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Retirement Planning > Retirement Investing > Annuity Investing

The Ins and Outs of Annuity Suitability

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The word “suitability” evokes a unique reaction within the financial services industry. It carries legal as well as emotional baggage that goes well beyond the synonyms of appropriateness or correctness. And, for anyone active in the annuity business, being accused of enabling or advocating an unsuitable transaction can have far reaching (and career-harming) implications.

Most practitioners know this already, but it is still worth repeating. The recommendation to purchase any annuity — whether it is variable, fixed, immediate or deferred — must satisfy an extra layer of scrutiny, taking into account a myriad of personal and economic circumstances. Thanks to the shenanigans involving 95-year-old widows and 25-year surrender charges (or is it the other way around?), the suitability benchmark is higher and the paperwork more onerous, compared to non-annuity products. Whether this extra cost is commensurate with the benefits is debatable.

In graduate-level statistics, we teach our students about two types of errors that decision makers might commit. Type I, in which you reject a hypothesis (read: product) that should have been accepted, and Type II, in which you accept a hypothesis (read: product) that should have been rejected. More importantly, it is not easy to design tests that minimize both errors simultaneously. It seems there are entire compliance departments whose primary mandate is ferretting-out unsuitable annuity transactions. Their law-school training has indoctrinated them that Type II errors should be minimized, which is often at the expense of Type I errors; more power to them.

Lord help the financial advisor, who recommends getting into a new annuity, as a replacement for another older annuity — or heaven forbid as an alternative to a mutual fund or managed account — who has not crossed the t’s and dotted the i’s on all the paperwork. I have seen this first hand as an expert witness on both sides.

Unfortunately, a transaction that seems to generate less scrutiny is the exact opposite of the above, namely, the process of getting out of an annuity.

In particular, I am talking about the recommendation — egged on by your competition down the block — to have a client terminate an existing annuity policy and instead move the money into mutual funds, a separately managed account or even another “cheaper” annuity contract. This, I believe, can be even more unsuitable, and doesn’t get nearly as much scrutiny as it should. Here is why.

Conventional wisdom dictates that when a policy is old enough, and the contract is out of the surrender charge period — i.e., it costs zero to leave — there is nothing wrong with allowing the money out. There are no exit fees. The door is wide open. No harm done. After all, why not replace a poorly performing asset or lousy investment with something that has greater potential?

If this were a mutual fund or some other non-insurance product we were taking about, I would have no issue with exercising the right to leave. Let my money go.

But, and this is my key message here, many of the older variable annuity policies now have living and death benefits that are deeply in the money, and can be worth much more alive than dead. The performance of the account value itself is a minor sideshow. In these circumstances, not having the annuity — i.e., taking the out —might be the unsuitable transaction.

Remember, the older generation of variable annuity policies (pre-financial crisis) was uniformly more valuable than the recent designs (post-financial crisis). What this means from a financial engineering perspective is that the embedded guarantees provided more protection and for less cost.

Just as an example, if a theoretical client of yours has a seven-year-old policy (vintage 2004) with a likely 7%, 8% or even 9% guaranteed living benefit, possibly with a ratchet or roll-up on a death benefit plus a variety of other bells and whistles on top, then he better think good and hard before walking away — even if it seems free and costless.

Note: The absence of a surrender charge might be a necessary condition for approving an exchange or outright surrender of a policy, but it is not a sufficient condition.

Let me say this again. One has to be absolutely certain that all features of the old policy are properly accounted for and valued before they are dismissed for something modern. Even if the account value currently exceeds the guaranteed death benefit or the base for the living benefit, the embedded option is worth something because of the potential for markets to reverse themselves.

Here is an analogy. Imagine replacing your original iPad, in favor of the latest iPad II, because you want the nifty camera, but then (mistakenly) leave all your data and apps on the old one you just discarded (or gave to your teenager.) Was it worth it? Obviously not.

Unfortunately, to make things worse, nobody has the incentive to correct or shed light on this problem. In most cases the recommendation to liquidate the old annuity — and get something modern instead — is being encouraged by (a different) financial advisor who gets nothing for maintaining the status quo.

The original annuity wholesaler who helped promote and facilitated the sale of the older product loses nothing at this point and has long exited the picture, and possibly the industry.

Surprisingly, the financial advisor who sold the original policy, who might be the only person who actually understands and appreciates the value of the original policy to this particular client, might not be aware of the surrender until well after it’s too late.

Finally, and here is where the real money comes into play, the insurance company standing behind and issuing the original policy actually stands to gain from the transaction, which might seem counter-intuitive at first.
After all, why would they want the money to leave?

Think about it though. If this policy represents real value to the policyholder, it is by definition a liability on the books of the insurance company. It is a zero sum game. Sure, they are getting some asset-based fees on the money management, and additional guarantee-based fees, but they are likely not enough to cover the present value of the guarantee.

Remember: A number of insurance companies were on the brink of extinction because of these liabilities. Wouldn’t they want the guarantee to walk away? This is the opposite of strategic default, much popularized in the housing industry.

So, let me get on my soapbox.

I believe that the insurance company — standing behind and issuing the older policies — must do a better job of ensuring that suitable annuity policies do not get destroyed by ignorance or by greed, even though they (perversely) are benefiting from this activity.

One thing they can do is ensure that the financial advisor on record — for the old policy — gets an immediate notice when a request to terminate or surrender has been received. Perhaps the advisor can talk the client off the ledge. Right now, my understanding is that few companies have this process in place. Would it be so hard to implement such a warning?

In sum, we are about to enter the second decade of the “living benefits” revolution amidst a horrendous period for stock investors. There are hundreds of millions of dollars worth of variable annuity policies sitting on insurance company books that are living and breathing liabilities. I’m sure these companies will be happy to see them leave. It might be suitable, and legal, but it isn’t honorable.

Given the economics and legality of the transaction, I think the insurance industry is the only one capable of implementing an early warning system, to help alert financial advisors of record that one of their clients is about to embark on what could be a costly and irreversible transaction. 


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