If you are considering the purchase of some kind of annuity, you know what you want and need. But how can you determine whether the annuity product being recommended to you will meet your needs better than a different kind of annuity or some non-annuity alternative (such as a CD or mutual fund)? And how did the insurance agent showing you the annuity decide that the product he’s showing you is the one most suitable for you?
The answer to both questions lies in that italicized word – suitable. Insurance agents and securities salespeople licensed to sell annuities are obliged by law to recommend only products that are “suitable” for their customers, and that determination must always be made on an individual, case-by-case basis.
In 2010, the National Association of Insurance Commissioners published its “Suitability in Annuity Transactions” Model Regulation #275 which, among other things, specified twelve factors that must be taken into consideration by an insurance agent prior to making any recommendation of any annuity product. Later in that year, Section 989J of The Dodd-Frank Financial Reform Act incorporated those twelve factors into Federal law, with the result that any securities salesperson or insurance agent is now obliged to discuss with you those twelve factors (or concerns) prior to recommending any annuity or life insurance policy. The objective is to determine whether the product being considered is suitable for you, given your financial situation and needs as revealed in that discussion.
The purpose of this article is to review those twelve suitability factors and to illustrate how your responses to the agent’s questions about them can help the agent and you determine whether the annuity being proposed is right for you. Much of what follows reflects the author’s opinion and the suggestions offered are just that – mere suggestions, based on one man’s opinion, formed after over forty years experience in selling, lecturing, and writing about annuities. With that understanding, we’ll examine those twelve factors. But first, it’s essential that the reader understand that all annuities aren’t alike. The different types of annuities are very different because they’re designed to do very different jobs.
TYPES OF ANNUITIES
An immediate annuity (sometimes called a “payout annuity”) is a contract you buy from an insurance company that guarantees an income stream, a regular series of payments to you which must commence within one year and which may last for either a set period of years (a “period certain” annuity) or for your entire lifetime (a “life annuity”). It offers no accumulation benefit because there is no accumulation, only income. There are two types of immediate annuities: (a) “fixed”, which pay an income that will either be constant (the amount will never change) or which will increase by a set percentage over time or (b) “variable”, in which the amount of each year’s income payment will vary with the performance of the mutual fund-like investment accounts you’ve chosen.
A deferred annuity is a contract you buy from an insurance company that has two phases: (a) the accumulation phase, during which your money will grow by credited interest, on a tax deferred basis and (b) the payout phase, during which the accumulated value of your annuity will be paid out to you as a regular income. In this phase, a deferred annuity acts like, and is taxed like, an immediate annuity.
Deferred annuities may be either “fixed” or “variable”. Fixed deferred annuities guarantee your principal and pay interest either declared annuity by the insurer (“declared rate” type) or linked to the increases in the value of an external equity index, such as the S&P 500® (“index type”). Variable deferred annuities do not guarantee principal and pay interest based on the performance of the mutual fund-like investment accounts you’ve chosen.
It is absolutely essential that you understand that these different types of annuities are designed to do different jobs. A general statement about “annuities”, as if they’re all alike, will always be nonsense. A statement that is true of one type of annuity is likely to be misleading, if not outright false, when applied to a different type.
Now, let’s get back to those “twelve factors”.
THE TWELVE FACTORS OF “SUITABILITY”
- AGE. This factor is critical. If you’re approaching or are in retirement and want an income, starting immediately, to last for as long as you live (or as long as you and your spouse live), a Life Immediate Annuity or Joint Life Immediate Annuity may be just the ticket. But if you’re much younger, and want your money to accumulate, an immediate annuity is totally unsuitable (because money in an immediate annuity is paid out and can never accumulate). If you’re interested in keeping your principal safe and want it to grow, a Fixed Deferred Annuity may be suitable, but most such contracts impose surrender charges if you withdraw money in the first few years. A Variable Deferred Annuity offers more potential growth, but does not guarantee either minimum interest or safety of principal; they, too, usually impose surrender charges. Deferred annuities are long-term instruments. They’re not a place to put your money if you might need it in a few years. If you’re a senior citizen, this is a big factor. And if you’re younger, you should consider not only the surrender charges that a deferred annuity (either fixed or variable) may impose but also the 10% tax penalty on distributions prior to age 59 ½.
- ANNUAL INCOME. If your annual income is high, and you don’t need additional income, an immediate annuity is probably not for you, because immediate annuities are all about income, and nothing else. But if you need additional income, one might be appropriate, especially if you need that income to last for your lifetime. If you need guarantees, variable annuities, either immediate or deferred, are probably not for you, with the possible exception of variable deferred annuities with Guaranteed Lifetime Income Riders.
