This week, we're spilling the beans on something I'm sure you've all been dying to hear about…surrender charges. What are they? Why do some life insurance policies and annuity contracts seem to have such long and harsh surrender charges? What do we think of surrender charges…good or bad? And much more on today's financial procast.
First, we should talk about what it is.
Our definition (which means it's nowhere close to official): It's basically as contingent deferred sales charge–an amortization of the expenses associated with the distribution and/or manufacturing of the insurance contract in question. It includes all of the marketing expense, underwriting cost, and the commission paid to the agent for selling you the product.
Instead of charging you (the consumer) an upfront sales charge for purchasing the product, the insurance company says “buy this, keep it for a specified length of time and you won't have to directly pay us any fees.” However, if you decide you'd like to terminate our relationship before the period has ended, we're going to ding you for it and we'll keep a portion of that money to compensate us for a proportionate amount of the expenses we (the insurance company) incurred for issuing the contract.
You won't pay to get in but you might have to pay to get out if you want to do it earlier than we initially agreed–that is you and the insurer.
Some are longer than others
In the past, we've seen pretty long surrender charge schedules. Some that stretched out for 20 years and pretty some very hefty charges associated with the early years of the schedule (think 18% or more)…yikes!
We don't really see an instance where something that long is warranted and we think something with that high of a charge is a bit punitive.
But do all insurance products have surrender charges?
Yes they do.
Even whole life insurance?
I thought that one of the big selling points of a whole life insurance policy is that there was no surrender charge? Yes, there is no mention of anything called a surrender charge. But there's no denying that whole life insurance absolutely amortizes the expense over a number of years. The only difference is that in a whole life policy there's no explicit disclosure of what those expenses (i.e. surrender charge) are.
There's a reason that your cash value lags in the early years of a whole life insurance policy. Yes, it's true that there is no adjustment in the cash surrender value if you decide to take all of your money out of whole life insurance contract, however technically speaking there is much more “cash in the bank” with the insurer than you are seeing as represented by your cash value. They just aren't required to tell you what that is and they're only required to show you what the surrender value is.
In a universal life insurance contract, you will see the account value (the total) and the surrender value (the total minus the surrender charge).
What do we really think of surrender charges?
We think it's a really clever way to get people to leave their money with an insurance company. Yep, it's a really great marketing strategy.
It's as if some marketing executives were sitting around one day and one of them (pure genius) said, “Hey…you know all that money we have reserved for them that we don't show them? What if we put another column in the ledger where we showed it to them and put it right next to the column where we show them what they'll actually receive if they want to pull it all out of the policy?”
Talk about an emotional trigger.
There's hardly a person who can stand to see that the surrender value is $50,000 but the account value is $48,000 and is willing to walk away without that $2,000.
We've encountered this very thing many times. People don't like losses.
Yes, the money isn't really yours but the insurance company has done a clever thing by showing it to people and it applies pressure to stay put.
Truthfully, surrenders charges aren't really good or bad. They're really just the cost of doing business and they don't negate all the good things that are offered by these products. You should just be aware that they exist, understand how long they last, and the ramifications of walking away early.