Chapter 3 — Analyzing Suitability

• Suitability must always be viewed from each client’s unique perspective — advisors should analyze the client’s needs first, not start with a product and look for buyers
• A thorough financial review covers personal information, assets & liabilities, income & expenses, tax status, and long-term financial goals
• Investors’ financial goals typically move through four phases: accumulation, conservation, distribution, and transfer
• Annuities should only be purchased with long-term money — funds the investor can afford to set aside for an extended period
• The 10% IRS penalty on withdrawals before age 59½ makes deferred annuities illiquid for younger investors (not applicable to senior consumers)
• Five key investment risk types: interest rate, purchasing power, credit, market, and legislative risk
• Fixed annuities are most vulnerable to inflation risk; EIAs and variable annuities offer some inflation hedge
• In Florida, creditors cannot attach or garnish annuity cash values unless the contract was obtained for the creditor’s benefit
• Replacements of one annuity for another must benefit the client — not merely generate a commission for the agent
• EIAs are particularly illiquid: early surrender often results in receiving only the minimum guaranteed rate, not the indexed value

One of the key responsibilities for any financial advisor is to determine whether a recommendation is suitable for a particular client. Suitability should always be viewed from each client’s unique perspective. Advisors should not start with a product to sell and ask “which clients would this be suitable for?” Rather, the advisor should carefully analyze the client’s needs and circumstances to determine which investments may be suitable for that particular client.

Florida regulators define suitability as the “appropriateness of recommended transactions when considering the risks associated with a transaction relative to a customer’s financial situation, financial needs and investment objectives.” An ethical corollary is the concept of fiduciary responsibility — the obligation to place the client’s interest above the advisor’s own self-interest (discussed further in Chapter 4).

Before making any recommendations, advisors should carefully review the prospect’s current and projected financial situation, starting with basic personal information:

• The client’s age and marital status
• Number of dependents and their ages (including parents and stepchildren, not just minor children)

Assets & Liabilities

A personal balance sheet — assets minus liabilities equals net worth — is the starting point. Key distinctions to make:

• Liquid vs. illiquid assets: Liquidity is especially important when recommending deferred annuities with surrender charges. All investors should maintain a liquidity cushion for everyday expenses and emergencies.
• Short-term vs. long-term liabilities: Debts due soon will drain liquid assets. Future balloon payments or business buy-out obligations affect investment horizon and liquidity needs.
• Lawsuit exposure: Clients in high-risk professions may benefit from annuities’ creditor protection features.
• Life insurance: Cash values may be treated as liquid assets on a balance sheet, but death benefits should not be counted as long-term assets — they provide no financial value during the investor’s lifetime. Annuities should not be viewed as substitutes for life insurance coverage.

Income & Expenses

Advisors should compare clients’ income with their expenses to assess the need to augment income from investments. Consider both current and projected income and expenses over time:

• Earned income (employment) tends to dominate early in life; investment income becomes primary in later years
• Income stability matters — a commissioned salesperson and a salaried employee at the same income level have very different risk profiles
• Some careers are shorter (professional athletes, physically demanding jobs); projected retirement date affects planning
• Projected expenses for college tuition, medical care, and long-term care should factor into recommendations

When income falls short of expenses, investments can shift from capital appreciation to income generation — purchase of an immediate annuity, or annuitization of a deferred contract, can serve that function.

Taxes

Tax-deferred growth is one of the most important features of annuities — and its value is greatest for clients in higher tax brackets. Advisors should review:

• The client’s current and projected marginal tax rate
• Filing status and sources of taxable income
• How an annuity fits into the client’s overall tax situation

Financial Goals

Over a lifetime, individual investment objectives typically pass through four phases:

• Accumulation: Early years; focus on capital appreciation
• Conservation: Mid-life; shifting from growth to safety of principal
• Distribution: Retirement; converting accumulated wealth into income
• Transfer: End of life; passing wealth efficiently to beneficiaries

Liquidity

Annuities should only be purchased with “long-term money” — funds the investor can afford to set aside for an extended period. Before recommending an annuity, advisors should confirm that the client has answered “yes” to both questions:

• “Is this money I can afford to tie up for an extended period?”
• “Do I have adequate cash or short-term investments to meet daily living expenses and emergencies?”

Key liquidity constraints on deferred annuities: surrender charges on early withdrawals (typically on a declining scale over 5–7 years); and a 10% IRS penalty on withdrawals prior to age 59½ (not applicable to senior consumers). Florida regulators have taken significant enforcement action against agents who misrepresented the liquid nature of annuities to elderly clients.

Tax Status

Tax-deferred compounding (“triple compounding” — interest on principal, on past earnings, and on tax savings) is a powerful benefit. However, annuity growth is taxed as ordinary income when distributed — never as capital gains. By contrast, profits on stocks, bonds, or mutual funds may qualify for more favorable capital gains treatment. Advisors must address both the advantages and disadvantages of the annuity’s tax treatment when making comparisons.

