Chapter 3 — Analyzing Suitability

• Suitability must always be viewed from each client’s unique perspective — advisors should analyze the client’s needs first, not start with a product and look for buyers
• A thorough financial review covers personal information, assets & liabilities, income & expenses, tax status, and long-term financial goals
• Investors’ financial goals typically move through four phases: accumulation, conservation, distribution, and transfer
• Annuities should only be purchased with long-term money — funds the investor can afford to set aside for an extended period
• The 10% IRS penalty on withdrawals before age 59½ makes deferred annuities illiquid for younger investors (not applicable to senior consumers)
• Five key investment risk types: interest rate, purchasing power, credit, market, and legislative risk
• Fixed annuities are most vulnerable to inflation risk; EIAs and variable annuities offer some inflation hedge
• In Florida, creditors cannot attach or garnish annuity cash values unless the contract was obtained for the creditor’s benefit
• Replacements of one annuity for another must benefit the client — not merely generate a commission for the agent
• EIAs are particularly illiquid: early surrender often results in receiving only the minimum guaranteed rate, not the indexed value

One of the key responsibilities for any financial advisor is to determine whether a recommendation is suitable for a particular client. Suitability should always be viewed from each client’s unique perspective. Advisors should not start with a product to sell and ask “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 regulators define suitability as the “appropriateness of recommended transactions when considering the risks associated with a transaction relative to a customer’s financial situation, financial needs and investment objectives.” An ethical corollary is the concept of fiduciary responsibility — the obligation to place the client’s interest above the advisor’s own self-interest (discussed further in Chapter 4).

In this chapter we’ll explore the client’s financial situation, investment objectives, various factors that affect suitability, the client’s existing annuity holdings, and how annuities compare with other investment alternatives.

Before making any recommendations, advisors should carefully review the prospect’s current and projected financial situation, starting with basic personal information:

• The client’s age and marital status
• Number of dependents and their ages (including parents and stepchildren, not just minor children)

Assets & Liabilities

A personal balance sheet — assets minus liabilities equals net worth — is the starting point. Key distinctions to make:

• Liquid vs. illiquid assets: Liquidity is especially important when recommending deferred annuities with surrender charges. All investors should maintain a liquidity cushion for everyday expenses and emergencies.
• Short-term vs. long-term liabilities: Debts due soon will drain liquid assets. Future balloon payments or business buy-out obligations affect investment horizon and liquidity needs.
• Lawsuit exposure: Clients in high-risk professions may benefit from annuities’ creditor protection features.
• Life insurance: Cash values may be treated as liquid assets on a balance sheet, but death benefits should not be counted as long-term assets — they provide no financial value during the investor’s lifetime. Annuities should not be viewed as substitutes for life insurance coverage.

Income & Expenses

Advisors should compare clients’ income with their expenses to assess the need to augment income from investments. Consider both current and projected income and expenses over time:

• Earned income (employment) tends to dominate early in life; investment income becomes primary in later years
• Income stability matters — a commissioned salesperson and a salaried employee at the same income level have very different risk profiles
• Some careers are shorter (professional athletes, physically demanding jobs); projected retirement date affects planning
• Projected expenses for college tuition, medical care, and long-term care should factor into recommendations

When income falls short of expenses, investments can shift from capital appreciation to income generation — purchase of an immediate annuity, or annuitization of a deferred contract, can serve that function.

Taxes

Tax-deferred growth is one of the most important features of annuities — and its value is greatest for clients in higher tax brackets. Advisors should review:

• The client’s current and projected marginal tax rate
• Filing status and sources of taxable income
• How an annuity fits into the client’s overall tax situation

Financial Goals

Over a lifetime, individual investment objectives typically pass through four phases:

• Accumulation: Early years; focus on capital appreciation
• Conservation: Mid-life; shifting from growth to safety of principal
• Distribution: Retirement; converting accumulated wealth into income
• Transfer: End of life; passing wealth efficiently to beneficiaries

Liquidity

Annuities should only be purchased with “long-term money” — funds the investor can afford to set aside for an extended period. Before recommending an annuity, advisors should confirm that the client has answered “yes” to both questions:

• “Is this money I can afford to tie up for an extended period?”
• “Do I have adequate cash or short-term investments to meet daily living expenses and emergencies?”

