Sunk Cost Fallacy: Annuity Surrender Charges
Posted June 7, 2014on:
Many people keep their bad annuity investment because it imposes a stiff surrender charge. This is a stereotypical example of sunk cost fallacy, an academic term which describes people throwing good money after bad.
Why surrender charges are sunk costs?
Imagine you were sold a $100k variable annuity with a ten year surrender period. The agent who sold you the contract collected a 10% commission, or $10,000. Where do you think this money came from?
Bingo! Your pocket. I hate to break it to you, but insurance companies are not in the charity business and they sure as heck aren’t gonna tell you that 10 of the 100Gs you just handed over to them are going to pay the agent’s commission! If they did that you’d pull your money out and rightly avoid them like the plague in the future.
So, they have this clever invention called a “surrender charge”. They say, “Your $100,000 is safe with us, but if you want to take it out, there is a $10,000 surrender charge.” It’s the same as saying, “If you need your money, be ready because you’ll only have $90,000 instead of $100,000”, but for some reason this “surrender charge” has the magical effect of making people want to keep the contract in order to avoid the already spent cost.
The insurance company benefits greatly from keeping your money, because now they can invest your money. They will make the same amount of money on it as you would if you invested it all by yourself, about $6,000. But now, since they hold your money, they keep $3,000 of the profit!
So you see, the money you’ve already lost to them, that $10,000 commission, aka “surrender charge,” keeps you out an additional $3,000 every year! This is called throwing good money after bad.
How to avoid surrender charges?
The only way to avoid the surrender change is to not sign the annuity contact. The moment your name is put on the dotted line, the charge is incurred. If you think you can wait out your surrender charge since it goes down 1% every year, then think again. For every year you wait, you give the insurance company 3% of your money for a fictitious 1% reduction in that “surrender charge.” Don’t do that!
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