There are many opinions among financial industry professionals on why annuity surrender charges exist, how they may be a good thing, and how they may enhance product designs.
On the flip side, many cynics believe they exist to further gouge a client, or that they represent an additional profit center for the carrier.
It may help to view all those opinions through the lens of the simple truth stated above.
Surrender charges result from the necessity of up-front commissions and the amortization of other acquisition costs.
Premium used to fund an annuity contract must be fully accounted for but commissions are not detailed on any statements because they are paid from another pocket — surplus.
Think of surplus as the money the carrier has already earned or that was contributed by stakeholders. It is free and clear and not allocated to any product.
Carriers must have surplus to sell products.
The Variable Annuity
One of the purest of all annuity designs, a variable annuity, will demonstrate this point.
The client and advisor decide where they want the premium invested. It may be in a subaccount by Fidelity, or American Funds, for example.
That money does not reside in the carrier's general account, as it is sent to the separate account for management by those firms.
How then does the carrier pay the broker/dealer a 6% concession? From surplus.
Some may remember the years after the tech bubble burst, when carriers were shutting down annuity production because they were growing too fast. That is because a billion dollars of new premium often requires at least $70 million from surplus.
If surplus is drained too quickly, ratings drop and regulators come knocking.
The profit model for annuities generates amounts earmarked for compensation each year.
The portion of the carrier's annual gross margin allocated to acquisition costs is used to offset that advances.
When commissions are heaped in year one, the carrier earns back that advance from the yearly earmarks.
However, if the client surrenders the contract before the carrier is made whole, someone must pay. Hence, a declining surrender charge schedule is today's norm.
Alternatives
What are some ways carriers can avoid imposing surrender charges?
• Charge a front-end sales load.
Early versions of some annuities did just that.
Much like an A-share mutual fund, the agent is paid in full, the fund company puts no money on the table (no need for a surrender charge), and the client is free to quit any time they want.
Those contracts stopped selling as soon as today's alternative was developed.
• Impose commission chargebacks.
A protocol that claws back any portion of the upfront commission not yet earned from the agent would work to make the carrier whole on any surrender.
However, any carrier trying this approach will have a difficult time appointing agents.
In addition, there has not been a great success rate in hunting down failed agents for debit balances due.
• Use a no-load, no-surrender charge method.
The agent is paid quarterly or annually from the portion the carrier earmarks for compensation for as long as the product remains on the books. If the client wants out, no hard feelings. This is referred to as a C-share and has had its knocks by regulators.
None of the above options have survived long or shown much promise.
Alternatively, products do exist that have no loads, surrenders, or commissions.
Burt Snover, ChFC, CLU, is president of 
