What Is a Surrender Charge?
These little-known fees can eat into your investment returns
A surrender charge, also called a contingent deferred sales charges or a back-end load, is a fee you incur when you sell, cash in, or cancel certain types of investments, insurance policies, or annuities during a pre-set number of years known as a surrender period. Understanding these expenses can help guide your selection of and approach for holding these products.
What Types of Products Have Surrender Charges?
Term life insurance, which has no cash value, is generally not subject to surrender charges. Similarly, immediate annuities, which are designed to provide immediate income, aren't subject to fees for short-term withdrawal.
Why Do Companies Impose Surrender Charges?
Companies that sell financial products pass along these costs to customers for a few reasons:
- They offset operating costs. Companies incur various sales, operational, administrative, and legal costs to offer financial products, including substantial upfront commissions to the agents who sell the products to you. The company recoups these costs by charging fees on the investment. But if you give up the product before the surrender period elapses, the internal fees alone won't cover the costs, and the company will lose money. To avoid taking a loss, issuing companies often attach surrender charges to products.
- They deter short-term use of long-term products. Investments and other products are designed for long-term financial goals, such as retirement, rather than short-term purposes, such as cash for an emergency expense. For example, in the case of mutual funds, a short-term surrender charge of 1% might apply if you buy and then sell shares within 30, 60, or 90 days of buying them to discourage you from using that investment for short-term trading.
- They help maximize returns. If customers hold products for a long period of time, the issuing company can put your money in long-term investments that carry the benefit of compounded returns over time. Surrender charges discourage short-term withdrawals, which may result in an inefficient money-management approach that yields lower returns because your money can only be invested over a short time period.
How Much Will You Pay In Surrender Charges?
The fees vary by the product, issuing company, and the period you own the product. For annuities and life insurance policies, the typical surrender fee schedule starts at 7% of the withdrawal amount in the initial year you own them and gradually decreases by 1% with each successive year you own the product until it is eventually eliminated. For investments such as Class-B mutual fund shares, surrender fees starting at around 4% of the redemption value are common; as with annuities, the fee gradually reduces to zero over the surrender period.
For example, you might be charged a 7% surrender fee if you withdraw funds from an annuity in year one, a 1% fee on withdrawals in year seven, and no surrender fee during or after year eight. On a $10,000 withdrawal, you would pay $700 in year one versus only $100 in year seven; you would be rewarded for your patience with a savings of $600.
In general, the shorter the holding period, the higher the surrender fee.
How Do You Avoid Surrender Charges?
There are three main ways to forgo these fees:
- Hold the product past the surrender period. Surrender charges are only imposed if you give up the product before the surrender period, which means that you can avoid the fee by holding it past that period. You can usually identify the surrender period in the surrender fee schedule listed in the prospectus or contract of the product when you first buy it. The period can vary from as short as 30 days for mutual funds to 10 years or more years for annuity and insurance products.
- Withdraw money during the free-withdrawal period. Most annuity contracts have a free withdrawal provision that lets you take out a certain percentage of the contract value, usually up to 10%, every year without incurring a surrender charge.
- Take advantage of fee waivers. The issuing company may waive surrender charges in certain conditions, such as when a survivor collects death benefits from an annuity, or a retiree takes required minimum distributions. Read the terms of the contract for the specific product to identify the circumstances and the associated steps to take to get the fees waived.
If you have to cash in your annuity or insurance policy, make sure you are not a few days away from an anniversary date that could spare you a surrender charge. For example, if your annuity stops imposing surrender charges after seven years of owning it, you wouldn't want to cancel it a few days shy of the seven-year mark.
Are Products With Surrender Charges Bad?
As a general rule of thumb, avoid products that impose these costs whenever possible because the fees reduce the value of and the overall return on your investment.
However, high-quality annuities, life insurance policies, and mutual funds that carry surrender charges may still be worthwhile if you have a long investment time horizon and are willing to give up liquidity during the surrender period. If, however, you have a short investment horizon and need high liquidity, you may want to stay away from products that impose a surrender charge if you do not lock your money up for years. However, a free-withdrawal period may make a product with a surrender charge more viable for you.
When choosing an investment or annuity product with a surrender charge, make sure the benefits, such as the potential for income or long-term capital appreciation, outweigh the lack of liquidity and the potential for the reduced value of and return on your investments.
Similarly, if you are considering a life insurance product with a surrender charge, know that you will need to own it and pay premiums for a long time for this purchase to work to your long-term benefit. Have the money to pay the premiums even if you were to suffer a job loss.
The Bottom Line
Surrender charges are fees imposed on investments, annuities, and life insurance policies. Although they help issuing companies recoup the costs, maximize your returns, and keep you from making impulsive money moves, they can eat into your returns, so avoid products that impose them unless you are willing to hold them for longer than the surrender period.
If you select products that carry surrender charges, read the prospectus or contract for the product or contact the sales agent at the company to determine the specific surrender fee schedule that would apply to you. This way, you can hold the product long enough to avoid these fees and take home more money.
If you're not sure about which financial product is right for your needs, consider working with a fee-only financial planner; they are not compensated for the sale of investment or insurance products, so you can be confident they are recommending products that are in your best interest.