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Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.

For the past several years, I’ve been offering free educational annuity seminars at our local public library, and inevitably the topic of bonus annuities always comes up. The concept can be confusing and the name itself is pretty misleading.

The Problem With Annuity Bonuses

Some annuity contracts offer a “bonus” between 3 and 10 percent or more. It sounds fantastic! The word “bonus” sounds like extra money, but that’s the problem — it’s not.

An annuity bonus is like a cash advance. It’s an advance against the future earnings of the contract. Any annuity that has a bonus also has a surrender schedule, and the surrender schedule penalizes the consumer for taking more money than the free withdrawal provision in any given year. The insurance company knows that they are able to advance some of the earnings that (more than likely) will be earned in the contract anyway.

Many people who buy bonus products don’t necessarily understand how the future earnings of the contract will be impacted. If they get a bonus on the front end, the future earnings will be lower. It’s not a bonus, it’s an advance on future earnings, or it’s recaptured through higher fees to the client.

Suitability Rule

A lot of carriers have a suitability rule that says you can’t replace an old product or a previously purchased product that the client already owns unless the bonus on the new product is more than a surrender charge on the old product. This leads people to believe that the bonus is free money, and it creates an excuse for insurance agents to replace products by leveraging a bonus as opposed to making an educated recommendation about the total value remaining in the current contract and whether it is greater than or less than the total value of moving to a new contract.

The suitability rule sometimes prevents the client from making a better choice. Occasionally, I’ll see a prospective client who bought a long surrender charge product because it had a bonus on the front end. The client is five or seven years into a 12-year contract, and the potential interest that could be credited each year is so small that it’s not a good idea to remain in the product. A suitable replacement product might have a short surrender, without a bonus. It may be beneficial for the client to forfeit the surrender charge and move to another contract with a  shorter surrender charge schedule, but a higher potential interest crediting over the remaining time period. However, some carriers will not allow it due to suitability concerns.

Decisions should be made by comparing the total benefits of the current contract versus the total benefits of a new contract.

When Do Annuity Bonuses Make Sense?

Occasionally, there are times when bonuses do make sense. For instance, when considering a contract where the client wants to commit as little money to the contract as possible in order to meet a certain need, a bonus can allow the client to commit less money to meet a need with a higher level of certainty. The only reason the client should take it is because it’s going to help her meet a goal more effectively than not taking it. Framing a bonus as buying a higher level of certainty by giving up future earnings potential is a much better way to help clients truly understand their purchase decision.

Building Trust Through Appropriate Framing

Advisors should expose annuity bonuses for what they are: advances on future earnings. The common misunderstanding can cause clients to fall into a trap. People are looking for a financial advisor they can trust, who can add value and clarity to some of the more complex elements of their financial plans. One way to build trust is by exposing the trap that annuity bonuses can create.

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Joe Elsasser, CFP, Covisum

Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn’t find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.

In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly impact cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model “what-if” scenarios with account positions and align a client’s risk tolerance with their portfolio risk.

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