Time Horizon & Age

Age is important but should not be the only factor. As investors age there is less time to recoup losses, creating a natural shift toward wealth conservation. However, advisors should not assume that retirement income is every older client’s only objective — wealthier clients may be focused on wealth transfer, while others need accessible liquid funds. Placing a senior client in an annuity with substantial surrender charges that may remain in force for most of the client’s remaining life expectancy is viewed very seriously by Florida regulators.

Risk Aversion

Advisors should understand each client’s tolerance for the five key investment risks:

Creditor Protection

In Florida, creditors of an annuity contractholder cannot attach or garnish the cash values or benefits of an annuity contract, unless the contract was obtained for the creditor’s benefit. Key caveats:

• Once the annuity company releases cash value to the contractholder, creditors may bring judgment against the released proceeds
• Death benefits paid to the contractholder’s estate (not to a named beneficiary) are also subject to creditor claims
• Proceeds released to a designated beneficiary (other than the estate) cannot be attached by the contractholder’s creditors
• A spendthrift trust clause can further protect death benefits from the beneficiary’s own creditors

Investment Sophistication

Advisors often fail to consider whether the client can understand the product being recommended. As Warren Buffett says: “If you can’t pronounce it and can’t explain it, you probably shouldn’t invest in it.”

• Traditional fixed annuities: Relatively simple — guaranteed rate, fixed income payments, few fees
• Variable annuities: More complex — investment options, management fees, varying values
• Equity indexed annuities: Highly complex — participation rates, spreads, caps, floors, and their interactions are difficult for most clients and many advisors to fully comprehend

If a client cannot understand a product’s features, the product is per se unsuitable for that client. Sales that boil down to “trust me” are at high risk for future misconduct charges — and any short-term commission gain may be far outweighed by long-term losses.

No investment recommendation is made in a vacuum. Advisors must take into account the type and amount of other investment holdings the client already has — and maintain contact to monitor whether an annuity remains suitable as the client’s circumstances change over time.

Existing Annuity Contracts

There is nothing inherently unsuitable about recommending an additional annuity contract to a client who already holds one. Fixed annuities often complement variable contracts — one provides safety of principal, the other hedges inflation risk. However, when replacing one annuity with another, advisors must weigh the following factors:

• Surrender charges on the old contract — may reduce the amount available for reinvestment and take years to recoup
• New fees on the new contract — sales loads, policy fees, and expenses may extend the break-even period
• Loss of liquidity — a new surrender charge period begins, extending the time the investor cannot fully access the funds
• Grandfathered tax rights — older contracts may hold favorable tax treatment that would be lost upon replacement
• Riders and endorsements — features available in the old contract may not be available (or may cost more) under the new contract
• Investment options — the new contract may not offer the same sub-account choices

Fixed Annuities vs. CDs & Bonds

Fixed annuities are often compared to certificates of deposit and bonds. The comparison is valid in terms of safety of principal. However, key differences include:

• Annuity income grows tax-deferred; CD and bond interest is fully taxed as ordinary income in the year earned. Annuity interest is also excluded from AMT calculations and Social Security taxability thresholds.
• Bonds can be sold at a profit if interest rates fall; annuities have no market price — the contractholder can only withdraw principal plus interest, less surrender charges.
• Annuities impose surrender charges on early withdrawals; the IRS imposes a 10% penalty before age 59½. Bonds and CDs do not carry the IRS penalty.
• Like bonds, annuities are not insured deposit accounts — both carry an element of credit risk.

Equity Indexed Annuities vs. Index Funds & ETFs

EIAs are sometimes compared to indexed mutual funds or ETFs. This comparison is not entirely valid. Key differences:

• Costs: Index funds and ETFs have minimal management fees; EIAs use equity options (which expire and must be replaced) as a hidden cost embedded in participation rates, spreads, and caps.
• Tax treatment: Index funds and ETFs must distribute income annually (triggering taxes); EIAs grow tax-deferred.
• Dividends: Index funds own the underlying stocks and generate dividend income; EIAs do not own the stocks and do not generate dividends. EIA returns are based on index price appreciation only, not total return.
• Participation: Index funds fully mirror the index (up or down); EIAs limit upside through participation rates, caps, and spreads — in exchange for downside protection through the guaranteed minimum rate.
• Liquidity: EIAs are particularly illiquid — early surrender often results in receiving only the minimum guaranteed rate, not the indexed value. Investors should plan to hold EIAs for the full stated term.

Variable Annuities vs. Mutual Funds

Variable annuity separate accounts are generally viewed as an alternative to mutual funds or equities. Florida’s Senior Suitability Law defers to FINRA for the suitability of variable annuity recommendations to senior consumers. A detailed comparison is beyond the scope of this chapter.