If you have a life insurance or annuity contract, you may have been approached by your broker or financial advisor to exchange the annuity or policy for a “new model,” one that is allegedly better or that has newer features that weren’t available when you purchased your annuity. Although your broker will likely sell you on the fact that an annuity switch or exchange may be accomplished income tax free and that the new contract is better for you, that does not mean that you will necessarily end up ahead by doing an annuity switch. In fact, given the large commission that broker’s derive for selling annuities (often as high as 4-5%), the only person that may be making out in the exchange is your advisor.
The practice of “annuity switches” or “annuity exchanges” has become so fraught with securities fraud that FINRA recently issued an alert related to the practice, noting that they found that a large number of investor’s were confused about variable annuity exchanges, and stating that FINRA has already seen numerous cases where investors were investing in variable annuities that were not suitable for them. For more information on FINRA’s “alert” please visit: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsurance/p006045
The following is intended as a summary of some of the important things you should know about annuity exchanges in determining whether to do an annuity exchange or in determining whether an annuity exchange that you have already done was suitable for you.
An annuity is a contract between you and an insurance company where the company promises to make periodic payments to you, starting immediately or at some future time. You buy the annuity either with a single payment or a series of payments.
Annuity contracts come in three basic flavors: fixed, variable and equity-indexed. Fixed means that the earnings and payout are guaranteed by the insurance company. Variable means that the amount that will accumulate and be paid will vary with the stock, bond, and money market funds that you chose as investment options. Unlike fixed contracts, variable annuities are securities registered with the Securities and Exchange Commission (SEC). Sales of variable insurance products are regulated by the SEC and FINRA. Equity-indexed annuities (EIAs) have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity.
Significantly, variable annuities may impose a variety of fees upon you when you invest in them, such as: surrender charges, which you owe if you withdraw money from the annuity before a specified period; mortality and expense risk charges, which the insurance company charges for the insurance risk it takes under the contract; administrative fees, for recordkeeping and other administrative expenses; underlying fund expenses, relating to the investment options; and charges for special features, such as a stepped-up death benefit or a guaranteed minimum income benefit.
The Internal Revenue Service does generally allow you to exchange an insurance contract that you own for a new life insurance or annuity contract without paying tax on the income and the investment gains earned on the original contract. Because this is governed by Section 1035 of the Internal Revenue Code, these are called “1035 Exchanges.”*
This benefit comes with some important strings.
• The tax code says that the old insurance contract must be exchanged for a new contract – you cannot receive a check and apply the proceeds to the purchase of a new insurance or annuity contract.
• The tax code also says you can make a tax-free exchange from: 1) a life insurance contract to another life insurance contract or an annuity contract or 2) from one annuity contract to another annuity contract. You cannot, however, exchange an annuity contract for a life insurance contract.
Why Make a Section 1035 Exchange?
There are various reasons why a variable annuity contract holder may want to exchange an existing variable annuity contract.
• Many annuity contracts now offer premium – sometimes called bonus – credits toward the value of your contract, of a specified percentage ranging from 1-5% for each purchase payment you make.
• Also, in recent years, there have been new developments in annuity features, especially in variable annuities, that are valid reasons to consider an exchange. The number of investment options has increased. Less expensive variable annuity contracts have been created. Death and living benefits have been enhanced. Also, with the growth in the stock market in the 1990s, many insurance contract holders have wanted to take part in that growth. These are all valid reasons for considering exchanging one insurance contract for another.
Why Not Make a Section 1035 Exchange?
Generally, the exchange or replacement of insurance or annuity contracts is not a good idea, for a variety of reasons.
• “Bonus” or “premium” payments made to you are usually offset by the insurance company’s adding other charges it makes to you.
• Other contract provisions, like surrender charges, eventually expire with an existing contract. However, new charges may be imposed with a new contract or may increase the period of time for which the surrender charge applies.
• You may also have to pay higher charges, such as annual fees for the new contract.
• You may not need the costly new features of the new contract.
• In many instances your broker is getting paid a higher commission for a variable annuity than he or she would for the sale of another securities product, such as a stock, bond, or mutual fund.
What You Should Watch For
You should exchange your annuity only when you determine, after knowing all the facts, that it is better for you and not just better for the person who is trying to sell the new contract to you.
Much of the sales growth of variable annuities in recent years has been from Section 1035 Exchanges. Even though some variable annuity enhancements have made variable annuities more attractive, you need to be sure that the exchange meets your objectives and benefits you. Variable annuities are long-term, retirement-oriented investment vehicles, and exchanging them may not benefit you.
Brokers or insurance agents recommending the exchange of an annuity contract must tell you important facts about the pros and cons of the exchange. Your broker or insurance agent is permitted to recommend such an exchange to you only if it is in your best interest and only after evaluating your personal and financial situation and needs, tolerance for risk, and the financial ability to pay for the proposed contract. This “suitability” obligation is based on FINRA rules, specifically, FINRA’s “Know Your Customer” Rule (among others).
To be sure that a replacement annuity is right for you, you should specifically ask the person recommending that you exchange your variable annuity:
• What is the total cost to me of this exchange?
• What does the change in the surrender period or other terms mean for me?
• What are the new features being offered? Why do I need or want those features?
• Are those features worth the increased cost?
• Will you be paid a commission for the exchange, and if so, how much is it?
You should not sign any exchange form or agree to exchange or purchase an annuity until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current contract.
If you have questions about annuity switches or a variable annuity you purchased, or if you believe that you have been the victim of a securities fraud, The White Law Group may be able to help. To speak to a securities attorney, please call our Chicago office at 312-238-9650.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.
To learn more about The White Law Group, visit http://www.whitesecuritieslaw.com.