Annuity sales have rocketed to record breaking levels in 2023, fueled by demand for products that give contract owners some stock exposure but provide limits that keep them from getting burned too severely by market fluctuation. More specifically, registered index-linked annuities, have gone from being a small blip on the independent broker-dealers’ radar to one of the hottest-selling products, according to a sales report issued by LIMRA. Variable annuity sales also remain high as financial advisors attempt to offer products to their clients that attempt to combat large swings in the equity markets.
What are Annuities?
There are several different types of annuities in the marketplace, which we outline below.
Fixed Annuities
A fixed annuity is a type of insurance contract that promises to pay the buyer a specific, guaranteed interest rate on their contributions to the account. Investors can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company, in turn, guarantees that the account will earn a certain rate of interest. During the accumulation phase, the account grows tax-deferred. Then the account holder annuitizes the contract, distributions are taxed based on an exclusion ratio. This is the ratio of the account holder’s premium payments to the to the amount accumulated in the account that is based on gains from the interest earned during the accumulation phase. The premiums paid are excluded and the portion attributable to gains is taxed.
Variable Annuities
A variable annuity is a type of insurance contract that pays interest that can fluctuate based on the performance of sub accounts tied to the variable annuity. Sub accounts and mutual funds are conceptually identical, but sub accounts do not have ticker symbols that investors can easily research. You can buy an annuity with either a lump sum or a series of payments, and the account’s value will grow accordingly. In the case of deferred annuities, this is often referred to as the accumulation phase. The second phase is triggered when the annuity owner asks the insurer to start the flow of income, often referred to as the payout phase. Some annuities will not allow you to withdraw additional funds from the account once the payout phase has begun. Variable annuities should be considered long-term investments due to the limitations on withdrawals. Typically, they allow one withdrawal each year during the accumulation phase. However, if you take a withdrawal during the contract’s surrender period, which can be as long as 10 to 12 years, you will generally have to pay a surrender fee.
Indexed Annuities
An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P 500 or Dow Jones Industrial Average. Indexed annuities are sometimes referred to as equity-indexed or fixed-indexed annuities depending on the product’s features.
Registered Index-Linked Annuity
A registered index-linked annuity, or RILA, is an annuity that uses a stock market index to determine gains and losses. What sets it apart from other types of annuities is your ability to set the maximum loss you are willing to tolerate. RILAs give you the opportunity to own an investment vehicle with the risk/reward characteristics that meet your overall financial objectives. RILAs, which were previously referred to as buffered annuities, offer investment growth opportunity with limited downside risk. Given their limited potential for loss, RILAs can offer protection in an economic crisis such as the market downturn.
Are Annuities Right for You?
Annuities are ripe for sales practice violations because the financial advisors are usually rewarded with high commissions on these products. These products are very complex and difficult to explain to prospective investors. Given the financial advisor’s incentive to earn a large commission, they may make misrepresentations or omissions regarding the risks related to the annuity, fees you will have to pay for the annuity and the lack of liquidity the investment may present to the extent you need access to the funds in the annuity.
If you are evaluating if an annuity investment is right for you, you should look at the same factors your financial advisor is obligated to review in order to assess the suitability of the sale of the annuity under FINRA Rule 2330.
1. Age
The age of the buyer of an annuity is an extremely important factor in any determination of whether that annuity is suitable. In the case of an immediate annuity payable for life, the age of the annuitant will determine the amount of each annuity payment. If the proposed annuitant is not in good health or if his or her family health history suggests a shorter than average life expectancy, the advisor should question whether a non-underwritten life annuity is appropriate. For such an applicant, a fully underwritten annuity — where the amount of annuity payments would take into account the annuitant’s health status — might offer a substantially greater benefit than a nonunderwritten contract.
If the contract being proposed is a deferred annuity, the age of the prospective owner and of the prospective annuitant, if different, are relevant factors. Many insurers will not issue a deferred annuity contract if the proposed annuitant is older than a certain age, which, in the authors’ experience, accounts for many contracts where the annuitant and owner are different individuals. This can create problems.
Even where the prospective owner and annuitant are the same individual, the age of that person is relevant to the suitability of a deferred annuity. The NAIC and insurance regulators of many states have issued consumer alerts, warning seniors of deceptive sales practices, and, in many states, special suitability requirements apply when the applicant of a deferred annuity is a senior citizen.
Where the proposed deferred annuity includes either a guaranteed minimum death benefit or a living benefit rider, the age of the owner and/or annuitant often determines the availability or the terms of that benefit.
2. Annual income
The annual income of the buyer of an annuity is relevant to the suitability of that contract for several reasons. If the contract is a flexible premium one, contemplating ongoing contributions, the applicant should be able to make those contributions.
3. Financial situation and needs, including the financial resources used for the funding of the annuity.
An annuity is a tool designed to meet specific financial needs; therefore, the nature and extent of those needs are relevant to the annuity’s suitability to do the job. The source of funds is of particular concern when securities are involved. The agent recommending the annuity must be appropriately licensed, not only for the annuity contract being proposed, but also for securities, if the source of funds for the annuity is securities and if he or she is recommending that those securities be sold to fund the annuity.
