Annuities often come with one feature that raises eyebrows: surrender charges.

For many consumers, the idea of a penalty for early withdrawal of funds can seem like a significant drawback, one that might make them wary of considering an annuity as a viable option. But is this really a major concern, or has it been a grossly misunderstood misconception for decades?
 

Here’s a question worth considering: Have you ever thought about why annuity surrender charges exist to begin with?  
 

Do you think surrender charges exist simply because insurance companies are trying to be mean, or because they want to make their products so unattractive that no one will buy them?
 

It’s almost a little comical when phrased like that, isn’t it?
 

See, it's easy to assume that surrender charges are just a way for insurance companies to penalize consumers for taking their money out early. But when you really stop and think about it, the idea that an insurance company would intentionally design a product with a feature so off-putting that it drives customers away just wouldn't seem quite logical, would it?

 

So doesn't that in turn also mean that there must be a more valid explanation as to why surrender charges exist in the first place?
 

What if we told you that surrender charges actually exist for very valid reasons, and in fact, they provide significant benefits — not only to the insurance company (when it comes to keeping your money safe and following through on their contractual promises to safeguard your principal)  but also to the consumer? Let’s take a deeper dive into why surrender charges are not something to fear but rather a feature that protects both you and the financial integrity of the company.

 

1. Surrender Charges Protect the Financial Integrity of the Insurance Company
 

To understand why surrender charges exist, we need to first recognize that annuities are long-term contracts, not short-term investments. When you purchase an annuity, the insurance company takes on significant financial obligations, especially if you choose a product with guaranteed income, principal protection, or other benefits. These promises are backed by the company’s investments, including bonds and other long-term assets.
 

But here’s where surrender charges come into play: If a large number of policyholders decided to liquidate their annuities early, the insurance company would have to quickly sell off a portion of their bond or investment portfolio. Selling these assets early could result in a loss, especially if the bonds are not due to mature for several years. The company would have to pass on that loss to the person withdrawing their funds early, which is a fair way to manage that risk.
 

In short, surrender charges protect the financial integrity of the insurance company. Without them, the company could face severe losses, which could jeopardize their ability to honor long-term commitments to other policyholders. This is one of the reasons why surrender charges are so important — they keep the company financially stable, and this ultimately protects you, the consumer, from the risk of the company failing to meet its obligations.

 

2. Surrender Charges Help Prevent a "Run" on the Company
 

Here’s a crucial point: Surrender charges help prevent a situation similar to what we see with banks during times of panic. When a large number of bank customers show up demanding their money at once, it can trigger a run on the bank, causing the institution to collapse, even if the majority of depositors don’t want to withdraw their funds.
 

With annuities, if too many people withdrew their funds prematurely, the insurance company could find itself in a similar situation, forced to liquidate assets quickly to cover the withdrawals. Surrender charges help smooth out this risk by discouraging sudden, large-scale withdrawals. In essence, surrender charges act as a safeguard, ensuring that everyone’s funds remain stable, which helps maintain the long-term financial strength of the insurance company.

 

3. The Role of Surrender Charges in the Financial Stability of Insurance Companies
 

One of the most remarkable things about the insurance industry is its historical ability to weather economic crises. For example, after the Great Depression, not a single A-rated insurance company failed, despite the fact that many banks and other financial institutions went under. In fact, the North American insurance industry was instrumental in bailing out the banking industry during that time.
 

This stability has largely been due to the way insurance companies manage risk. Surrender charges, in addition to other regulatory safeguards, help ensure that insurance companies maintain sufficient capital to honor their obligations. This is a major reason why, in U.S. history, there are few documented cases of people losing principal due to an insurance company going under. A well-rated, financially stable insurance company (with an A or A+ rating) is highly unlikely to fail, and surrender charges are a key part of maintaining that stability.

 

4. Surrender Charges Support Long-Term Commitment
 

Annuities are designed as long-term contracts, meant to provide guaranteed income, principal protection, and other benefits over many years — often decades. Surrender charges encourage you to stay invested for the long haul, which allows you to take full advantage of the product’s benefits.
 

For conservative retirees who prioritize safety of principal and predictable returns, this long-term commitment is crucial. Remember, annuities can be an excellent tool for retirees who want to guarantee income for life, especially in turbulent economic times. During the Great Depression, for example, no one lost a penny from their annuities.
 

The stability that annuities provide — particularly for conservative investors — is a key selling point. And the surrender charge is just a small price to pay to ensure that this stability remains intact for the long term.

 

5. The "Worst-Case Scenario" of a Surrender Charge Is Mild Compared to Market Risks
 

Now let’s consider the worst-case scenario: You need to access your annuity early and are faced with a surrender charge. How severe is this penalty, really?
 

Most annuity surrender charges begin around 10% and decrease gradually over the life of the contract, typically over 5-10 years. This means that if you’ve held your annuity for several years, the charge may be reduced to just a single-digit percentage, or in some cases, you might face no surrender charge at all. Even in the worst case, you're likely to be able to access 90% or more of your balance within just a few business days — a pretty good outcome when compared to the alternative.
 

Now, let’s compare that to a real-world scenario: When the COVID-19 pandemic hit in early 2020, millions of people lost their jobs and were forced to liquidate their 401(k) and other retirement accounts to make ends meet. Those people had to sell their stocks at the bottom of a market downturn (the S&P 500 fell by 30% in just a few months). The losses they incurred were far worse than any surrender charge on an annuity. In fact, it would be akin to having a 30% surrender charge — something that would be unheard of with annuities.

 

6. Annuities Should Be Part of a Well-Diversified Portfolio
 

It’s important to remember that annuities are usually only one part of a well-diversified financial portfolio. In most cases, annuities are meant to cover a portion of your retirement income needs, typically around 40-60% of your overall portfolio. This means that the remaining 40-60% of your assets are likely invested in more liquid, accessible forms of wealth, such as stocks, bonds, or cash to begin with.
 

The annuity income laddering strategies that we design of our clients always give them ample liquidity (outside of the annuity ladder) in case of emergency. And if they did have such a catastrophic emergency where they had to access more than 40% of their life savings on a moments notice  — would a modest surrender charge on the annuity really be their biggest concern at that point?  The point is, as long as annuities are used correctly and responsibly within a greater overall plan, there literally should never be a viable reason that they would even need to cash out their annuities early and take a penalty.  
 

In fact, for many retirees, the peace of mind provided by having a secure, predictable income from their annuity, in addition to a diversified investment portfolio, is far more important than worrying about a mild surrender charge.

 

Conclusion: Surrender Charges Are Not the Villain They’re Made Out to Be
 

When you hear about surrender charges, it’s easy to get caught up in the idea that they are a penalty — a financial trap that makes annuities unappealing. But as we've seen, surrender charges serve a valid purpose:

They protect the financial integrity of the insurance company, help prevent a "run" on the company, and encourage long-term commitment, which is ultimately beneficial to you as a consumer.
 

In fact, surrender charges are a small price to pay for the many benefits annuities provide, such as safety of principal, guaranteed income, and protection during volatile economic times. And when compared to the risks of market downturns and emergency withdrawals from other investment vehicles, the worst-case scenario of a surrender charge is mild by comparison.
 

So, next time you’re considering an annuity, remember: Don’t let surrender charges cloud your judgment. When understood in the proper context, they’re just one piece of a larger puzzle designed to provide you with financial security and peace of mind for the long term.