One of the key responsibilities for any financial advisor is to determine whether a recommendation is suitable for a particular client. In some ways, suitability is a nebulous concept to describe. Justice Potter Stewart famously wrote in a Supreme Court decision that pornography is difficult to describe but “I know it when I see it.” The same could be said for suitability — there are no hard and fast guidelines as to what is or is not suitable, but unsuitable recommendations are relatively easy to spot.
Suitability should always be viewed from each client’s unique perspective. Advisors should not start with a product to be sold and ask themselves “which clients would this be suitable for?” Rather, the advisor should carefully analyze the client’s needs and circumstances to determine which investments may be suitable for that particular client.
Florida adopted the NAIC’s revised Suitability in Annuity Transactions Model Regulation (#275) effective January 1, 2024, elevating the standard of care from “suitability” to a best interest obligation. Under Florida Statute §627.4554, an agent, when making a recommendation of an annuity, shall act in the best interest of the consumer under the circumstances known at the time the recommendation is made, without placing the financial interest of the agent or insurer ahead of the consumer’s interest. This standard applies to consumers of all ages — not just seniors — and aligns with the SEC’s Regulation Best Interest (Reg BI), which took effect June 30, 2020.
A producer has satisfied the best interest obligation by fulfilling four specific duties:
- Care — Exercise reasonable diligence, care, and skill to know the consumer’s financial situation and objectives, understand available options, have a reasonable basis to believe the recommendation effectively addresses those needs over the life of the product, and communicate the basis for the recommendation.
- Disclosure — Disclose the nature of the relationship and the producer’s role, whether the producer is authorized to sell a particular product, the number of insurers the producer is appointed with, and the sources of compensation (including commissions). Upon request, the producer must provide a reasonable estimate of the amount of cash compensation to be received.
- Conflict of Interest — Identify and either avoid, or reasonably manage and disclose, any material conflicts of interest arising from financial interests in the transaction.
- Documentation — Record the basis for any recommendation in writing. If a consumer refuses to provide profile information, the producer must obtain a signed statement acknowledging the refusal and its potential consequences.
In the previous chapter we reviewed various types of clients and their general investment objectives (accumulation, conservation, distribution and transfer) as well as other investment factors such as:
- the need for liquidity
- the client’s tax situation
- investment horizon
- risk aversion
- sophistication
- the need for creditor protection
- estate planning considerations
In this chapter we’ll look at how a client’s financial situation may affect their investment choices, and the recommendation of annuities in light of other investments in the client’s portfolio and other investment alternatives in the marketplace.
Client’s Financial Situation and Needs
Before making any recommendations, advisors should carefully review a prospect’s current and projected financial situation. Under Florida’s Best Interest standard, the producer must make reasonable efforts to obtain Consumer Profile Information from the consumer before recommending an annuity. The regulation specifies the following 14 items:
- Age
- Annual income
- Financial situation and needs, including debts and other obligations
- Financial experience
- Insurance needs
- Financial objectives
- Intended use of the annuity
- Financial time horizon
- Existing assets or financial products, including investment, annuity, and insurance holdings
- Liquidity needs
- Liquid net worth
- Risk tolerance, including willingness to accept non-guaranteed elements in the annuity
- Financial resources used to fund the annuity
- Tax status
An investor’s age is a key factor in a changing spectrum of investment objectives over the investor’s lifetime. Given the increasing lifespan of Americans, it’s important to note that dependents are not limited to the client’s children — many clients now find themselves supporting their parents in later life. Likewise, today’s high divorce and remarriage rates create blended families that present a wider set of dependents (e.g., stepchildren living in the investor’s household or child support payments for natural children living with an ex-spouse) than the traditional nuclear family.
Assets & Liabilities
Once basic information is obtained, the advisor should review the investor’s financial circumstances, typically in the form of a personal balance sheet and income statement. The basic balance sheet equation — assets minus liabilities equals net worth — is a convenient place to start the review. While it is helpful to be as accurate as possible, approximate values for assets and liabilities are usually adequate for this task.
In addition to the assets’ values, advisors should be aware of the types of assets and liabilities the investor has. In the case of assets, it is important to distinguish between liquid assets and illiquid assets. Some investors are, as old farmers used to say, “land rich and cash poor”; others may hold nothing but liquid assets. The investor’s liquidity position is an important factor in the decision to invest in deferred annuities, which typically impose steep surrender charges on withdrawals in the early years of the contract. All investors should have some liquidity cushion to meet everyday expenses and unforeseen emergencies.
