Unsuitable annuity sales and sales practices have been big news this year, along with Congressional hearings and various proposed standards to address suitability issues. Let’s consider three well-publicized cases:
o An Oregon woman liquidates her entire stock portfolio to buy a $166,824 annuity. In a subsequent emergency, she is unable to access these funds without paying a $12,000 surrender charge.
o A 73-year old widow puts most of her $75,000 savings into deferred annuities. When she needs to pay for urgent dental work and home repairs, she is unable to access these funds or annuitize the contracts without significant surrender charges.
o An insurance company is sued for selling deferred annuities with 10- to 16-year surrender schedules to 1,200 people aged 75 years or more at the time of purchase. Allegedly, many invested more than half their net worth in these annuities.
What do all of these cases have in common? In each, the alleged problem was not that the deferred annuity failed to provide an adequate return but rather that liquidity was insufficient given the owner’s circumstances.
Yet most deferred annuities continue to be promoted, sold and purchased with an emphasis on return or “upside potential,” whether it be in terms of bonuses, credited rates, generous caps or participation rates, sub-account performance or, in the case of fixed products, minimum guaranteed rates.
Living benefits are also a key selling point for deferred variable annuities and, increasingly, fixed indexed products. But these benefits do not eliminate the need to consider the liquidity needs of the client. For example, what if funds are needed before the guaranteed minimum withdrawal period begins or the client needs more money than the specified annual percentage that can be withdrawn?
The client’s liquidity needs should be primary in determining whether a deferred annuity of any kind is suitable and, if so, in selecting products to recommend.
To begin with, no investors of any age should buy a deferred annuity if the purchase will leave them without liquid assets sufficient to cover at least a year of living expenses plus a reasonable amount for emergencies. (If the client will need access to some of the deferred annuity’s accumulated value before age 59 1/2 , the purchase is likely inappropriate as well because withdrawals probably will be subject to penalty by the Internal Revenue Service.)
If there are sufficient liquid assets and there are good reasons to consider a deferred annuity (such as tax deferral, minimum guarantees or living benefits), liquidity needs still should be considered.
The next question probably should be, how long is the client willing or able to tie up funds in a deferred annuity? The vast majority of deferred annuities impose surrender charges if the contract is liquidated before a stated period. But fixed annuity products with surrender periods of more than 10 years are a rarity these days. More than 62% have surrender charges of 5 to 7 years, as shown in chart 1.
Surrender periods are of less concern if the deferred annuity has a guarantee of principal, because the client can get the premium back at any time, despite surrender charges and market value-adjustments. (Accumulated earnings usually are forfeited.) Almost a third of the fixed annuities in Beacon’s AnnuityNexus database provide principal guarantees. Optional return of premium riders serve the same purpose.
Of course, it’s better to receive the full accumulated value of the contract than just the principal. So even with a principal guarantee or ROP rider, it’s important to ask: Under what circumstances might the client need to liquidate the entire deferred annuity contract?
Surrender charge waivers allow the owner to do so in the event of various emergencies.
Look for disability and unemployment waivers if the client is still working. Unless they have good long term care insurance, older people probably should have a nursing home waiver or, even better, a waiver that applies when the owner is unable to perform two or more activities of daily living. Hospital waivers may be a good idea at any age, depending on the client’s health insurance coverage. If the heirs will need the contract’s accumulated value upon the owner’s death, death waivers also are advisable at any age.
The above are the most common waivers among fixed annuity products in the AnnuityNexus database (see chart 2).
When it comes to waivers, it’s wise to read the fine print. Many are only applicable after one or more contract years or after an elimination period of 30 days to a year. Some have restrictions based on age. Others are unavailable in certain states or vary by state.
Perhaps the client just needs the option of withdrawing smaller amounts without surrender charges. As mentioned, alternatives in addition to GMWBs are desirable because larger amounts can be withdrawn sooner in most cases. Some 77% of the fixed annuities in our database allow a percentage (usually 10%) to be withdrawn annually without penalty. Just 11% provide more favorable cumulative withdrawal privileges. (For example, if the allowable 10% is not withdrawn in year one, 20% can be withdrawn in year two, etc.) Almost all have systematic withdrawal options, which provide periodic payments.
Check to see if withdrawal options apply early in the contract and whether MVAs are imposed.
Finally, does the client need the option of annuitizing the contract during the surrender period? This could be valuable if, for example, she retires early and uses the payments to provide income until she’s eligible for Social Security. Almost half of the products in our database have annuitization waivers, but many aren’t available in the early contract years, so choose waivers that fit the client’s situation.
Look for annuitization bonuses and check the minimum payouts, which could be important in a low interest rate environment like last year’s. Depending on the guaranteed minimum interest rate and the mortality table, products in our database provide minimum monthly payments that vary as much as $156 a month (37%) for the life of a 60-year old owner of a $100,000 fixed annuity. That’s a difference of $46,800 over 25 years.
It’s important to recognize that there’s usually a tradeoff between deferred annuity liquidity and return (be it in lower credited or participation rates, and caps, or larger spreads or expense charges).
Less liquidity generally translates into more accumulated value (proving once again that, in most cases, there is no free lunch). But having more accumulated value won’t really matter if the owner or heirs can’t get access to the money when they need it.
Therefore, the smart strategy would be this: Consider liquidity first, and avoid many suitability issues later.
Jeremy Alexander is chief executive officer of Beacon Research, a fixed annuity data source and application service provider in Evanston, Ill. His e-mail address is Jeremy@beaconresearch.net.