A 1035 annuity exchange may look good, but only on paper

When advisers consider whether a client should exchange his annuity for a new model, one of the easiest mistakes they can make is to underestimate the real value of the current contract.
“An adviser who doesn’t understand the client’s current annuity may sacrifice tremendous embedded value without realizing it,” said Michael Kitces, director of financial planning at Columbia, Md.-based Pinnacle Advisory Group Inc.
A major reason for this mistake is basing your analysis of the current annuity on a statement provided by the client, instead of calling the insurer for complete information, he said. Unfortunately, annuity statements don’t always tell the whole story. “A semiannual statement or a transaction confirmation may not show all the contract benefits and features,” said Mr. Kitces. “The current statement may say the cash value is $300,000, for example — but it doesn’t show that the actual death benefit is now $500,000 because of embedded step-ups and guarantees. I’ve seen this kind of mistake quite often.”
Today’s annuities have more sophisticated, elaborate, complex guarantees, features and structures, said Mr. Kitces. That often means you can find a new contract that’s better matched to a client’s particular needs than the one he already owns — but not always, he said. “It’s easy to find a new contract that looks better on paper, but really isn’t,” he concluded.
Sophisticated products are available to help advisers compare annuity costs and benefits. The major player in this market, Variable Annuity Research and Data Service from Chicago-based Morningstar Inc., was recently joined by a new competitor, Annuity Intelligence Report from Annuity Sales Corp. in Oakbrook Terrace, Ill., which provides a format that permits detailed side-by-side comparisons of three contracts.
But meaningful comparisons are difficult because the product guarantees work differently from company to company, Mr. Kitces said. One company’s higher-priced, in-depth guarantee may really be a better value than another company’s less expensive but weaker guarantee.
“You have to understand the features each annuity provides, and in what situations.” he said. “There are a lot of moving parts.”
For example, the annuity’s death benefit guarantees that there will be a legacy for the client’s heirs even if he or she dies with a net investment loss. But depending on the contract, the guaranteed legacy could be a return of the original premium, just the current cash value or the high-water mark of the underlying investments, Mr. Kitces said. Some annuities also step up the death benefit over time — and each product uses its own step-up formula. Other guarantees are equally complex and varied, he said.
“For example, many living benefit riders say, ‘If you choose to annuitize, we’ll let you do it based on a higher value,’” said Kitces. “That higher value is a phantom number — and it may grow, based on different formulas.”
Besides, he added, comparing the costs and features of the client’s current annuity to those of other contracts is only part of the adviser’s job. You also need to determine how well the client’s annuity actually meets his needs, Mr. Kitces said. “For instance, a product may offer an unbelievably well-priced death benefit — but if the client is 28 years old and in great health, that’s a wasted expense,” he said. “He doesn’t need it.”
Once you’ve deciphered the current contract and weighed it against the client’s needs, you may conclude that he would indeed be better served by another annuity. Lower expenses and/or better guarantees (assuming the client needs them) are good reasons to consider a 1035 exchange into a new product. Another important consideration is the insurer’s creditworthiness, said Loretta Nolan, a financial adviser and president of an eponymous Old Greenwich, Conn., firm
“A 1035 exchange may give you an opportunity to upgrade from coach to first-class without a tax consequence,” she pointed out. “Of course, you also want to look at the cost to get out of the current annuity. But if the insurer is a company that’s struggling financially, it may be worth paying a surrender charge to upgrade to a top-rated company,” Ms. Nolan said.

This is the second of three columns about 1035 exchanges. The next column will discuss situations in which it may make sense to cash out of an annuity instead of exchanging it for another product.