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Life Health > Annuities

State Crackdown on Annuities Sharpens Suitability Issues for Advisors

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Annuities remain among the most popular retirement income planning tools on the market today—highlighting the important role that these products can play in a successful advisor’s repertoire. Predictably, however, annuities (particularly indexed annuities) have also become more complicated and varied as they have surged in popularity. Newly issued New York regulatory guidance highlights the fact that explaining the variations between different types of immediate and deferred annuities can prove challenging for even the most experienced advisor. 

As states crack down on suitability review issues, an advisor’s ability to competently determine which type of annuity product is advisable has never been more important, especially when the complications that arise when a client wishes to replace one annuity with another enter the picture.

Hybrid Indexed Annuities

As clients look for more options to participate in the equity markets through annuity investing, indexed annuities have evolved to offer “hybrid” indexing options. A hybrid indexed annuity—while known by a variety of names—is essentially a type of indexed annuity that ties the potential for participation in market gains to more than one index. While the traditional indexed annuity bases the performance of the annuity upon one major index (usually a stock index, such as the S&P 500), a hybrid indexed annuity is able to allocate the risk of loss—and maximize the potential for gain—by combining multiple indexes.

Unlike directly investing in an index (or indices), the indexed annuity product itself typically offers a cushion against investment losses in exchange for a cap on the potential for investment gains. In many cases, hybrid products are considered to be more favorable investment products because of the fact that they allocate risk between a variety of indices, including nontraditional indices that might not otherwise be available in a standard indexed annuity.

For example, in some cases the hybrid index (which is typically specific to the carrier itself) will consist of both a major stock index and a bond index. In this case, the carrier attempts to maximize growth potential while hedging against the risk of loss as the weight is shifted (often on a daily basis) between the stock and bond indices based on market volatility.

While the hybrid indexed annuity may be attractive to many clients, clients need to be made aware that the ability to invest through an annuity in this manner comes at a cost—some carriers charge an additional fee (usually around 50 basis points) for the hybrid indexing option. A traditional indexed annuity typically does not impose a fee simply for the index the client chooses.  The advisor will need to carefully evaluate whether this fee adds value for the client—based on the client’s individual financial circumstances and goals—in order to appropriately recommend a hybrid indexed annuity.

Capped vs. Uncapped Investment Potential

Additional complications can arise when a carrier offers an annuity with the potential for “uncapped” growth. Clients need to understand that this does not mean that the products allow for 100% participation in any market gains. In order to offer protection against downside risk, the carrier imposes a cap on the level of the client’s participation, so that use of the term “uncapped” can be misleading.

Often, gains are credited to the client’s contract annually—a crediting method often referred to as “annual point-to-point”—or even monthly in some cases. However, these gains may be subject to a rate cap that limits the participation to a certain percentage of market gains. In other cases, a “spread” may be used to minimize the risk to the insurance carrier. A spread is essentially a fixed percentage that is subtracted from any gain that the indices generate within a set period. For example, a 4% spread would simply reduce a 10% gain for the year, so that the client’s account is actually credited with a 6% gain.

Essentially, clients need to understand that while their product may technically offer “uncapped” growth, other features attached to the annuity may serve to limit the growth potential of the product.

The Exchange Factor

Actions taken by New York state regulators have recently highlighted the importance of the advisor’s suitability review in the context of an annuity exchange. While the annuity exchange itself can often be achieved without recognizing gain or loss, the tax treatment alone is not dispositive of whether the exchange is the right move—the advisor must also ensure that the replacement annuity is suitable for the particular client.

For example, an uncapped hybrid indexed annuity may initially sound appealing to a client who currently owns an indexed annuity tied to a traditional index with a fixed interest cap.  However, the additional fees that can be associated with the hybrid indexing must be compared to any value that multiple indices can offer—and the client must also be made aware of “hidden” caps that still serve to limit his or her market participation.

Further, New York regulators have pointed out that a client with an existing deferred annuity may benefit more from keeping that annuity because interest rates and mortality rates were more favorable when that contract was issued. Replacing an existing deferred annuity with an immediate annuity can actually lower the client’s guaranteed income level, meaning that the replacement annuity would likely not be suitable for the client absent other circumstances.

New York regulators have recommended that advisors clearly show clients a comparison between the benefits (and fees) associated with both the existing annuity and the replacement annuity in order to ensure that the exchange is appropriate.


Even though many advisors may be counting on the repeal of the Department of Labor fiduciary rule by a republican-controlled federal government in 2017, it’s important not to lose sight of the suitability review that needs to be undertaken even if the advisor is no longer formally obligated to act as a fiduciary.

See these additional blog postings by Professors Bloink and Byrnes:

The Roth Annuity: A Bright Star in Annuity Investing


Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

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