Chapter 5 — Annuity Suitability (continued)

No investment decision is made in a vacuum. Each recommendation must be made in the context of the client’s unique circumstances. One aspect of the client’s situation that the advisor must take into account is the type and amount of other investment holdings the client may have. As discussed in Chapter 4, Modern Portfolio Theory is based on the investment principle of diversification — so it is imperative that advisors be aware of the client’s existing portfolio before making any recommendations that may upset that diversification. Since the purpose of this course is annuity suitability, we’ll limit our focus here to existing annuity contracts and how annuities may or may not be more suitable than other available investments.

Annuity contracts can be used to meet a variety of investment objectives: deferred annuities can accumulate wealth, fixed annuities can conserve wealth, an annuitized contract can distribute wealth, and the minimum guaranteed death benefit can transfer wealth efficiently to beneficiaries. Due to this versatility, advisors may find themselves recommending that clients with an existing annuity add another annuity to their portfolios. There is nothing inherently unsuitable about recommending an additional annuity contract — but the recommendation should be made in light of the other contracts the investor may already hold. Quite often, fixed annuities complement variable contracts: one provides safety of principal, the other hedges inflation risk.

As an investor’s financial situation changes, an existing annuity may no longer fit the investor’s circumstances. For example, a client who purchased a deferred variable annuity years ago to invest for retirement may wish, as she approaches retirement, to convert the accumulated value into fixed annuity payments. Her advisor recommends she exchange the variable annuity for a new immediate fixed annuity that has more favorable payout options than offered under the variable contract. As noted in Chapter 2, the IRS permits a tax-free exchange under Section 1035 from one annuity to another, so there would be no tax consequences to this “switch.”

Under Florida law, such an exchange is treated as a “replacement” of coverage and is subject to Florida’s Best Interest standard and Replacement Rule (F.S. §627.4554). Recommendations of replacement are only compliant if the exchange clearly benefits the client — the agent may not place his or her financial interest ahead of the consumer’s. The Florida Best Interest standard specifically requires that when evaluating an exchange or replacement, the producer consider the whole transaction, including whether:

• The consumer will incur a surrender charge
• The consumer will be subject to the commencement of a new surrender period
• The consumer will lose existing benefits (such as riders, endorsements, or grandfathered tax treatment)
• The consumer will be subject to increased fees or charges
• The consumer has had another annuity exchange or replacement within the preceding 60 months

The procedural steps agents must follow when replacing coverage are discussed in detail in Chapter 6. In the above example, the intent is admirable — but if surrender charges on the old contract cost more than the more favorable terms on the new policy will deliver, the client would have been better off not making the change.

The above situation, with annuitization as the investor’s purpose, is quite common. Typically, the minimum guaranteed payout schedule included in the original annuity will not be as favorable as payments currently available under new immediate contracts — one can argue that an advisor who does not consider replacement under these circumstances ill-serves the client. Replacements for this reason are routine and generally benefit the client’s income needs. Replacements of one deferred annuity for another deferred annuity may not be so benign.

When recommending annuities, advisors must be able to explain how annuities compare with other investment options available to the client. The sections below compare each annuity type with its closest alternatives.

Fixed annuities are sometimes compared with other fixed income investments such as certificates of deposit (CDs) or bonds. From a safety of principal point of view, this comparison is valid. Fixed annuities (including indexed annuities) provide a fixed, guaranteed rate of return if held to maturity — as do CDs and bonds.

The comparison is less valid when considering liquidation prior to maturity. The market price of bonds fluctuates based on the current level of interest rates. If interest rates go down after purchase, the price of the bond will increase — and the investor could sell it at a profit. Conversely, if interest rates rise, the bond’s price will fall. Annuities are not marketable securities. There is no opportunity to sell a deferred annuity at a profit (or loss) due to favorable interest rate movements. The contractholder can simply withdraw principal plus interest accumulated at the guaranteed rate, less any applicable surrender charges. In this respect, a fixed annuity is similar to a CD that imposes penalties for early withdrawal.

It bears repeating that annuities, like bonds, are not insured deposit accounts — there is an element of credit risk in both. The “guaranteed” payments are only as good as the institution making the promise.

The rate of return on fixed annuities (and the guaranteed minimum rate on indexed annuities) is comparable to that of CDs of equal maturity. The key tax distinction: income earned in an annuity contract is tax-deferred, while interest paid on CDs or corporate bonds is fully taxed as ordinary income in the year it is earned.

Another tax advantage for annuity investors is that they may choose to time withdrawals for when they are in a lower tax bracket. A disadvantage, however, is that withdrawals taken from a deferred annuity prior to age 59½ are subject to a 10% IRS penalty — no such penalty applies to bonds or CDs. Depending on an investor’s need for liquidity and age, fixed annuities may or may not be as suitable as investments in bonds or CDs.

Charges & Fees

Most fixed immediate annuities do not impose upfront sales charges or annual charges — the insurance company’s costs are factored into the payout schedule. Immediate annuities do not charge surrender charges, as those apply only to withdrawals or surrenders, which are not permitted once the contract is annuitized.

Fixed deferred annuities are more complicated. Until fairly recently, many fixed deferred annuities imposed an initial sales charge or “load.” These were unpopular with investors, and today very few fixed deferred annuities assess an upfront charge. Instead, deferred fixed annuities impose a surrender charge to recover the company’s acquisition costs (primarily commissions) if the contract is surrendered or large amounts are withdrawn in the first years of the contract’s life.