The word "suitability" evokes a unique reaction within the financial services industry. It carries legal as well as emotional baggage that goes well beyond the synonyms of appropriateness or correctness. And, for anyone active in the annuity business, being accused of enabling or advocating an unsuitable transaction can have far reaching (and career-harming) implications.
Most practitioners know this already, but it is still worth repeating. The recommendation to purchase any annuity — whether it is variable, fixed, immediate or deferred — must satisfy an extra layer of scrutiny, taking into account a myriad of personal and economic circumstances. Thanks to the shenanigans involving 95-year-old widows and 25-year surrender charges (or is it the other way around?), the suitability benchmark is higher and the paperwork more onerous, compared to non-annuity products. Whether this extra cost is commensurate with the benefits is debatable.
In graduate-level statistics, we teach our students about two types of errors that decision makers might commit. Type I, in which you reject a hypothesis (read: product) that should have been accepted, and Type II, in which you accept a hypothesis (read: product) that should have been rejected. More importantly, it is not easy to design tests that minimize both errors simultaneously. It seems there are entire compliance departments whose primary mandate is ferretting-out unsuitable annuity transactions. Their law-school training has indoctrinated them that Type II errors should be minimized, which is often at the expense of Type I errors; more power to them.
Lord help the financial advisor, who recommends getting into a new annuity, as a replacement for another older annuity — or heaven forbid as an alternative to a mutual fund or managed account — who has not crossed the t's and dotted the i's on all the paperwork. I have seen this first hand as an expert witness on both sides.
Unfortunately, a transaction that seems to generate less scrutiny is the exact opposite of the above, namely, the process of getting out of an annuity.
In particular, I am talking about the recommendation — egged on by your competition down the block — to have a client terminate an existing annuity policy and instead move the money into mutual funds, a separately managed account or even another "cheaper" annuity contract. This, I believe, can be even more unsuitable, and doesn't get nearly as much scrutiny as it should. Here is why.
Conventional wisdom dictates that when a policy is old enough, and the contract is out of the surrender charge period — i.e., it costs zero to leave — there is nothing wrong with allowing the money out. There are no exit fees. The door is wide open. No harm done. After all, why not replace a poorly performing asset or lousy investment with something that has greater potential?
If this were a mutual fund or some other non-insurance product we were taking about, I would have no issue with exercising the right to leave. Let my money go.
But, and this is my key message here, many of the older variable annuity policies now have living and death benefits that are deeply in the money, and can be worth much more alive than dead. The performance of the account value itself is a minor sideshow. In these circumstances, not having the annuity — i.e., taking the out —might be the unsuitable transaction.
Remember, the older generation of variable annuity policies (pre-financial crisis) was uniformly more valuable than the recent designs (post-financial crisis). What this means from a financial engineering perspective is that the embedded guarantees provided more protection and for less cost.
Just as an example, if a theoretical client of yours has a seven-year-old policy (vintage 2004) with a likely 7%, 8% or even 9% guaranteed living benefit, possibly with a ratchet or roll-up on a death benefit plus a variety of other bells and whistles on top, then he better think good and hard before walking away — even if it seems free and costless.
Note: The absence of a surrender charge might be a necessary condition for approving an exchange or outright surrender of a policy, but it is not a sufficient condition.
Let me say this again. One has to be absolutely certain that all features of the old policy are properly accounted for and valued before they are dismissed for something modern. Even if the account value currently exceeds the guaranteed death benefit or the base for the living benefit, the embedded option is worth something because of the potential for markets to reverse themselves.
