Considering Suitability: 3 Red Flags in Variable Annuity Transactions

Posted by Mike Carretta

March 18, 2015 at 1:30 PM

red flags in variable annuity transactionsIt would be an understatement to say that the variable annuity landscape has changed significantly in the past five years. We've seen cutbacks in living benefit payouts, carriers offering buybacks of existing policies, and some carriers leaving the market altogether. So, it's no surprise that we've also seen an increase in regulatory scrutiny of variable annuity sales, especially replacements.

In light of this, we'd like to share a few red flags in variable annuity transactions, as well as suitability best practices to keep in mind when considering these products for your clients. Although your firm's policies for documenting your recommendations may differ, it can't hurt to be as thorough and detailed as possible.

Red Flag #1: Contingent Deferred Sales Charges (CDSCs)

Replacement or transfer with remaining CDSC of more than 3 percent. Variable annuities are designed as long-term investments. The expectation is that your client will hold the product for at least the duration of the surrender schedule. Typically, CDSCs gradually decline, so replacing a variable annuity prior to when it's surrender-free could indicate a premature sale.

What to do. If you have a client in this situation, be sure to document the economic benefit of the replacement, illustrating factors that outweigh the surrender charge. If your client's goals and objectives have changed since the original variable annuity was purchased, it's important to note these details as well.

CDSC schedule inconsistent with client's investment horizon. The time horizon is the time the client plans to hold the variable annuity—not when the client plans to draw income. Generally, products with a shorter surrender schedule (e.g., L-share variable annuities with a four-year CDSC) have come under additional scrutiny due to higher costs and potentially higher commissions.

What to do. Proposing a C- or L-share annuity for a client with a time horizon of greater than 10 years requires additional disclosure. This includes:

  • Explanation of products you've discussed (e.g., B-, C-, or L-share annuities)
  • Why the product selected makes the most sense given the client's objectives and time horizon

Red Flag #2: Senior Client/Locking a Senior Client into CDSC Cycle

Variable annuities can be appropriate for senior clients. But various factors have resulted in heightened scrutiny of these sales to older clients. These include the products' complex nature, the lack of sophistication of some investors, and the high-pressure sales tactics sometimes used in the industry.

This red flag applies to two age bands, both of which warrant additional review and documentation:

  • Clients older than age 75
  • Clients ages 65–74, combined with another red flag

There are also potential liquidity issues for senior clients if they need money to live on during retirement, or if they have to take required minimum distributions (RMDs) and the variable annuity isn't RMD-friendly. These excess withdrawals may incur CDSCs or negatively affect the client's living and/or death rider benefits.

What to do. It's important to discuss other products that could better meet your client's needs with less possible downside. Despite their potential to offer some downside protection, variable annuities do come with market risk. You should confirm that your client understands he or she may lose principal with market exposure.

Red Flag #3: Source of Funds Is a Buyback/Enhanced Surrender Value Offer on an Existing Variable Annuity

Beginning with Hartford in 2013, industry professionals and regulators very quickly became familiar with the enhanced surrender offer or "buyback." Here, an immediate cash bonus and/or waiver of remaining CDSC is offered in exchange for the removal of living benefits or surrender/replacement of the contract. To be sure, there are certainly scenarios where it would make sense for a client to take advantage of this type of offer. But a large number of 1035 exchanges in a short time period is likely to catch an auditor's eye. In addition, many living benefit riders available today are not as competitive as those offered several years ago.

What to do. We highly recommend being proactive with clients in buyback situations, as some clients may accept buyback offers without consulting their advisors. Be aware that both sides of the 1035 exchange will be reviewed when evaluating a proposed replacement. It will be important for you to:

  • Fully document the rationale for each replacement.
  • Explain why the client is electing to surrender his or her existing product, particularly when the client decides to purchase a new annuity.

Additional Recommendations

Focus on the tangible economic benefit. While buybacks are a current item of interest, the same rationale should apply to all 1035 exchanges. The most important thing to keep in mind when proposing any variable annuity trade is that a tangible economic benefit must be documented. This might include, for example:

  • A significant reduction in annual expenses
  • A new living benefit rider that will guarantee a higher annual income regardless of market performance
  • Locking in a significant step-up in death benefit or benefit base

Especially in situations where clients give up an existing living or death benefit, different investment options, concerns over the carrier, or poor service cannot be the sole reason for a replacement. These concerns will be factored into the overall review, but there must be a tangible economic benefit driving the trade. For example, investment options cannot be considered as the primary reason for a replacement, and it cannot be guaranteed that new subaccounts will outperform existing subaccounts.

Provide as much detail as possible. Be sure to fully explain and document why a trade is in the client's best interest. This includes providing a thorough explanation of how the client plans to use the particular product you recommended. Often, a questioned trade ends up being approvable with additional documentation. We encourage you to be as detailed as possible on the front end. By providing all the information necessary for any review, you'll avoid the need to request updated paperwork from the client.

The current variable annuities regulatory environment has presented some changes to the landscape for these transactions. By keeping aware of potential red flags (and what to do if you encounter them), you'll be on track to successfully navigate compliance challenges and continue to meet your clients' goals and objectives.

Have you run into other red flags in variable annuity transactions? How does your firm's Compliance department handle these issues? Please share your thoughts with us below.

Tips for Conducting a Self-Audit of Your Practice

Topics: Compliance

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