Annuity Liquidity Risk

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Annuity Liquidity Risk

Even though an annuity is considered a long-term investment, at some point you are going to want to take your investment principal and earnings out of it. So it is important to know that annuities carry a certain level of liquidity risk—the risk that proceeds from the annuity will not be available when you need them, or will be available only at a significantly reduced value. Again, because we are speaking of both fixed and variable annuities, there are really two types of liquidity risk to consider.

The risk comes from two sources

First, most annuities, whether fixed or variable, carry liquidity risk derived from two specific product features, namely, surrender charges (also known as contingent deferred sales charges, or CDSCs) and early withdrawal penalties. Most annuity accounts can be opened without any initial charges. The insurance company gradually recovers its costs over a number of years through a spread between what the company actually earns on investments and what is credited to the annuity account. Surrender charges reimburse the insurance company for costs not recovered due to an early surrender or withdrawal of funds from the account. Because annuities are designed for and intended as retirement vehicles, they offer the benefit of tax deferral on all earnings. However, in exchange for this tax advantage, annuities carry a considerable penalty, imposed by the Internal Revenue Service, for withdrawals prior to the annuitant’s reaching age 59½.

More about surrender charges

While surrender charges might vary from one company to the next, a typical surrender charge might start out as high as 10 or 15 percent and decline down to zero over a 10-year period. Additionally, if withdrawals are made from the annuity prior to the annuitant’s age 59½, all earnings and tax-deferred premium payments are assessed a 10% penalty by the IRS, in addition to ordinary income tax. For example, if you decide to liquidate your account after only five years of ownership, and you are under age 59½, you will be socked with both a surrender charge and an early withdrawal penalty, in addition to any income tax. Keep in mind that the surrender charge and the early withdrawal penalty are separate. While the surrender charge is imposed by the insurance company, the early withdrawal penalty is imposed by the IRS. You could incur both, as in the above example, or one of them, depending upon the situation.

The risk of lowered account values

The second type of liquidity risk is that associated with variable annuities. Like other investments, a variable annuity carries with it the risk that, at the time of liquidation, account values will be down. In other words, a key aspect of liquidity often overlooked by investors is not just easy access to account balances, but access to balances at fair market value. If you find yourself in need of cash and must liquidate a variable annuity, there is no guarantee that on the date of liquidation, the balance will be anywhere near what it was previously, simply because of market fluctuations.