In the main, financial intermediaries, such as insurance agents and stockbrokers, are supposed to make sure that whatever they recommend or sell, including variable annuities, are suitable for you.
But if you’re in retirement or nearing retirement, there are going to be times when certain products, such as a variable annuity, might be unsuitable. But what are those times, and how can you make sure that you don’t buy something that’s not suitable?
Well, more often than not some of those times might come when you come into money, and you say you want guaranteed income. Perhaps you left your employer and you’re trying to figure out what to do with your 401(k) or severance pay, or perhaps you’ve inherited some money or just got a death benefit from a life insurance policy, or perhaps you’ve sold your house or a business. That’s when you’re likely to talk to an adviser about what to do with that money. So, the first bit of advice is this: Don’t just talk to one adviser about one product or solution.
Did you consider other options?
Before buying any variable annuity, evaluate other investments and strategies.
“I have a number of issues with the suitability of variable annuities for older investors,” said Robert Port, an attorney specializing in securities arbitration and litigation with Cohen Goldstein Port & Gottlieb. “Although I am not an investment adviser, those advisers I respect tell me that except in very rare instances, there is almost always a cheaper, less complicated option than buying a variable annuity.”
And not surprisingly, those options do not include paying a huge commission to the broker selling the variable annuity, said Port. “In my view, the huge commissions earned by those selling variable annuities tell most of the story. If they were such a good product, why would insurers have to so aggressively incentivize their sales force to sell this stuff?”
If, however, if you are looking for the sort of income that’s associated with annuities, Jack Marrion, the president of Advantage Compendium, a St. Louis-based research and consulting firm, suggested the following: “From purely a ‘safety-of-annuity-income’ view, a fixed immediate annuity or an annuity with a guaranteed lifetime withdrawal benefit (GLWB) rider might be more suitable than a variable annuity without that rider.”
For one, he said the cash value or immediate annuity benefit of a fixed annuity is covered by a state guarantee fund if the carrier becomes insolvent. At the moment, 38 states cover $250,000 or more of the cash value or annuity income present value and the other 12 states cover at least $100,000.
As for the annuity with the GLWB rider, it guarantees that a certain percentage (typically 2 to 8%, often based on age) of the amount invested can be withdrawn each year for as long as the contract holder lives, according to the lobby group for variable annuities, the Insured Retirement Institute.
Of note, fixed immediate annuities and annuities with GLWBs pay commissions to those selling the products. Read Strategies For Existing Variable Annuities With GLWB Or GMIB Riders.
Do you understand what you’re buying?
It would be hard to argue with this fact: If you don’t understand what you’re buying, it’s likely unsuitable for you. “The fact is that variable annuities are complicated investments that very few purchasers understand,” said Port. “The sales presentations often scare investors into believing they’ll loss all their money if they invest in traditional stocks and bonds, and highly tout the guarantees of variable annuities, glossing over, or never addressing, their complicated structure, surrender charges, tax issues, and the like.”
As a general rule, Port, said if you can’t explain how an investment works, your hard-earned money ought not to be placed in it.
Does it sync up with your estate and tax plan?
Experts also note that variable annuities are more often sold than bought. Given that, such products come with a lot of hype. To be fair, it might be hard to separate the hype from the truth. But it’s quite possible that even when you uncover the truth, a variable annuity might be unsuitable if it doesn’t sync up with your financial, investment, tax, and estate planning goals.
“The advisers I respect believe the supposed tax benefits of variable annuities are overhyped and oversold,” said Port.
Even though variable annuities grow tax-deferred, when the investor takes distributions from the annuity, those distributions are taxed at ordinary income-tax rates. “For most investors, that is higher than the rate that would have been paid on long-term gains and dividend income earned in a taxable investment,” said Port. “That difference can easily eat up the advantage of an annuity’s tax-free compounding.”
John Duval, president of John Duval Associates, a securities litigation and arbitration firm, shared that point of view. “Variable annuities only offer ordinary income, no capital gains opportunities, ever,” he said.