Key liquidity constraints on deferred annuities: surrender charges on early withdrawals (typically on a declining scale over 5–7 years); and a 10% IRS penalty on withdrawals prior to age 59½ (not applicable to senior consumers). Florida regulators have taken significant enforcement action against agents who misrepresented the liquid nature of annuities to elderly clients.

Tax Status

Tax-deferred compounding (“triple compounding” — interest on principal, on past earnings, and on tax savings) is a powerful benefit. However, annuity growth is taxed as ordinary income when distributed — never as capital gains. By contrast, profits on stocks, bonds, or mutual funds may qualify for more favorable capital gains treatment. Advisors must address both the advantages and disadvantages of the annuity’s tax treatment when making comparisons.

Time Horizon & Age

Age is important but should not be the only factor. As investors age there is less time to recoup losses, creating a natural shift toward wealth conservation. However, advisors should not assume that retirement income is every older client’s only objective — wealthier clients may be focused on wealth transfer, while others need accessible liquid funds. Placing a senior client in an annuity with substantial surrender charges that may remain in force for most of the client’s remaining life expectancy is viewed very seriously by Florida regulators.

Risk Aversion

Advisors should take time to understand the client’s tolerance to risk. Long-term relationships are built on mutual understanding. There are five general risk types investors should consider:

• Interest rate risk: The risk that rising rates will make existing fixed-rate investments less attractive. Fixed annuities with guaranteed rates are subject to this opportunity cost; most issuers reset rates annually but are not required to match prevailing market rates.
• Purchasing power (inflation) risk: The risk that future dollars will buy fewer goods than today’s. Even 4% annual inflation halves purchasing power over 20 years. Fixed annuities are most vulnerable; EIAs and variable annuities may provide some hedge.
• Credit risk: The risk that the insurer becomes insolvent. Life insurers are generally financially stable and subject to state reserve requirements. Variable annuity separate accounts offer protection through segregation from the company’s general assets.
• Market risk: The risk of a general stock market downturn. Fixed annuities are immune; variable annuities are fully exposed. Indexed annuities, combining a minimum guaranteed rate with market-linked returns, may best address market risk.
• Legislative risk: The risk that Congress alters the tax advantages currently granted to annuities. What Congress grants, it can take away — though existing contracts are typically “grandfathered” when the tax code changes.

Creditor Protection

Some occupations — medicine, law, and others — carry heightened exposure to lawsuits and legal judgments. Annuities (and other insurance products) offer better protection against creditor claims than most other assets.

In Florida, creditors of an annuity contract owner may not attach or garnish the cash values or other benefits of an annuity (or insurance policy), unless the contract was obtained for the benefit of the creditor. If the annuity company releases cash value to the contract owner, however, creditors may bring judgment against the released proceeds. Note: proceeds released to a designated beneficiary (other than the estate) cannot be attached by the contract owner’s creditors. A spendthrift trust clause can protect death benefits from the claims of the beneficiary’s creditors by having the annuity company hold and distribute benefits over time.

Investment Sophistication

One factor many advisors fail to consider is the sophistication of the investor. As Warren Buffett says: “If you can’t pronounce it and can’t explain it, you probably shouldn’t invest in it.” Traditional fixed contracts are relatively simple to understand; variable annuities and especially EIAs — with their participation rates, spreads, caps, floors, and complex interactions — can be difficult even for financial professionals to explain clearly.

If a client is incapable of understanding a product’s features, then the product is, per se, an unsuitable investment for that client. Sales made on the basis of “trust me” rather than genuine understanding are ripe for future complaints — and any short-term gain from a commission may be offset by much higher losses in the long run.

