Annuity Suitability

Other investment factors


During their lifetimes, most individuals will have investment objectives of accumulation, conservation, distribution and transfer.  What makes each client unique, however, is the particular set of circumstances each individual faces.  Advisors must apply their creative talents to adapt general investment concepts to each client's situation.  The decision whether the purchase of annuity is suitable must be based on each client's unique set of circumstances.  And if an annuity is purchased, the advisor should maintain contact with the client to monitor whether the annuity remains a suitable investment as the client's objectives and circumstances change. 





Liquidity, the ability to easily turn an investment to cash without incurring large expense, is a major factor in most investment decisions.  Annuities should only be purchased with "long-term money", i.e., funds that the investor can afford to invest over a long time horizon.  Before making a decision to purchase an annuity, the investor should ask: "Is this money that I can afford to tie up for an extended period?" and "Do I have adequate reserves of cash or short-term investments to meet daily living expenses and unforeseen emergencies?"  If the answer to either of those questions is "No", then an annuity is not a suitable investment. 


Annuities can be readily converted to cash, either through withdrawals in the accumulation period or by converting the contract into a stream of income payments.  There are, however, a couple of key points to keep in mind.  Most contracts impose surrender charges for withdrawals in the early years of the contract.  These fees are usually on a sliding scale — beginning with relatively large surrender charges in the earliest years, tapering off over the first five to seven years, and no surrender charges after that point.  Surrender charges are typically waived for beneficiaries in the event the contractholder dies.    Another hurdle makes deferred annuities rather illiquid: a 10% penalty tax on withdrawals prior to age 59½. Obviously, this is not a consideration for “senior consumers”.


Recent changes in Florida law have been motivated by agent misrepresentations of the liquid (or illiquid) nature of annuities.  The suitability disclosure requirements discussed in Chapter 1 are a direct result of those misrepresentations — particularly to elderly clients. 



Tax status


One of the key selling features of annuities is their tax-deferred status.  Earnings in the contract grow tax-deferred, allowing the contractholder to "triple compound" his interest — interest is earned on the initial investment to the contract, on past earnings in the contract and on monies that would have been used to pay taxes on those earnings.  By contrast, earnings from investment in a taxable investment, such as a mutual fund, are taxable in the year they are distributed to the investor.  If the investor chooses to reinvest, only the after-tax portion of the distribution is available for compounding.   Triple compounding allows for faster capital appreciation in tax-deferred contracts, and as you would expect, this is a strong incentive to invest in annuities.  Tax-deferral is more valuable to clients in higher tax brackets.  There are, however, tax disadvantages to an annuity too.  Earnings will be taxed when the account's value is distributed to the contractholder — either as a withdrawal or as a series of periodic payments.   All growth in an annuity contract's value — regardless of its source — is taxed as ordinary income, not capital gains.  By contrast, profits on investments in taxable securities like mutual funds, stock or bonds, will be subject to more favorable capital gains treatment when the security is sold. 


When comparing a tax-deferred annuity to other taxable alternatives, advisors should be careful to address both the tax advantages and disadvantages of the annuity.  Whether the annuity makes more sense from a tax perspective depends on the investor's current tax bracket, the investor's projected tax bracket when monies will be taken out, the different treatment of ordinary income, dividends and capital gains, and the expected timeframe of the investment (the time earnings will grow tax-deferred).  Obviously future changes in the tax code may also affect whether the annuity turns out to be the better investment. 



 Time horizon / Age


The earlier discussion about individual investment objectives was based, in part, on the natural aging process.  As investors grow older, there is less time to recoup losses, which leads to a natural progression from asset accumulation to wealth conservation.  While age is certainly an important factor in many investment decisions, advisors should inquire as to the purpose of the investment prior to making a recommendation.  While a comfortable retirement income may be a goal of most older clients, advisors should not assume that is their only objective.  Wealthier clients may be looking beyond retirement for a way to preserve assets for beneficiaries.  Others many need income and readily accessible funds.  As we’ve mentioned earlier, there have been numerous complaints about sales of annuities to elderly clients.  Placing a client into an investment with substantial surrender charges that may remain in force for most of the client's remaining life expectancy is viewed very dimly by state insurance regulators.  




Risk aversion


Advisors should take the time to understand the client's tolerance to risk.  Long-term (and profitable) relationships are built on mutual understanding.  Advisors should determine whether their clients can sleep at night with the investment decisions they have made, and clients should be aware of the imprecise nature of investment analysis in a world of imperfect information.  


There are four general risks that investors should consider when making any investment:  interest rate risk, purchasing power risk, creditor risk, and market (or systemic) risk.


Interest rate risk is the risk that interest rates will rise in the future.  Rising interest rates make existing fixed income securities with their older, lower rates of interest less attractive.  If the older security needs to be liquidated prior to maturity, the investor will suffer a loss.  Even if the investor can hold until maturity, there is the opportunity cost of having locked into a lower rate than what could have been earned otherwise.  Fixed annuities, with their guaranteed rate of interest are subject to this opportunity cost.  Most issuers of fixed annuities will set a new rate for the contract each year — but there is no requirement that the company must match prevailing market interest rates when it resets its contractual rate.  Indexed annuities will reset the rate each year based on market rates of return, but those rates are based on the returns of the stock market, which tend to be far more volatile than general interest rate fluctuations.