4. Financial experience
The financial experience of a consumer is important, especially if the financial product being recommended is complicated or appropriate only for sophisticated buyers. A complaint often made by plaintiffs in annuity-related litigations, is “I did not understand what I was buying.”
5. Financial objectives
Any assessment of its suitability must necessarily consider the job to be done. It is vital that everyone involved in the sale of an annuity — the applicant, the recommending advisor, and the insurance company issuing the annuity — understand what financial objectives that annuity is being purchased to achieve. It is probably impossible to over-emphasize the importance of this factor or to over-document its consideration.
6. Intended use of the annuity
Consideration of this factor can produce useful, and possibly unexpected, results. For example, if the proposed annuity includes a guaranteed minimum death benefit and the purchaser shows a special interest in this feature, a discussion of life insurance, which is usually a more efficient delivery instrument for death benefits than an annuity, may be in order.
7. Financial time horizon
Time horizon can be a confusing term. It can be used to mean the maximum period during which this investment will be held. It can also be used to mean the number of years before which distributions, or income, are expected to be needed. Both are relevant to a proper determination of suitability.
8. Existing assets, including investment and life insurance holdings
Existing assets are important, not only because they are part of that client’s financial situation, but because the nature and extent of those assets will help the advisor to determine the extent to which the financial objectives are likely to be met. A review of existing assets can also help the financial advisor assess the accuracy of the client’s responses to the advisor’s questions regarding the other suitability factors. For example, a client claiming to have extensive financial experience and sophistication and a great desire for tax-favored treatment of his investments, yet who holds only certificates of deposit, may not understand the extent to which the expressed concerns are inconsistent with his prior financial decisions and current holdings.
9. Liquidity needs
The liquidity of an asset refers to how quickly and cheaply it can be converted to cash. While an annuity that imposes surrender charges (as most do) can be surrendered for cash relatively quickly, the cash received might, because of those charges, be significantly less than the annuity’s value just prior to surrender. In a few indexed annuities, surrender charges never expire,
and may even apply to death proceeds taken in a lump sum; those annuities may be considered relatively illiquid.
10. Liquid net worth
After learning the liquid net worth of the annuity applicant, the advisor can compare that figure with the applicant’s liquidity needs. If it appears that the liquid net worth is not sufficient to meet the liquidity needs during the surrender charge period, the advisor may wish to recommend that some of the funds being considered for investment in the annuity be placed in a highly liquid account to meet that potential shortfall.
11. Risk tolerance
Risk tolerance is an essential factor in the determination of the suitability of an annuity because annuities are risk management instruments. Unfortunately, this simple fact is not widely, or well understood by many financial advisors. Moreover, the very notion of risk is largely misunderstood and, often, misapplied.
What is risk? Textbooks in finance tell us that there are many different kinds of risk, including market risk, interest rate risk, inflation risk, currency risk, credit risk, liquidity risk, etc. Yet many risk tolerance questionnaires used by financial advisors — and often required by insurers and/or broker/dealers to be completed prior to the sale of an annuity, especially a variable annuity — focus only on one of these: market risk, which is commonly defined in either of two very different ways.
One definition says that market risk is the risk that market pressures may cause the value of an investment to fluctuate. In that sense, market risk means volatility. Another definition, also used widely, says that market risk is the possibility that market pressures will cause the value of an investment to decline. In that sense, market risk equals principal risk. Both involve uncertainty — which, the authors believe, is the central element of risk — as to the future value of one’s capital.
Certainly, that’s an important consideration to any investor; but it’s not all-important. The widespread use of risk tolerance assessment tools, such as a questionnaire, that identifies risk only as the possibility of losing one’s capital, or principal, focuses attention only on the capital preservation and wealth accumulation potential of the product being considered, concerning which tool is employed.
That can be a problem when one is assessing the suitability of an annuity because the risk that is of greatest concern to a prospective annuity purchaser may not be “that I might lose some principal” but, rather, that “I might run out of income.” Moreover, principal risk is never a factor in an immediate annuity, because an immediate annuity is an income stream, and typically has no principal or accessible cash value. It may not be a factor when the product proposed is a fixed deferred annuity, because all fixed deferred annuities guarantee principal, except to the extent that surrender charges or a market value adjustment may erode principal if the contract is surrendered early. Indeed, principal risk may not be a great concern even when the proposed product is a variable deferred annuity if a guaranteed living benefit has been chosen because the income guaranteed with such benefits is often immune to adverse market performance.
12. Tax status
The tax status of the applicant for an annuity is obviously important because annuities can receive special tax treatment. The tax deferral that is enjoyed by a deferred annuity comes with a cost: Namely (a) all ordinary income treatment of all distributions and (b) a ten percent penalty tax on any distribution not qualifying for an exception under Code section 72(q)(2).
The benefit of such tax deferral is much greater for applicants in high tax brackets than for applicants in very low brackets, for whom the benefit may be outweighed by its cost.
Questions about Annuities Sales
If you have suffered losses related to the sale of an annuity, we would like to hear from you. Contact us to discuss your legal rights and potential options to recover losses. The Schwartz Law Firm represents investors in claims against financial advisors and their firms. If you have questions about your potential claim or need assistance from an investment fraud lawyer, please contact us at 866-618-0545 or email Matthew Schwartz directly at [email protected].
