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To 1035 or not to 1035?

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Lately, I’ve been receiving a lot of questions about whether, or not, I have concerns about 1035 exchanges in the current interest rate environment. Why?

  • Maybe you missed the memo, but you are currently selling annuities in the worst interest rate environment ever. Ever!
  • A 1035 exchange eliminates all rights and benefits under the annuity that is being exchanged.

Before we begin the debate, a little elementary education for the insurance professionals in our audience. A 1035 exchange is a tax-free method of exchanging an existing life insurance or annuity policy for a new policy with a different company. (1035 refers to the tax code number.) This procedure is often exercised when it is beneficial for the policy owner to move to a more favorable contract that offers rates or features they don’t currently have in their existing plan.

Beneficial I hope you caught that part of the definition. More on that in a moment…

I can attest to the fact that there are tons of annuities on insurance companies’ in-force blocks of business that are only crediting their minimum guaranteed interest. This would seem to be a motivator for many to perform a 1035 and get the annuity purchaser into something more attractive. Well, that might be more difficult than you think. Especially considering that “more attractive” is rather subjective. The annuity that you are considering replacing may:

  • Only be crediting the minimum guaranteed interest, but that interest rate might be 4 percent.
  • Not have a market value adjustment a feature that is practically standard issue on annuities today.
  • Offer 10 percent penalty-free withdrawals ever year of the contract; a feature that sadly is going by the wayside on annuities.
  • Pay the full account value of the contract on death, as opposed to the cash surrender value, another benefit that seems to be absent from new annuities being introduced to the market.
  • Have fantastic annuitization factors, as opposed to the historical low factors being offered on new annuities sold today.

Given that, many insurance professionals are pausing before advising their clients to proceed with 1035 exchanges these days and for good reason.

On the other hand, it is also worth noting that new annuities issued today will generally not experience an increase in their credited rates (or caps, participation rates, etc., in the instance of indexed annuities), once the policy is issued. So, once interest rates improve (in a couple of years, five years, sometime later?), people who purchased annuities during this current historically low rate period won’t have the opportunity to take advantage of those improved rates without purchasing a new annuity.

So, will a 1035 exchange be beneficial to today’s annuity purchaser, once rates improve? It certainly could be.

Just remember that every case is different and that each annuity purchaser’s wants/needs/goals are different from the next. While exchanging a product for another with a higher rate may be desirable to one annuitant in one year, it may not be a good idea for a different annuitant. In turn, having the flexible income options of a Guaranteed Lifetime Withdrawal Benefit may be enough to spark interest in an exchange with one prospect, while the draw of a relatively high guaranteed interest rate may be enough to keep another annuitant happy with the product they already own.

In short, always be cognizant of your client, their goals, the economic environment, and product when evaluating 1035 exchange options.

For more from Sheryl J. Moore, see: