Not long ago, Jason Branning encountered a client holding a one-year-old fixed-rate annuity with guaranteed income for five years. Branning, a certified financial planner at Branning Wealth Management in Ridgeland, Miss., ended up recommending that the client trade in the annuity for a newer model.
Why? Because higher interest rates mean newer annuities will pay more, and the crediting rate, or guaranteed payout, was going to be higher in this case. “Even though the surrender fee was a high percentage,” Branning recalls, “the client would be $10,000 better off … because of the significantly higher crediting rate.”
Branning isn’t the only one asking clients to consider exchanging annuities.
Annuity swapping “can make a lot of sense right now,” says David Lau, founder and CEO of DPL Financial Partners, an RIA consultant network in Louisville, Ky., that specializes in low-cost, commission-free annuities.
Tempting, But Not Always Wise
However, there are many caveats and exceptions for clients who want to go down this road. “Care needs to be taken to review individual situations,” Lau says, adding that it isn’t always a wise strategy.
“Many fixed annuities will renew into the higher current rates automatically, so a new policy may not be necessary to benefit from today’s higher rates,” adds Lau.
Different Types Of Annuities Are Affected Differently
Not all annuities benefit from higher interest rates in the same way. Fixed annuities, which pay a set amount over a specified time period, are most directly tied to prevailing interest rates. When rates go up, their payouts go up.
Variable annuities (VAs), which invest in mutual-fund-like subaccounts that rise and fall with the stock market, can also become more generous as rates rise. Their optional “living benefit” riders, such as lifetime income guarantees (offered for an extra fee), typically pay more when rates are higher.
In addition, many fixed-indexed annuities (FIAs), which reward annuity holders with a percentage of an index’s gains in exchange for complete downside protection, tend to enjoy increased gains on an account when interest rates go up. So do registered index-linked annuities, also known as RILAs (variable annuities that credit a higher percentage of investment gains while providing a degree of downside protection).
Clients have other products that have helped them lock in higher rates as well, including longer-term multiyear guaranteed annuities, or MYGAs. “The majority of MYGA sales were predominantly in guarantee periods of five years or less,” says Toby Leonard, head of product development at Security Benefit in Topeka, Kan. “But now we are seeing clients extend their MYGA guarantees to seven years or more.”
Surrender Charges
Another caveat for potential swappers is that most annuities have a surrender period lasting six to eight years after you purchase them, which means you can’t sell them or take a substantial withdrawal without incurring a hefty fee. These early-surrender charges would reduce the value of exchanging for a higher-paying contract.
But, as was the case with Branning’s client, that’s not necessarily prohibitive. “It may be worth paying the charge if there is a large enough difference in return,” says Michael Finke, professor at the American College of Financial Services in King of Prussia, Pa.
Surrender charges often decline over time as well. The older the annuity, the smaller the hurdle.
That means advisors must perform a careful analysis to determine whether the swap is cost-effective. “Look at the amount of lifetime income the current contract provides versus how much lifetime income could be provided by moving the contract value, net of surrender charges, to a new annuity with a higher payout rate,” says Wade Pfau, author of the Retirement Planning Guidebook, in an email. “If the new guaranteed income is greater, it might be worth doing.”
Beware Market Value Adjustments
But with annuities, nothing is ever quite so simple. “Even if you have a no- or low-surrender-fee annuity, there could still be a market value adjustment,” says David Blanchett, Lexington, Ky.-based head of retirement research at PGIM, the investment management group of Prudential.
When you buy an annuity, he explains, the insurance company that issued it invests the lion’s share of your premium in bonds. Today, with higher interest rates, those older bonds have lost value. So if you surrender your old annuity now, you might get less for it than what you bought it for.
“Given the rise in rates, the market value adjustment could have a significant negative impact on the economics of the exchange,” says Dave Byrnes, head of distribution at Security Benefit.
If you buy a newer model, you might also lose some of the bells and whistles you got on older ones. “Some of the older annuities may have long-term-care riders that are not available on the newer plans,” says Jennifer Kim, a managing senior partner at Signature Estate & Investment Advisors in Los Angeles.
What’s more, many of the living benefits on older variable annuities had “such rich benefits, due to overly optimistic pricing expectations, that they still offer much better income and investment flexibility than you can get on a VA today,” says Scott Stolz, a managing director at iCapital Solutions in St. Petersburg, Fla.
Also consider that if you buy a new annuity, you’ve reset your surrender period. “You will have a new surrender charge schedule based on the new annuity contract,” says Richard Anzelone, a managing partner at StrategicPoint Investment Advisors in Providence, R.I. That means clients should consider whether they might need this money sooner than the new surrender period allows, he says.
The quality of any annuity provider must enter into the calculation, too. “Insurance carrier strength and ratings should always be an important consideration,” says Ashton Lawrence, director and senior wealth advisor at Mariner Wealth Advisors in Greenville, S.C. You don’t want to buy an annuity from a carrier that’s likely to default.
Reasons To Trade
Nevertheless, it might still pay off for clients to trade in their annuities. “Much like a decision whether or not to refinance a mortgage, it comes down to the cost to exit the old versus the time to realize the advantages of the new,” says Frank O’Connor, vice president of research at the Insured Retirement Institute in Washington, D.C.
Brett Bernstein, CEO and co-founder of XML Financial Group in Bethesda, Md., says you must assess “where the client is today versus when they purchased their existing annuity. It’s possible their risks and goals have changed.
“If it is all aligned, then it may make sense to consider a 1035 exchange,” Bernstein adds, referring to the section of the tax code that allows tax-free swapping of an existing annuity or life insurance policy for another of the same type.
Finke notes that salespeople are encouraged to help clients evaluate the benefit of comparison shopping. But, he warns, “Commission-compensated agents are incentivized to recommend switching.”
In any case, most clients are not currently considering annuity swapping. Even though higher interest rates have driven record-breaking annuity sales overall (according to data tracker Limra) most of that has come from new buyers, not trade-ins.
“We have looked at this extensively, and we do not see signals of significant exchange activity,” says Todd Giesing, assistant vice president and head of Limra Annuity Research in Windsor, Conn.
And yet that might be a missed opportunity. “Many annuity companies are offering fixed rates that are higher than U.S. Treasurys and other fixed-income instruments,” says Christopher Van Buren, a private wealth advisor at LVW Advisors in Rochester, N.Y.