James I. Moore, CFP®

Annuities are financial products sold by insurance companies. They may be appropriate for some individuals, but they are often less than ideal investments for most people.

Because annuity contracts are so complex, they can be difficult to analyze and compare with each other, even for professionals. Many individuals end up being sold an annuity without fully understanding all the details, and it may not be until years down the road that it starts to become clear that the wonderful promises from the annuity salesperson are not coming to fruition. Whether because of misleading return projections, surrender charges, or tax issues, many annuity owners begin to realize that they own a “lemon” of an annuity policy.

So what do you do if you find yourself owning one of these annuity “lemons”? First, don’t beat yourself up! Even though your annuity may not have been an ideal investment, you have options going forward. A deeper dive into the contract may reveal a detail or policy rider that may make the annuity more valuable than you may have initially thought. And even if additional analysis does end up confirming that the annuity is as bad as you thought, there may be a way to get out of it and move to more efficient investments. Our Fullerton financial planning firm has helped numerous clients evaluate their options.

Option 1: Surrender the Policy

After analyzing the contract details, you may come to the conclusion that the annuity is not worth keeping. Maybe it has become clear that one of the annuity’s “guarantees” is not exactly what you initially thought it was. Maybe the numerous sub-account fees or rider fees are taking their toll on the performance. Whatever it is, it might end up making sense to just surrender the annuity policy outright. The policy contract will lay out the details, but most policies allow you to request a full surrender, giving you control of your money again. If you are considering this, make sure to watch out for surrender fees and taxes.

Most annuity policies will ding you with a surrender charge if you want to surrender your policy before you have owned the policy for specific time period. A seven year surrender period is relatively typical. The charge may start at 7% and go down 1% per year until the annuity has been held for seven years. Unfortunately, we have also seen surrender periods of up to 15 years.

The other factor to watch out for is taxes. If you surrender a nonqualified annuity that has experienced a gain, you will generally owe ordinary income tax on the gain, all at once as soon as you surrender. For a policy that has been held a long time, that tax hit could be significant. It may be so significant that you may feel like you have no other choice but to keep holding onto your less-than-ideal annuity.

Option 2: 1035 Exchange

For situations where a large unrealized gain in the annuity makes the surrender option unappealing, luckily there is another potential option. A 1035 exchange allows you to essentially “exchange” your existing annuity for a different annuity, all without realizing any taxable gains. While probably not as good as a full surrender, the benefit of a 1035 exchange comes from being able to exit out of an expensive, inefficient annuity and into a more efficient, less expensive one.

When attempting a 1035 exchange, it is important to abide by the IRS rules, which generally only allow transactions for the same type of insurance product. It is also important to be aware that a 1035 exchange does not mean that you can ignore the obligations under your original annuity contract. For example, you usually cannot get out of a surrender charge by doing a 1035 exchange.

Option 3: Continue to Hold the Policy

When considering if a policy surrender makes sense, it is important to avoid the “sunk cost fallacy”. A “sunk cost” is a cost that has already been incurred and cannot be recovered. The “sunk cost fallacy” is our tendency to continue on with something just because of our previous investments of time or money, even if it is not the most beneficial future course of action for us. This behavioral fallacy can make it difficult to give up on a bad investment. It is hard to admit a mistake and move on.

However, we can also make the opposite mistake. We may look at how poorly an investment has performed in the past and jump to get out too quickly. When analyzing an annuity, we need to understand the past performance, but our focus should be forward-looking. We need to compare the future outlook for the annuity to the future outlook of the potential alternative investment.

This forward-looking analysis may sometimes tell us to continue holding the annuity, even if just for a certain period of time. For example, it often makes sense to continue holding annuities with significant surrender charges in place. Each year, the annuity owner may recover somewhere between 1-2% of the initial surrender charge. Even though that money is really just a return of your original investment, it should still be considered.

For significantly older annuities, sometimes we notice there is a guaranteed minimum interest rate that has become more attractive in today’s low interest rate environment. Even if the since-inception performance of the annuity had been poor, we only want to consider the performance from this point going forward, which means that the annuity could possibly still have a place in your portfolio.

Sometimes an annuity may contain a rider or contract provision that makes it worth holding onto as well. For example, we once reviewed an annuity that had performed very poorly for the client for over a decade. However, we discovered that there was a rider that would allow the client to draw down from the policy’s cash value without affecting the policy’s benefit base amount. We laid out a strategy that would maximize the benefit from this particular rider. We explained how the client could make limited annual withdrawals for about ten years and then annuitize the contract using the benefit base amount unaffected by all those withdrawals. It was a relatively complicated strategy with a projected outcome that ended up being slightly favorable compared to just surrendering the policy outright.

Whenever we assist clients in situations like this, our ultimate goal is to help them understand their annuity and their options so they can make an educated decision about what they would like to do.

If you have specific questions about your own unique situation, our Fullerton financial advisory firm is happy to help. Please feel free visit our website at www.eclecticassociates.com to schedule a complimentary phone call or meeting with one of our fee–only financial advisors.