No investment decision is made in a vacuum. Each recommendation must be made in the context of the client’s unique circumstances, including the type and amount of other investment holdings. Advisors must be aware of the client’s existing portfolio before making any recommendations that may upset diversification.

Existing Annuity Contracts

Annuities can meet a variety of objectives: deferred annuities accumulate wealth, fixed annuities conserve it, annuitized contracts distribute it, and death benefits transfer it efficiently to beneficiaries. 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 already holds. Quite often, fixed annuities complement variable contracts: one provides safety of principal, the other hedges inflation risk.

As a client’s financial situation changes, an existing annuity may no longer fit. For example, a client approaching retirement may wish to convert the accumulated value in a deferred variable contract into fixed annuity income payments. Such an exchange is permitted tax-free under IRC Section 1035 — but under Florida law it is treated as a replacement of coverage, subject to Florida’s Replacement Rule. The intent of the rule is to minimize replacements recommended solely to generate a commission. Replacements are only suitable if the exchange benefits the client.

Replacement Considerations

When contemplating an exchange of one annuity for another, advisors must evaluate:

• Surrender charges: Charges on the old contract reduce the amount available for reinvestment. Market value adjustment provisions may also negatively impact the principal balance.
• New fees: Sales loads, policy fees, and other expenses on the new contract may mean it takes years to break even on total contract values.
• Loss of liquidity: The new contract will likely have new surrender charges, extending the effective surrender charge period.
• Grandfathered rights: If the old contract was purchased under more favorable tax laws, replacement may forfeit those grandfathered income tax benefits.
• Riders and endorsements: The old policy may include riders not available under the new contract, or available only at additional cost.
• Investment options: The new contract may not offer the same investment options available under the old contract.

Fixed Annuities vs. CDs & Bonds

Fixed annuities are sometimes compared with certificates of deposit or bonds. From a safety-of-principal standpoint this comparison is valid — all provide a fixed, safe rate of return if held to maturity. The comparison breaks down, however, when considering early liquidation. Bond prices fluctuate with interest rates; an investor may sell a bond at a profit or a loss depending on market conditions. Annuities are not marketable securities — the contractholder can only withdraw principal plus credited interest, less any applicable surrender charges. In this respect, fixed annuities resemble CDs that impose penalties for early withdrawal.

The guaranteed rates on fixed and indexed annuities are comparable to CDs of equal maturity — but annuity earnings grow tax-deferred, while CD interest is fully taxable as ordinary income in the year earned. Tax-deferred interest income in an annuity is also not included in the calculation of Alternative Minimum Tax (AMT) or the taxability of Social Security benefits.

Equity Indexed Annuities vs. Index Funds & ETFs

EIAs are sometimes compared to indexed mutual funds or exchange-traded funds (ETFs). Those comparisons are not entirely valid:

• Index funds and ETFs include dividend income in total return; EIA returns are based solely on price appreciation of the index — no dividend income.
• Index funds and ETFs participate fully in the index’s ups and downs. EIA upside is limited by participation rates, caps, and spreads; downside is limited by the minimum guaranteed rate.
• EIA “hidden cost”: The index options that support EIAs expire periodically and must be replaced — a cost not always visible to contractholders.
• EIA earnings grow tax-deferred; index funds must distribute income annually (taxable in the year distributed).

EIAs are primarily accumulation vehicles. Advisors should view them as a fixed annuity with a minimum guaranteed rate — any indexed return above that minimum is a bonus. Surrendering an EIA early can be particularly costly: in many contracts, the indexed rate applies only if the contract remains in force to maturity; early surrender may yield only the minimum guaranteed rate.

Variable Annuities vs. Mutual Funds & Equities

Variable annuity separate accounts are typically viewed as alternatives to mutual funds or equities. The sale of variable annuities is subject to dual regulation under both state and federal law. Under §627.4554, F.S., agents who are registered representatives of FINRA broker-dealers and who comply with applicable FINRA and SEC best interest obligations are deemed to satisfy the state annuity suitability requirements for variable annuity recommendations. A detailed comparison of variable annuities and other equity investments is beyond the scope of this course.