Regarding the investor’s longer-term assets and investments, the advisor should inquire as to the nature of those holdings. Some of these assets may be viewed as “pure investments” — holdings that can be redeployed without other personal considerations, such as a portfolio of stocks and bonds. Other investments such as the investor’s primary residence, vacation homes, ownership in a business, or inherited property are much more entwined in the investor’s lifestyle and may have significant personal as well as financial considerations. Also, some investments such as retirement plan holdings limit access to those funds during the employee’s working years, and the tax code imposes additional penalties for withdrawals at younger ages. Advisors should be aware of these constraints.
Advisors should also examine the investor’s liabilities. Like assets, liabilities can be classified as short-term and long-term. Short-term liabilities should be viewed in tandem with liquid assets — debts that need to be repaid in the near future will typically drain the investor’s liquid assets, so what may appear to be an adequate liquidity position today may quickly become inadequate.
As for long-term liabilities, the advisor should distinguish between debts that are self-amortizing and those that will require a lump sum repayment. Mortgages and car loans amortize over time and those debts are retired a little at a time through routine periodic payments. On the other hand, a mortgage with a balloon payment or an agreement to purchase a retiring partner’s business interest create a need to raise cash at “maturity” — which in turn may affect investment objectives, or at the least shorten an investor’s investment horizon.
Another question financial advisors should ask is whether the investor is prone to lawsuits or legal judgments. These may create new liabilities in the future. As discussed in Chapter 4, annuities (and other insurance products) offer better protection against creditor claims than other investment options.
Income & Expenses
Before making suitable recommendations, advisors must inquire into their clients’ income and expenses. An adequate income is the key to maintaining one’s lifestyle. Income typically comes from one of two sources: earnings and investments. In the investor’s younger years, presumably with few investments, most income will be earned income. As the investor accumulates wealth, some investments may generate “unearned” income — dividends from stocks and mutual funds, interest from bank accounts and bonds, rent from real estate holdings, etc. In later years, after retirement, the investor will rely primarily on unearned income from private investments, plus pensions and Social Security. An advisor should compare the client’s income with their expenses to ascertain the need to augment current income from investments.
All of this should be done with an eye on both current and projected income and expenses. Over time, sources of income will vary — younger workers typically rely on earned income; older clients on investment income. Advisors should also note that some occupations are relatively stable sources of income, while other positions may be subject to wide variations. Consider two employees of the same company earning $75,000 this year — one is a salaried office worker and the other is a salesperson working on commissions. While the current income level appears to be the same, the commissioned sales position is a less certain source of future earnings. A financial advisor should be aware of such differences and adjust recommendations accordingly.
Similarly, some career paths are shorter than others. Professional athletes have relatively few years to make their “nest egg,” as do other physically demanding occupations — while less strenuous jobs allow clients to continue to work into their later years. The client’s projected retirement date also has an impact on projected future income.
Projected expenses will vary over time, too. Clients may face college tuition, medical expenses, or long-term care costs for themselves or dependents. To the extent that these can be foreseen, financial advisors should take these into consideration when making recommendations. Some of these costs can be addressed proactively: pre-paid college plans, long-term care insurance, medical expense policies, and so on.
If income falls short of expenses, investments can be redeployed from those seeking capital appreciation to those generating more income. The purchase of an immediate annuity can serve that function — as can annuitization of a deferred annuity.
Taxes
One expense bears special consideration: taxes. Annuities offer investors a bundle of features, but one of the most important is the tax-deferred growth they provide. That tax advantage is of more value to investors in relatively high tax brackets. An advisor should carefully review a client’s tax status including:
- the client’s filing status (single, married, etc.)
- the client’s current and projected marginal tax rate (“tax bracket”)
- the sources of the client’s taxable income
Different sources of income have different tax treatment: ordinary income from paychecks, capital gains from security trades, passive income from tax shelters, and business income passed through to the client from S corporations. In order to make suitable recommendations, an advisor must have a clear understanding of how an annuity fits into the client’s overall tax situation.
Financial Goals
While the need to save and invest for a comfortable retirement is nearly universal for individual investors, that is not the only goal most investors have. Young families may want to save for their children’s college education or a down payment on a new home. Budding entrepreneurs may want to start a business. Established businesspersons may wish to buy out a retiring partner’s interest. All of these require accumulation of capital.
The thing that distinguishes these goals is the length of each investor’s investment horizon. Recommending an illiquid investment to a client with a short-term investment horizon is unsuitable, even if the investment eventually turns out to be highly profitable. Generally speaking, recommendations of conservative and liquid investments are more suitable for clients with shorter investment horizons. Clients with long-term horizons can more easily handle illiquid and more speculative investments.