A Precautionary Tale on Annuities
Suppose you own an annuity. A financial advisor, on reviewing your assets, proposes that you exchange your old annuity for a new one. After hearing the description of a first year “bonus” interest rate higher than your current one, and interest rates in the years following the first either at a respectable rate of return or “equity indexed,” you think “what’s the harm? I already own an annuity.” You should know that, even though under federal tax laws you can exchange one annuity for another while continuing to defer taxes under what is known as a Section 1035 exchange, the trade could cause you to lose ground, not gain. Here is how.
Surrender Penalties. When you purchased your current annuity, you received a schedule telling you the surrender penalties connected with early withdrawal. The penalties reduce over the years until, at a given date, you can get your full original investment back with accumulated earnings without paying a penalty. This surrender penalty is charged by the company and is separate from the issue of payment of taxes.
If you exchange your annuity for a new annuity contract, you set the clock over again and begin from ground zero on your surrender penalties.
Here is an example. John, at age 62 in the year 2000 purchased a single premium deferred annuity. If he cashed in the annuity the same year he bought it, under the terms of his contract he would have paid a 12% surrender charge but John kept the annuity. Each year he owned his annuity, the surrender penalties reduced. Now it is year 2008. John’s annuity is 8 years old. His surrender charge under his current contract has reduced to 4%.
If John now decides to exchange his annuity for another annuity, under the new contract he will start over with new surrender charges. The penalty under the new contract could be 12% or more or less depending on the terms of the new contract. An annuity should never be purchased or exchanged without understanding the surrender charges under the contract.
Is the bonus really a bonus? In considering the rate of return, a consumer might figure that the first year “bonus” rate for a new annuity seems attractive. When taking the surrender penalty into account, the bonus might not be as much of a bonus as it originally appears to be.
The new contract, for instance, may have a bonus of 5% and a regular interest rate of 4%. If the surrender charge is 12%, then the annuity owner who withdraws the funds in the first year of ownership of the new annuity has a net loss of 3%. Even with a 9% surrender charge, the owner only breaks even. If the “regular” interest return without the bonus for the new annuity is comparable to the interest rate of the current policy, it often makes sense to stay with the current policy.
Liquidity. It could be argued that surrender charges only matter if the consumer is going to withdraw funds. With a typical annuity contract, the owner can withdraw 10% per year without penalty. Because of this, some financial advisors consider annuity funds to be liquid. I would not.
The most serious issue is not with the investor who parks a minor portion of his funds in an annuity and has the freedom, with his remaining assets, to invest as he decides although, even in that case, there could be loss of investment opportunity. Serious problems arise when a major share of a senior’s assets are invested in deferred annuities and, in a health crisis, the owner is unable to reach them without penalty.
In one matter I handled where over $300,000 was invested and the senior shortly thereafter moved to a nursing home for skilled care, the 10% or $30,000, that she could receive without penalty paled by comparison with her nursing home bills at close to $100,000 per year. This could have been avoided by a “nursing home waiver” provision but that was not contained in her new policy.
Annuitization. Not all annuities are the same. Another date that owners should explore is the date when an annuity can be “annuitized,” that is when it can be used to create a monthly income stream. This can be very useful for planning purposes. There are “Medicaid” annuities but, recognizing the complexity of the federal Deficit Reduction Act and State regulations, these should not be considered absent extreme expert legal and financial assistance.
About the Author Janet Colliton
Esquire, Colliton Law Associates, P.C. Janet Colliton has practiced law for over 38 years, 37 of them in Chester County, Pennsylvania, a suburb of Philadelphia. Her practice, Colliton Law Associates, PC, is limited to elder law, Medicaid, including advice, applications and appeals, and other benefits planning including Veterans benefits, life care and special needs planning, guardianships, retirement, and estate planning and administration.