By FPA member Tim Sobolewski, CFP®
Last Updated: January 23, 2012
When an insurance agent or broker recommends an annuity replacement, it may actually be a good idea for you and your family — or it may just be a good idea for the agent because of the seven percent commission he'll receive. Careful analysis is required of any replacement proposal, and you should seek the help of a CERTIFIED FINANCIAL PLANNER™ professional in performing this analysis.
As with a life insurance policy replacement, an annuity replacement usually involves moving the cash value from an older policy into a new one through a Section 1035 exchange, as we discussed in November. Once again, this requires your agent to first disclose that you are intending to replace an annuity, and to obtain current information and projections from your existing annuity company. After the information is received (usually within about three weeks), the agent can then provide a side-by-side comparison of your existing and proposed annuities. It is only at that point that he can take an order from you.
Unfortunately, annuity replacements are among the most problematic transactions in all of the investment product world, and should be assessed very carefully before a commitment is made to proceed. According to Financial Industry Regulatory Authority FINRA,
“An exchange of an existing annuity for a new annuity may be the only way a salesperson can generate additional business. However, the new variable annuity may have a lower contract value and a smaller death benefit. You should exchange your annuity only when it is better for you and not just better for the person trying to sell you a new annuity.”1
Annuities come in several varieties: fixed, variable, or equity-indexed, and immediate and deferred. Fixed annuities are often sold as an alternative to Certificates of Deposits (CDs), but in fact are more complex than CDs and are subject to a different set of IRS rules and penalties. Equity-indexed annuities are linked to stock market returns, but surprisingly are not yet regulated as securities, and may be sold by people with an insurance license but no securities training at all.
This article will primarily cover variable deferred annuities (VA's), since they are among the most complex consumer investment products and are the source of the most frequent abuse. For example, in 2009 FINRA fined Fifth Third Securities $1.75 million for "250 unsuitable sales and exchanges to 197 customers through 42 individual brokers...who, in many cases, worked in Fifth Third Bank branches. They used lists provided by the bank of customers with maturing CD’s and referrals from bank employees to identify new customers — some of them elderly and/or unsophisticated and with conservative investment objectives — to purchase VA's."2
What are the potential advantages of an annuity replacement?
- Special features. An older VA may lack some of the features that are available on newer ones, such as a stepped-up death benefit, return of premium or a guaranteed income rider (“living benefit”) of some sort. If, after the salesperson has explained how these features work and what they cost, you decide that these features are worth it, this can be a valid reason for replacement. Never buy a product (or a feature) that you do not understand, and never be shy about asking questions until you do.
- More investment choices. There may be a bigger assortment of variable sub-accounts with a newer annuity (although since the crash in 2008, some insurance companies have moved to limit these options, particularly if a guaranteed income rider is chosen). Naturally, more does not necessarily mean better.
- Lower cost. It is possible that the basic cost (“mortality and expense charges”) would be lower in the new VA than in the old. However, be sure to get the costs clearly explained, particularly if any extra features or bonuses (which carry separate charges) are involved.
Bonus credit. A bonus credit ranging from one percent to five percent may be offered on a new VA. However, you usually end up paying for this bonus yourself through higher expenses and a longer surrender period. In some cases, a salesman may try to sell you the bonus as a way to offset surrender charges still attached to an older annuity — a deceptive practice and a bad idea, since you would be the one to pay for it.
What are the disadvantages of a policy replacement?
- New surrender period. Although there is no up-front sales charge, a new VA would have a new set of surrender charges over a four to 10 year surrender period, during which any withdrawal beyond the “free withdrawal corridor” (usually 10 percent per year) would be penalized. This is in addition to the 10 percent early-withdrawal penalty that the IRS might levy for customers younger than 59½.
- Cost. There are several components to cost in a VA, and the added features you may be buying could add quite a bit. A VA with a death benefit step-up and a guaranteed income feature could cost you around three percent per year in fees — in addition to the charges built into the sub-accounts. Needless to say this creates quite a drag on returns, which will matter to you if you someday need to withdraw funds.
- Loss of features. If an older VA had an income benefit or a stepped-up death benefit, replacing it may mean the loss of the accrued value of those benefits, even if the same features are available again in the new VA. It would also mean that the costs of those features over the years would have been squandered. Similarly, replacing an older fixed annuity could mean losing a guaranteed rate that may be much higher than what's currently available.
- Taxable gain. It is important to note that [except for Individual Retirement Account (IRAs)] if the transfer of funds from the old to new annuity does not qualify as a §1035 exchange and isn't handled properly as such, then any gain in the old contract would be subject to income tax, even if the cash from surrender of the old policy is immediately redeposited.
In New York, for example, your agent is required to itemize on the Reg. 60 and other annuity replacement disclosures the reasons for the replacement. Remember, however, that this material is not scrutinized or approved by the state before the sale, and despite FINRA regulations a sales supervisor may sign off on “reasons” that an arbitrator may later find invalid.
According to FINRA, “You should exchange your annuity only when you determine, after knowing all the facts, that it is better for you and not just better for the person who is trying to sell the new contract to you.”3 These are very complicated products, and complicated transactions; whenever you're considering the replacement of an annuity, you should seek the advice of a CERTIFIED FINANCIAL PLANNER™ professional.
FPA member Tim Sobolewski, CFP®, is President of The Financial Planning Center in Amherst, N.Y.
1 "Variable Annuities: Beyond the Hard Sell." FINRA. 31 August 2009.
2 "FINRA Fines Fifth Third Securities $1.75 Million for 250 Unsuitable Variable Annuities Transactions." FINRA. 14 April 2009.
3 "Should You Exchange Your Variable Annuity?" FINRA. 02 March 2006.