Variable Annuity ABC L-Share — the exact same product with a 3-year surrender and a 1.65% MEA (this is the average industry MEA fee on an L-Share at the time of this writing). You are paying a premium in terms of MEA fees for the privilege of having a surrender period that is 3-4 years less than the less expensive, standard product. Typical surrender schedule: 8%,7,6,5,0%.
With the 7-year product, after 10 years your account value will be $233,499 (10% growth less 1.15% MEA fees). With the 3-year product, after 10 years your account value will be $222,992 (10% growth less 1.65% MEA fees). Because of the higher MEA fees on the L-Share, your account value would be $10,507 less (4.50% less) than 7-year surrender product, which is otherwise exactly the same!
Now let’s suppose that for some reason you had to withdraw $50,000 at the beginning of the 5th year, a point in time at which there would be no penalty in the L-Share, but a 4% penalty in the 7-year product. At that time, the account value on the 7-year product would still be $2,634 greater than the L-Share. Subtract the $1,600 surrender penalty on the 7-year product, and you would still be better off by $1,034 than if you bought the L-Share!
This is just an illustration ? of course there are scenarios where would have a higher account value with an L-Share depending on the amount of withdrawal. Annuity FYI is not saying that you should not purchase an L-Share annuity because of the higher fees ? we just want you to be aware of them, and weigh the additional cost against the shorter surrender period. We also want to remind you that we view annuities as longer-term investments, and if you think you may need access to your investment in 3-4 years, a variable annuity or any equity based investment may not be right for you. You can always speak with an licensed financial professional by clicking here or calling 866 223-2121 to discuss your specific situation.
The L-Share Annuity Pays Your Financial Advisor a Higher Commission, So He or She May Recommend it Against Your Better Interests
You may be wondering, where did the $10,507 go in the above example? The answer is primarily to your financial advisor ? an L-Share annuity typically pays the financial advisor that sells it to you a much higher commission. Unfortunately, this creates an incentive for the advisor to sell an L-Share annuity to you even if it may not be in your best interest. Annuity FYI does not want to promote distrust between you and your financial advisor, but we do want you to be aware that there is a potential conflict of interest.
Are All L-Share Annuities Bad? Why Would Anyone Buy One?
There may be specific reasons why an advisor and investor are looking at the shorter surrender periods offered with L-Shares. One reason is that new annuity plans and products are coming onto the market every week, and generally speaking the trend is that the changes are beneficial to investors. Insurance companies are trying to capture Baby Boomer money (the 78 million Americans born between 1946 and 1964) and to do so they are coming out with better and better products. So perhaps you want a 3-year plan with the expectation that you may want to transfer into another, better annuity at the end of that period, and are willing to pay a higher MEA fee for the privilege. We are not going to recommend against this, as long as you know that you are paying a higher fee.
Also keep in mind that there are a handful of low-cost L-Share annuities on the market, with MEA fees around 1.40% (compared to a 1.65% industry average at the time of this writing) — contact Annuity FYI for more information on these products. But keep in mind that there is almost always the same annuity available with a 7-year surrender period for a lower MEA, so again, there is no sense in paying for the shortened surrender period unless you really believe you need it. One idea might be to invest in a couple of plans, for example a lower cost standard plan and a lower cost L-Share.
In Summary: Before You Purchase an L-Share Annuity
- An L-Share may or may not be the best thing for you and your specific situation, but Annuity FYI is biased against L-Share annuities for reasons stated above.
- If your financial advisor is recommending an L-Share annuity, demand that he or she disclose to you all the different ways you can purchase the same annuity product ? make sure your advisor tells you all about the no-surrender, bonus, and standard (7-year) versions as well! You and your advisor should discuss the different options together and choose the best one for you. If in the end it works on that the L-Share is the best thing for you, at least you’ve made and informed decision and there will be no surprises down the road.
- When in doubt, contact an licensed financial professional by clicking here or calling 866 223-2121. Our Experts will give you an unbiased opinion of the annuity being recommended by your financial advisor. Who are the licensed financial professionals?