The takeaway: You can lose a bad annuity without losing your shirt — maybe. Even though annuities can alleviate a lot of anxiety about outliving your money, sometimes what seemed like a winner turns out not to be. Since you typically put a fair amount of money into an annuity, it’s important to understand your basic options for exit–both before and after you buy.
Part 2 of a series on annuities that will appear here from time to time.
By all indications, Elaine and Merlin Toffel seemed to understand the basic concept of annuities. You buy one, and in return, the annuity company pays you back, with interest, for the rest of your life.
Initially reported by Tara Siegel-Barnard over at the New York Times, the Toffels found out that simple sounding annuities are actually quite complex and loaded with pitfalls. (We’ll touch on these in upcoming posts in this series.)
Once you discover these pitfalls, you may decide you want out of the annuity. You can’t get out until you pay surrender charges, which in the case of the Toffels was $45,000.
What’s a surrender charge?
A surrender charge is a penalty you pay if you exit the annuity before the contract says you can. Three of the four major types annuities; fixed, equity-index, and variable; all have surrender charges.
If you’re interested in an annuity, you’ll certainly be pitched one of these three. Generally, they bring the highest incentives to the sales agent and generate the most money in fees for the annuity company.
(Immediate annuities do not have surrender charges and are discussed separately in an upcoming post in this series.)
How long do surrender charges last and how much do they cost?
Most annuity contracts require you to maintain your annuity for seven to eight years. These seven to eight years are called the surrender period. If you try to get out of your annuity before the end of the surrender period, the annuity company penalizes you with surrender charges that decline each year.
Here’s how it works. If you want to get out of the annuity the first year of the surrender period, there’s generally a 7% to 8% surrender charge. Each year thereafter, the surrender charge reduces by one percentage point, until it reaches zero.
If you pay the surrender charge and pull your money out of the annuity, Uncle Sam will tax the money as ordinary income. Depending on your tax bracket, that could be as high as 37%.
If you don’t love all these charges, you have four options to lose your bad annuity.
- Take advantage of the annuity’s free-look period.
- Use the contract’s free-withdrawal provision.
- Exchange your old annuity for a new one via what’s called a 1035 exchange.
- Accept that sometimes life’s-a-bummer-in-the-summer. Cut your losses.
Take advantage of the annuity’s free-look period.
After you buy an annuity, you have between 10 and 30 days to look it over and make sure you want it. This is called the free look-period.
If during the free-look period you decide you don’t want the annuity, you can notify the company. Depending on your state, you’ll either get back all your money or the current value of the annuity account.
Unfortunately, like the Toffels, you don’t usually realize the mistake you’ve made until you’ve had several months (or years) of experience with the annuity. Here are some other options to help you work around those pesky surrender charges.
Take advantage of the free-withdrawal provision.
If you have sufficient money from savings and other investment vehicles, you could consider riding out the surrender period, while taking advantage of your annuity’s
free-withdrawal provision. The free-withdrawal provision allows you to withdraw 10% of the annuity’s value each year without penalty. Most of the annuities we’re discussing have a free-withdrawal provision.
Lose your bad annuity by exchanging it for a new one via a 1035 exchange.
A 1035 exchange, named after a specific section of the Internal Revenue Code, essentially lets you exchange one annuity for another. You can make this exchange without paying tax on the income or the investment gains the original annuity has generated.
Before swapping out your old annuity for a new one, think long and hard if you’re not yet out of the surrender period on your first annuity. “
Questions to ask the sales agent before buying a 1035 exchange. Here are some questions, borrowed from the Financial Industry Regulatory Authority, to ask your sales agent.
- What’s the total cost of this exchange?
- What’s the surrender charge on this new annuity?
- How does this annuity differ from the one I already have.
- What are the features of this new annuity?
- What are the benefits of each of these features?
- How much do each of these features cost?
Make sure you write down every answer the agent gives you. Then, flash those pearly whites and ask the sales agent to sign the answers you wrote down.
Hey! Why so embarrassed to make that request?
- Your sales agent isn’t necessarily a fiduciary. As such, there’s no legal requirement that the agent selling you an annuity has to sell you one that’s in your best interest. The Toffels determined the variable annuity they’d been sold was not in their best interest and hired a lawyer to litigate their claim.
- You’re not buying an annuity to make friends or provide charity to family. Don’t make the same mistake I did when I bought an annuity to help a relative, only to have the annuity declare bankruptcy soon thereafter.
( Hard knocks knowledge on how to avoid an annuity headed for bankruptcy will be in a future post in this series.)
Cut your losses.
Boomer, at this point, you may feel that the above options don’t make up for the aggravation, financial or otherwise, the annuity is causing you. Without shame, sometimes we just have to admit we made a mistake.
If you’ve never made a financial mistake, you were due. Forgive yourself and move on.
The rest of the Toffel story.
From the sound of Ms. Siegel-Bernard’s reporting, it doesn’t seem that the Toffel’s have moved on.
They’re riding out the surrender period, while also hiring a lawyer to litigate the unsuitability of the variable annuity they were sold. As the case drags on, the Toffels are still legally required to annually pay $26,000 in annuity fees, substantially higher than most annuity charges.
There’s no indication they were advised of the 1035 exchange option. Hopefully, they were able to pull some money out of their annuity via the free-withdrawal provision discussed above.
What we know for sure is the sales agents were not fiduciaries; nor did the law require them to be. Always exercise extreme caution when approaching an annuity sales agent in the wild. (!)
Most folks (but not you).
Most people are in the same boat as the Toffels.
They don’t know the 11 critical questions to ask before buying an annuity. If things head south, they don’t know to protect themselves with the free look period and the other options we’ve discussed.
But you, savvy Boomer, are not most people. You’ve now read the 11 critical questions and today’s post. You now know more about annuities than most annuity owners who’ve shelled out thousands for a product they never really understood.
You got this.