Port also noted that if an annuity investor dies and the annuity balance is paid to a beneficiary, the beneficiary must pay ordinary income-tax rates on any earnings beyond the original investment. “In contrast, investments directly inherited by a beneficiary may enjoy a ‘stepped-up’ basis, and if so, the beneficiary would owe little or no income tax at the time of inheritance, and would likely owe little or no capital gains tax if the investment is sold soon after the inheritance is received,” said Port. So by moving assets into variable annuities, some seniors have unknowingly hurt their beneficiaries — instead of inheriting assets with a step-up in basis, the beneficiaries get an inheritance on which income tax needs to be paid on any earnings.
Duval is of the same opinion. “High net worth investors and variable annuities trigger double taxation at death,” he said. “In fact, the beneficiaries get 1099s for the gains.”
Surrender charges could make variable annuities unsuitable
According to the Securities and Exchange Commission, if you withdraw money from a variable annuity within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as 10 years), the insurance company usually will assess a surrender charge, which is a type of sales charge.
Port said surrender charges, which in some cases can be as long as 12 years on variable annuities create an unnecessary and artificial constraint on liquidity.
“Even though many variable annuities allow up to 10% to be withdrawn annually without surrender charges, many seniors do not consider the reality that they might need more than that if they face a significant medical expense, need to enter an assisted living or nursing home, or have some other need for access to cash,” Port said. “I have had a number of situations where children have learned, too late, that their parent(s) were recently sold a variable annuity, and when mom or dad needed to go to a nursing home, the family suffered significant charges just to get the money out.”
What’s more, Port said the following: “Given surrender charges and the underlying expenses of a variable annuity, such as administration expenses, insurance expenses, subaccount expenses, annual fees, and other charges, “even if the variable annuity were a viable investment option (which I doubt) the investment would have to be in place for a long period for the tax deferral to overcome the continuing expense costs. Seniors, almost by definition, are not long-term investors.”
Others agree. “Elderly investors who are always vulnerable to instant liquidity needs such as medical and family emergencies” ought to consider variable annuities with long surrender periods as unsuitable, said Duval.
Thus, a variable annuity might be unsuitable if your life expectancy or time horizon is short or you might need to tap into the money in the variable annuity within the surrender charge period. Read the SEC’s primer, Variable Annuities: What You Should Know.
Beware 1035 exchanges
According to a Financial Industry Regulatory Authority notice to investors, if you have a life insurance or annuity contract, you may have been approached to exchange it for a new model, one with better or the latest features. That’s called a 1035 exchange and it might be unsuitable. Yes, even though tax law makes the exchange income tax free and the new contract may sound better for you, you may be losing — not gaining — if you make the exchange, according to FINRA.
For his part, Port said many insurers are aggressively trying to convince annuity holders to switch into new annuities with less favorable terms because they have concluded that what they sold before is too generous. In a blog, Port also noted how some companies are changing the terms on older policies, which offered much more generous guarantees than the companies can now financially support. “Annuity purchasers do not realize that most annuity contracts have contractual ‘escape valves’ allowing the insurance company to alter the terms of the annuity, long after it was purchased,” Port wrote. “This demonstrates once again that annuities are complicated investment and insurance products, and are often aren’t suitable for most investors…What other investment permits the rules of how the investment works to be changed after the investment is made?”
An annuity might also be unsuitable if the promises being made, in terms of guaranteed income, aren’t in line with that of other providers. If something sounds too good to be true, it likely is. That’s the case right now: Many insurance companies are asking contract holders to either be bought out or to switch to an investment that has lower returns, according to a lawyersandsettlements.com report. And contract holders who do not agree to either a buyout or a different investment could lose their guaranteed income.
So, if you were being pressured into switching from one variable annuity into another, think twice about whether this in your best interest or the agent’s. Read FINRA’s Should You Exchange Your Variable Annuity?