Purchasing power risk, or inflation risk, is the risk that the value of the dollars that are eventually returned to the investor will purchase fewer goods and services than could have been bought at the time of the original investment.  Even modest rates of inflation over a long period of time can seriously erode purchasing power (e.g., 4% annual inflation over a 20-year period will cut the purchasing power of the dollar in half).  While there is little the investor can do about government policies that cause inflation, he or she can minimize its effects by investing short-term, that is, don't give inflation a long opportunity to cause damage.  For deferred annuity investors, however, this is not an option as annuities are inherently a long-term investment.  Fixed annuities, with a fixed rate of return, are most vulnerable to the effects of inflation.  Indexed annuities and variable annuities may provide some hedge against purchasing power risk.


Credit risk is the risk that a borrower becomes insolvent and will not be able to repay the investment.  For the most part, life insurance and annuity companies are financially stable — and failures of large insurers are rare. Ratings organizations assess the financial strength of insurers — although in light of recent troubles on Wall Street, advisors should be aware of the shortcomings of the ratings system.   State insurance regulations require companies issuing fixed annuities to maintain adequate reserves to meet their obligations, invest prudently and submit to periodic examinations to assure the public that the companies remain financially solvent.   Variable annuity holders don't enjoy such protections.  The sole source of protection for a variable contract is the value of the assets held by the separate account.  As was noted earlier, the separate account is segregated from the firm's general assets, so in the case of insolvency, there are specific assets earmarked exclusively for the variable contractholders.


Market risk is the risk that the general stock market may experience a downturn, generally as a result of the natural progression of the economy through the business cycle.  This is sometimes referred to as "systematic" risk.   Studies have found the more than one-half of the change in any company's stock price is the result of general market conditions.  In a bull market most stocks advance, in bear market most decline.  (One can argue whether that is a cause or an effect, but the fact remains: when times are good, most stocks benefit, when times are bad, most stocks suffer.)   Fixed annuities are immune from market risk, as their returns are based on a fixed, guaranteed rate of interest.   Variable annuities are very susceptible to market risk.  To a certain extent, some general market risk can be minimized by the selection of actively managed separate accounts.  Some investment managers may be able to overcome general market downturns by outperforming the market.  Passively managed separate accounts (and exchange traded funds, or ETFs) will be more subject to market risk, since they are designed to closely mirror the ups and downs of the general market.   Indexed annuities, which links a minimum guaranteed rate of return with returns based on a measurement of the general market, are perhaps the best solution to address market risk.


One last risk, legislative risk, applies particularly to insurance products.  Congress grants insurance and annuity products special tax treatment — primarily tax-deferred growth.  That special treatment is subject to political considerations.   The tax code is under constant review and revision.  What Congress grants, it can take away.   Investors who may invest today based on the promise of tax advantages may find those features altered in the future.  Typically, Congress has “grandfathered in” old tax regulations for existing contracts when it changes the tax code, but that may not necessarily be true for any future changes Congress may make. 



Creditor Protection


We live in a litigious society. Some occupations, such as the medicine, are more susceptible to malpractice or other legal proceedings.  These types of clients may want to consider certain types of investments that offer a greater level of protection from the claims of creditors than do other assets. Both the federal Bankruptcy Code and state laws provide this heightened level of protection.  The most obvious examples of protected assets are the debtor's homestead, retirement plans (including IRAs), life insurance and annuities. The law offers this protection so that the debtor's family can maintain a minimum level of financial well-being and avoid becoming a burden to the state. This protection is tempered by society's concern for the creditor's competing rights to access the debtor's property for the satisfaction of legitimate claims. 


In Florida, creditors of an annuity contractowner 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 the cash value to the contractowner, however, the creditors may bring judgment against the contractholder for the released proceeds.   The same applies to death benefits paid to the estate of the contractholder.  Once released to the estate, the creditors of the deceased’s estate can claim the death benefits.  Note: Proceeds released to a designated beneficiary (other than the estate) cannot be attached by the contractholder’s creditors.  A spendthrift trust clause can protect death benefits from the claims of the beneficiary’s creditors by having the annuity company hold the benefits and distribute them over time.



Investment Sophistication


One factor many advisors fail to consider when making recommendations is the sophistication of the investor.  Basic investments, such as stocks and bonds, may be relatively easy to understand, while packaged products such as mutual funds and annuities present a more complex situation.  As the famed investor Warren Buffet says:  "If you can't pronounce it and can't explain it, you probably shouldn't invest in it."  Some annuities, such as traditional fixed contracts, are very simple to understand: a guaranteed rate of return, fixed income payments for life with relatively few fees.  On the other hand, a variable annuity's investment options, management fees, and varying values are more difficult to comprehend.  The myriad moving parts of an equity indexed annuity — participation rates, spreads, caps, floors, etc. and their complex interactions — can be damned near indecipherable to the general public (and probably many financial professionals, too).


Regulatory organizations impose a number of disclosure requirements on annuity salespersons.  The intent is to educate prospective clients as to the advantages and disadvantages of the annuity product and allow the client to make an informed decision.  But if the client is incapable of understanding the product's features, then the product is, per se, an unsuitable investment for that client.  If the sales pitch boils down to "trust me", the product most likely will become a future problem for both the client and the agent.  In these situations, the client may trust an advisor who may not fully understand the product (after all, he was unable to adequately explain the contract to the client).  This puts the client at heightened risk.  For the agent, sales made in this manner are ripe for future charges of misconduct — and any short-term gain from the sales commission may be offset in the long run by much higher losses.



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