Divorce and annuities: a costly combination

Divorce can be a very difficult process for all parties involved. Setting aside the emotional impact, it can also be very destructive to the financial well-being of both parties. And if your client counts an annuity or two among his or her investable assets, that client’s net worth may be reduced even more than expected.

Most divorce attorneys just assume an annuity should be split evenly between both spouses, like most other assets. Unfortunately, when the divorce decree is issued by the court to do just that, irreversible damage has usually been done.

Here’s how I learned about the complexities of annuities in divorce. Several years back, a divorce attorney contacted me in hopes I would help her evaluate the annuities involved in a divorce settlement. The attorney’s client and her soon-to-be ex-husband owned 18 different annuities totaling well over $2 million. These variable annuities came in all shapes and sizes. Some were in retirement plans and some were not; most had living and death benefits, but some did not.

Fortunately, this attorney knew she was in over her head and thought to reach out for some advice on what these annuities were and, more importantly, what strategy she should implement in the negotiation process. After just a couple of phone calls to some of the companies that issued the contracts, I knew that my involvement in this case was going to take more than a few hours.

Why So Complicated?

The core of the problem is that very few insurance companies actually “split” the annuity contract. Instead, the vast majority of them process this request by making a “withdrawal” from the original contract and issuing a new one. Splitting a contract and issuing two identical pro-rata contracts in terms of account value, living benefit values and death benefits is an administrative burden for most insurance carriers.

By comparison, processing a withdrawal and issuing a new contract is easy. And it should not go unnoticed that processing it as a withdrawal will often reduce the guarantees of the policy and therefore can be a financial benefit to the insurance company.

A withdrawal can create the following problems:

1. It can be taxable. While most companies I’ve talked with will automatically process the transaction as an internal exchange, some will do this only if the divorce decree stipulates that it should not be taxable. Since the transaction is considered a withdrawal, absent proper instructions, some companies will treat it that way for tax purposes, as well.

2. If a living benefit is attached to the policy, a withdrawal will most certainly reduce both spouses’ future guaranteed income. Living benefits limit the contract owner to a specific amount of income per year — typically 4 to 6% of the income base. A withdrawal exceeding that amount will be considered an excess withdrawal. A withdrawal of half of the annuity value will most certainly be considered an excess withdrawal. Any excess withdrawal will result in a reduction in the future guaranteed income.

   In fact, with some living benefit designs, an excess withdrawal will actually reset the living benefit income base to the account value, thereby wiping out any additional benefits earned on the contract to date. And finally, many living benefit designs stop growing the income base at the guaranteed growth rate upon the first withdrawal.

3. The death benefit will likely be reduced pro-rata by the amount of the “withdrawal.”

4. Surrender charges can apply.

5. One of the spouses may have to accept a newer version of the contract. Many companies require the proceeds of the “withdrawal” to go into a contract that is currently available for sale. Therefore, if the existing contract is one with benefits and a cost structure that is no longer offered, one of the spouses will lose these superior benefits.

Advisor Opportunity

This situation creates an opportunity for financial advisors to build relationships with divorce attorneys and assist them in taking the best course of action for their clients who own annuities.

Divorce attorneys rarely give thought to how annuities might be impacted when marital property is divided. Even the attorney I worked with probably would not have reached out to me had there not been so many annuities involved. I would suggest reaching out to your local divorce attorneys and letting them know about the potential problems and how you can help. Your involvement and knowledge could benefit you, the divorce attorney and, most importantly, the client.

Should you succeed in getting the attorneys to consult with you — or even if you are just helping your existing clients — you must have a strategy for dealing with these cases. A few potential strategies are highlighted below. Of course, each client situation is different, and all aspects of a client’s situation should be considered prior to making a recommendation.

Strategy No. 1. Call the insurance company and ask how they handle an annuity in a divorce before you make any recommendation. This is not something the average phone rep is likely to know, so make sure you get their answer in writing. And make sure you do this before the court order because once the insurance company receives the court order, its hands will be tied.