- FINANCIAL SITUATION AND NEEDS, INCLUDING THE FINANCIAL RESOURCES USED FOR THE FUNDING OF THE ANNUITY. This one’s pretty general, and amounts to a requirement that your agent take into account your entire situation including where the money to buy the annuity will come from.
- FINANCIAL EXPERIENCE. If you’re relatively inexperienced in financial matters, especially if you find complex financial instruments too confusing, you may find some annuities hard to understand. Your agent can do a lot to help you gain that understanding, but if you don’t understand how an annuity works even after he’s explained it, what its fees and charges are and how it will benefit you, don’t buy it!
- FINANCIAL OBJECTIVES. Most people have more than one goal. What are your goals? How will putting some of your money into an annuity help you solve one or more of those goals?
- INTENDED USE OF THE ANNUITY. This one’s critical. What are you trying to accomplish with the money you’re thinking of putting into the annuity? An annuity is just a tool; what’s its job? What do you need it to do for you? What don’t you want it to do (e.g.: if you don’t want to risk losing what you’ve invested, a fixed annuity may be dandy, but a variable one is the wrong tool).
- FINANCIAL TIME HORIZON. This one can be tricky, and even some financial professionals don’t fully understand it. It’s really a two-part issue. Part One is “How long will it be before you will need money from this investment?” Part Two is “Over what period of time will you need to be withdrawing money from it?” You and the agent need to consider both.
- EXISTING ASSETS, INCLUDING INVESTMENTS AND LIFE INSURANCE HOLDINGS. Your agent must not make any recommendation about where you should put the money you’re considering for the annuity unless he knows where the rest of your money is. Is all your money in CDs? Stocks and stock mutual funds? Real Estate? Any annuity must work as part of your overall financial plan. To do so, it must not conflict with the rest of your planning.
- LIQUIDITY NEEDS. Will you need access to much or all of the money in the annuity in the next few years? If so, a deferred annuity that imposes surrender charges is probably inappropriate. Of course, if you have other liquid assets (e.g.: checking or savings accounts, money market funds) sufficient to meet expected and unexpected short term needs, then the restrictions on liquidity that surrender charges represent may not be a concern. If you’re considering an immediate annuity, you will probably be restricted to only the regular annuity payments. Some contracts offer the opportunity to take a “commuted value” of remaining income payments in cash; most do not. Be aware that buying an immediate annuity amounts to exchanging a lump sum of money for an income stream. Once you’ve bought it, your lump sum is gone.
- LIQUID NET WORTH. This one works with #9. What assets do you already own that can be tapped if you need cash?
- RISK TOLERANCE. What risks concern you? If the possibility of losing your own money (“principal risk”) causes you to lose sleep, a variable deferred annuity is probably not a good idea (except, as noted earlier, one that guarantees that you’ll always have an income, from a Lifetime Income Rider; but even then, the “cash in” value of a variable annuity can decline, through bad investment performance and annual fees). On the other hand, a fixed deferred annuity guarantees both principal and a minimum rate of interest, but it’s subject to inflation risk and, as noted earlier, liquidity risk. Make sure that you’ve asked your agent what risks the annuity will transfer from your shoulders to the insurance company (that’s what annuities are – risk transfer instruments) and what risks you will assume by buying the annuity.
- TAX STATUS. This is one you should spend some time on. All deferred annuities enjoy “tax deferred” treatment, meaning that the annual interest isn’t taxable until you withdraw it. But the cost of that tax deferral is twofold: (1) All distributions, both in your lifetime and after death, that are taxable will be taxed at Ordinary Income rates. No Capital Gains treatment – ever, and (2) All distributions will be subject to a 10% penalty tax unless an exception applies (Internal Revenue Code Section 72(q)). These exceptions include distributions made after your age 59 ½, distributions upon your death or disability, and a few others. If you might take distributions early in life, consider the impact of this penalty tax. Immediate annuities also get a tax break, as part of the annual income they pay to you will be treated as a tax-free return of principal (until you’ve gotten all your principal back tax free).
The foregoing analysis is, as noted earlier, largely John Olsen’s opinion. You may see the issues presented differently. And that’s fine. The objective of this article was to point out those issues so that you, the consumer, can make a better informed judgment when considering the purchase of an annuity.
Author’s Note: Some of the material in this article was taken from the author’s book “Taxation and Suitability of Annuities for the Professional Advisor” (Olsen & Marrion, LLC, 2012 – www.indexannuitybook.com). It is used by permission.
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