Are Annuities Considered Liquid Assets?
Explore where annuities fall on the liquidity spectrum. This analysis looks beyond simple definitions to the contractual rules that govern access to your money.
Understanding the accessibility of your money is part of personal financial management. Different assets offer varying degrees of access, which affects your financial flexibility. When building a portfolio, it’s important to consider how quickly you can convert an asset into cash. This brings up a common question for those planning for retirement: where do annuities fit into this picture?
Defining Asset Liquidity
Asset liquidity refers to the ease with which an asset can be converted into cash without causing a significant change in its market price. The most liquid asset is cash itself, as it requires no conversion. Assets that can be sold quickly at a predictable price, such as publicly traded stocks or bonds, are also considered highly liquid. A large market of buyers and sellers ensures a swift sale close to the last traded price.
On the other end of the spectrum are illiquid assets. These are investments that cannot be sold or converted to cash quickly without a substantial loss in value. The process of selling an illiquid asset is often slow and costly, with an uncertain price outcome. Examples include real estate, which involves a lengthy sales process, or an ownership stake in a private company, for which finding a buyer can be difficult.
The Structure of an Annuity
An annuity is a long-term contract with an insurance company where an individual makes a payment or series of payments. In return, the insurer promises to make payments back to the individual in the future. The purpose is often to provide a steady income stream during retirement, but the contract imposes specific timelines and rules.
An annuity is split into two phases. The first is the accumulation phase, where the owner funds the contract through a lump-sum premium or a series of payments, allowing funds to grow tax-deferred. The second is the payout, or annuitization, phase, where the insurance company begins making regular income payments.
Different types of annuities—such as fixed, variable, and indexed—all share this framework. A fixed annuity offers a guaranteed interest rate, a variable annuity allows investment in sub-accounts similar to mutual funds, and an indexed annuity provides returns linked to a market index.
Factors Affecting Annuity Liquidity
Annuities are considered illiquid due to restrictive features that enforce their long-term nature. A primary barrier to liquidity is the surrender period. This is a set number of years, often five to ten, during which withdrawals are subject to penalties called surrender charges.
These fees are a percentage of the amount withdrawn and are highest in the first year of the contract, declining each year until the surrender period ends. For example, a contract might have a surrender charge that starts at 9% in the first year and decreases by 1% annually.
Tax regulations also impose penalties. Under Internal Revenue Code Section 72(q), withdrawals of earnings from an annuity before age 59½ are subject to a 10% federal tax penalty. This is in addition to the ordinary income tax that must be paid on the withdrawn earnings.
Some fixed annuities also contain a Market Value Adjustment (MVA), which can impact the withdrawal amount separately from surrender charges. If interest rates have risen since the contract was purchased, the MVA will decrease the withdrawal value. Conversely, if interest rates have fallen, it may increase the value.
Provisions for Accessing Annuity Funds
Despite restrictions, most annuity contracts contain provisions that offer a degree of liquidity. A free withdrawal provision allows the owner to take out a certain amount each year without incurring surrender charges, often limited to 10% of the contract’s value.
For a regular cash flow, systematic withdrawals can be established, allowing the owner to schedule automatic payments. As long as these withdrawals stay within the free withdrawal allowance, they avoid surrender charges, though tax on the earnings portion of the withdrawal still applies.
The most definitive way to create an income stream is through annuitization. This is the process of converting the accumulated value of the contract into a guaranteed series of payments. These payments can be structured to last for a specific period or for the owner’s life, transforming the asset into a predictable cash flow.
A less common option is selling future annuity payments on the secondary market. This involves a transaction with a third-party company that purchases the rights to the future income stream for a discounted lump-sum price. This provides immediate cash, but the discount can be significant, and the process is subject to court approval and regulatory oversight.