When do they make sense, and when do they signal regulatory suicide?

With the creation of one-shot wrinkle reducers like Botox, battery-operated automobiles and cloned humans, can a world where there is no need to replace variable annuities be far off?

That's a hard call even today, after four years in which regulators have been on the warpath against those brokers whom they say replace variable annuities unnecessarily, costing each investor thousands or more in new commissions, lost benefits and annual fees.

Proponents of the product, which combines both a life insurance and investment component, say the new bells and whistles like guaranteed income and death benefits that are the hallmarks of the new generation of products mean there will be no compelling reason to replace variable annuities in the future. "If your principal is protected, there's no need to replace the product," says Carly P. Maher, manager of variable annuity products at Commonwealth Financial Network in Waltham, Mass. "I think this will change the industry as a whole."

But critics and observers are less convinced, and counter that the main motivation for brokers to switch client variable annuities will be the same as it has been for more than a decade-boosting their own sizeable commissions.

So where does that leave planners and advisors who are being approached by clients, many of them disenchanted with the former generation of annuities they were sold sans the income and expanded life insurance benefits now available? These features, and the painful memory of the bear market, are compelling clients to consider trading in their old contracts for new ones. They're looking for "guaranteed" features to protect them, and at least part of their retirement nest egg, from the next possible round of market losses.

In fact, newer bells and whistles caused variable annuities sales to increase 10% last year, to $124 billion. Companies are also reporting that advisors who never sold variable annuities before are starting to do so. The reason? Their goal is to provide some income guarantees to clients who are demanding it.

Enticing product features and client demands notwithstanding, regulators have come down particularly hard on variable annuities switches that don't benefit anyone but the selling broker or planner. The National Association of Securities Dealers and the Securities and Exchange Commission have conducted more than 75 investigations, resulting in broker-dealers, reps and advisors paying hundreds of millions of dollars in fines and commission restitution orders. As a result, it's difficult to be too safe when it comes to justifying and documenting variable annuities exchanges. Such regulatory scrutiny also makes it critical for clients to understand all of the ramifications of a variable annuity switch (also called a 1035 exchange, after the section of the Internal Revenue Service code that stipulates such exchanges do not trigger income taxes).

So how do you ensure that you don't cross the line regulators have drawn in the sand when clients come calling and want to replace their variable annuity? "That's a dandy question, and more planners need to ask it," says John L. Olsen, principal of Olsen Financial Group in St. Louis County, Mo.

The first step in any replacement analysis-and a demonstrable analysis is needed to fully understand and protect client interests-should be more client-oriented than product-centered, he says. "What is the client trying to achieve through an exchange?" Olsen asks. "If they tell you they hate their annuity because it lost money in the past few years, it's important to show them they would have lost money in mutual funds, too."

Once investors understand this point, it's important to see if their existing policy accomplishes their goals or can be modified to do so. Sometimes companies allow riders to be added, even guaranteed income or death benefit riders, in order to keep contracts in force. In other instances, clients may be unhappy with their investment choices but not aware that they can accomplish some or all of their goals by switching funds in their existing annuity's subaccounts. Better investment choice alone is a dicey justification for doing a variable annuity exchange and not likely to sit well with regulators, compliance consultants say.

While the thought of being able to guarantee income is enticing, there is as much as an additional 50 to 60 basis points charge for such a benefit, which can bring the overall cost of a variable annuity into the 3% range. And that is before investment subaccount expenses are added in. Clients who don't need to generate income may not be a good fit for an exchange.

That's why it's critical for advisors to zero in on the client's original and current goals for owning the product. "If the original intent is legacy planning, and then we get an application for a transfer that says the client needs to generate a certain dollar benefit every month, we'll request a new investor profile that states clearly what has changed," says Commonwealth's Maher. "Circumstances can change, but we just want the client to understand that what they're saying now is different from what they said a few years back."

Once a clear understanding of a client's present goals is established, and a determination made that there is a possible advantage to a variable annuity exchange, advisors can begin to look carefully at the real costs and benefits of such a transfer. A sound analysis should include what the client is paying, what they're leaving behind and what they're gaining. Compliance experts agree that there should be multiple reasons and benefits for doing an exchange because of the heady costs involved in cashing in one variable annuity for another.

Commonwealth flags any exchange that costs a client 3% or more in a surrender charge. The compliance department then carefully reviews such applications and can choose to reject them or ask the advisor or planner for additional justification.

Telling a client it will cost him, say, 2% in surrender charges to do an exchange, will not free an advisor from the glare of regulators. For example, Commonwealth often requires advisors to get clients to sign a letter of understanding that clearly lays out the actual dollar amounts they'll pay to do the exchange.

Such a client letter might say something like: "I understand it will cost me $12,000 in early surrender charges and a $125,000 life insurance policy to exchange my existing variable annuity for a new one."

At times an advisor may believe that an exchange may actually save a client money, but that is not always the outcome, especially if there are additional charges for guarantee riders. Careful documentation should be done to evaluate all immediate and long-term costs, says Michelle Heyne-Wyrick, a partner in the compliance firm of BD/IA Complete LLC in Seattle.

As part of overall cost disclosure, it's also smart to disclose advisor compensation. And saying no to clients should always be a consideration, too, the consultant maintains. "If the rep or advisor believes an exchange is not a good idea, it's crucial to say so," Heyne-Wyrick says. "You can even say something like, 'I'll make 4% on this transaction, but I think there are major downsides for you.' It's important for planners to be upfront about compensation disclosure. So many problems come from planners' embarrassment over what they make."

The area of life insurance, especially newer guaranteed insurance benefits, can also prove problematic when it comes to making a convincing case for a pricey exchange. Why? Sometimes clients can be persuaded that guaranteed life insurance is a great buy, when it fact they don't need it or may be able to purchase the insurance cheaper outside of the variable annuity.

If a client really does want insurance to protect heirs, is a guaranteed death benefit rider-which is a bit of a misnomer at best-really the way to go? On newer policies, the guarantee provides a death benefit that is the greater of what a policy is worth at death or, if the market is flat or bearish, what was invested compounded at an annual rate. Such calculations add a definitive air of uncertainty if the insurance analysis a planner conducts shows a client has the need for a certain amount of life insurance.

On average, to lock in a death benefit floor clients will pay 40 to 50 basis points annually or pay a higher surrender charge, or both. What that means is if a variable annuity does well and the market does not go down, the guaranteed minimum death benefit will never be realized, but clients will still have paid for it.

"I'm not opposed to guaranteed death benefits, but the prudent advisor will say, 'You already paid a lot of overhead cost for your existing annuity and you're halfway through a surrender charge'. Before I put you in a brand new surrender charge schedule, we better evaluate what your true life insurance needs are,'" says Olsen.

Sometimes, Olsen says, clients don't have any life insurance needs or their needs are met by other existing policies, which really negates using a guaranteed death benefit as a reason for doing an exchange.

Tax planning is also important when considering an exchange-and the justification for an annuity in the first place. Using annuities for legacy planning can raise nasty questions, since subaccounts passed on to heirs are always taxed as income. As for the Bush administration's reduction in taxes, most notably the reduction in the capital gains rate to 15%, proponents say it's had a negligible impact on the sale of variable annuities. "You're just not going to get the guaranteed income or death benefits in other products," Commonwealth's Maher says.