As the preceding discussion illustrates, 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 we 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. A full discussion of portfolio diversification is beyond the scope of this course. 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.
Existing annuity contracts.
As we saw in Chapter 4, 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 benefits can transfer wealth in an efficient manner 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 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 number of years ago, a client purchased a deferred variable annuity to invest for retirement. As the client approaches retirement she wishes to convert the accumulated value in the variable contract into fixed annuity payments. Her advisor recommends that she exchange her variable annuity for a new immediate fixed annuity that has more favorable annuity payout options than offered under the variable contract. As we 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, however, such an exchange is treated as a "replacement" of coverage — and is subject to Florida's Replacement Rule. The intent of the rule is to minimize the possibility that replacement is recommended solely to generate a commission for the agent. This rule spells out the steps agents must follow when replacing coverage, and these are discussed in greater detail in Chapter 6. Regardless of the procedure, recommendations of replacement are only suitable if the exchange of contracts benefits the client. Using the above example, the intent of the agent — to obtain more favorable annuity payout options for his client -- is admirable. But does the exchange truly benefit the client? 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 of the annuity under these circumstances ill-serves his or her client. Replacements for this reason are routine — they benefit the client's income needs and the advisor earns a commission on the sale of the immediate annuity. Replacements of one deferred annuity for another deferred annuity may not be so benign. Among the factors to consider when contemplating an exchange of one annuity for another:
Surrender Charges. The old contract may impose surrender charges if the policy is exchanged for another in the first few years following the contract's inception. This reduces the amount available for "reinvestment" in the new contract. Likewise, market value adjustment provisions may negatively impact the investor's principal balance.
New Fees. The new contract may impose new sales loads, policy fees and other expenses, which may mean that it could take the client years to break even in terms of total contract values.
Loss of Liquidity. The new contract will probably have new surrender charges, which will limit the contractholder's ability to access the full amount under the contract for a number of years. Often, contract replacement will extend the investor's effective surrender charge period.
Grandfathered Rights. If the old contract was purchased when tax laws were more favorable, replacement may entail the loss of "grandfathered" income tax benefits.
Riders and Endorsements. The old policy may include riders and endorsements not available under the new contract, or available only at an additional cost.
Investment options. The new contract may not offer the same investment options available under the old contract.
Annuities vs. Other Investment Alternatives
Fixed annuities are sometimes compared with other fixed income investments such as certificates of deposits or bonds. From a safety of principal point of view, this comparison is a valid one. Fixed annuities (including indexed annuities) provide a fixed, guaranteed rate of return if held to maturity, as do certificates of deposit and bonds. The comparison, however, is not as valid if one considers liquidation of the asset prior to maturity. The market price of bonds fluctuates based on the current level of interest rates (and how current rates compare with the stated interest rate on the bond). If interest rates go down after an investor purchases a bond, the price of the bond will increase — and the investor could sell it at a profit. Conversely, if interest rates rise, the price of the bond 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 his or her principal plus interest accumulated at the guaranteed rate, less any applicable surrender charges. In this respect, a fixed annuity is similar to certificates of deposit that impose 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, that is, 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 certificates of deposit of equal maturity. The income earned in an annuity contract is tax-deferred, while interest paid of CDs or corporate bonds is fully taxed as ordinary income in the year it is earned. (Municipal bond interest, in most cases, is free of federal income taxation. Interest on US government obligations is free of state taxes.) Tax-deferred interest income in an annuity is not included in calculation of the Alternative Minimum Tax (AMT) or taxability of Social Security benefits — taxable interest income from other investments is.
Another tax advantage for annuity investors is that they may choose to time the withdrawal from the annuity when they are in a lower tax bracket. A disadvantage, however, is that withdrawals taken from a deferred annuity prior to age 59˝ are subject to a 10% 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.
Most fixed, immediate annuities do not impose upfront sales charges or annual charges (the costs incurred by the insurance company are factored into the payout schedule it offers). Immediate annuities do not charge surrender charges, as those apply only to withdrawals or surrenders, which are not permitted once the contract is annuitized (and for immediate annuities, that happens when the contract is established). Fixed deferred annuities are considerably more complicated than immediate contracts. 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. Today, deferred fixed annuities impose a surrender charge to recover the company's "acquisition costs" (primarily commissions to sales personnel) if the contract is surrendered or large amounts withdrawn from the contract in the first years of the contract's life.