Are you trying to figure out whether or not it makes sense for your client to do a tax-free Section 1035 exchange out of his or her old variable annuity into a new one?
The question is certainly valid given the many new features available today in annuities. But brace yourself for a challenging assignment.
The innovations that have helped make deferred annuities more popular have also made them a lot harder to compare, said Robert Carlson, a Fairfax, Va.-based financial adviser with about $20 million under management, and editor of Retirement Watch, a monthly newsletter based in Oxon Hill, Md. Besides, analyzing the client’s annuity and comparing its costs and benefits with those of potential replacements is just one piece of the job. There’s also the big picture to consider: Is an annuity an appropriate investment for this client in the first place?
Annuities often are part of a new client’s portfolio, said Loretta Nolan, a certified financial planner and president of an eponymous Old Greenwich, Conn., firm. They’re not always an appropriate investment, she said. “If you wouldn’t have suggested an annuity for this client in the first place, it may make more sense to undo it than to exchange it,” Ms. Nolan said.
Finally, there’s the challenge of explaining all of this to your client in a way he or she can understand. “Meeting regulatory suitability and disclosure requirements is an absolute minimum,” said Michael Kitces, director of
financial planning at Pinnacle Advisory Group Inc. in Columbia, Md., and author of “The Annuity Adviser” (National Underwriter Co., 2005).
“Client education is fundamental. You take a significant business risk if people don’t understand what they’re buying from you,” he said.
Don’t rely on conversation alone. It’s a good idea to write up your product analysis as well as a straightforward explanation of the pros and cons of the client’s potential choices. “With any complex product, there’s always the risk that people will have selective amnesia and forget the warnings they didn’t like,” Mr. Kitces said.
THE NEW GUARANTEES
The main innovation in annuities comes in the form of “living benefits” riders. There are three basic varieties:
1. A minimum-income benefit, which guarantees the client a specific minimum future income for life after he or she has annuitized the contract.
2. A guaranteed-minimum-withdrawal benefit, which returns the client’s original investment over time, typically in 5% to 7% annual installments, without requiring annuitization.
3. A guaranteed-minimum-accumulation benefit, which puts a floor under the annuity’s value regardless of the market performance of its underlying investments.
Needless to say (but essential to explain to the client), every guarantee adds to the cost of the annuity, reducing its potential investment return.
The new guarantees make annuities more attractive to many consumers. But they also make the product harder to understand. It’s not unusual for a client to have misconceptions about what his or her contract actually provides.
Ms. Nolan said she recently met with new clients who already owned an annuity. Their contract guarantees them a 5% minimum annual withdrawal, available immediately, based on the annuity’s highest anniversary value. (The account’s value will rise and fall, but if the high-water mark for the year is $100,000, for example, they can take a $5,000 withdrawal.) The clients had decided to invest the entire annuity in small-cap stocks to maximize their potential return. “They reasoned that if their investment reached the moon, even for a nanosecond, they’d get the benefit,” Ms. Nolan said.
The clients assumed that their 5% withdrawals based on the annuity’s highest anniversary value are guaranteed for life. But when Ms. Nolan read the contract, she saw that the annual withdrawal is not an annuitization option — the guaranteed 5% payments will last only until the clients’ original investment is returned.
In this case, a 1035 exchange into another annuity would be an expensive choice, she said. An exchange is tax-free but not cost-free. “If they walk away from the annuity now, there’s a 6% or 7% surrender charge.”
Ms. Nolan’s first thought is to reallocate the annuity’s underlying investments to a more conservative mix. In general, a balanced portfolio is a better choice in an annuity than an all-equity portfolio, she said. “If you buy small-caps in a taxable account and the bottom falls out of the market, you can use your capital loss to offset other gains,” Ms. Nolan said. “But in an annuity, you have no capital loss offsets. That’s why I don’t think an annuity is the best place to invest in a high-risk asset class.”
This is the first of three columns about 1035 exchanges of annuities. The next column will discuss the factors advisers should consider in comparing a client’s current annuity with new products.
