You already own an annuity, but a salesperson promises to swap it out for a new contract – one that supposedly offers you better benefits.

It’s a pitch many investors have heard at some point. If you become one of them, be sure to ask the right questions before signing on the dotted line.

Who Benefits from an Annuity Swap?

The first thing to know about annuity replacements: They’re sometimes a better deal for the seller than they are for the contract holder. Life insurance agents and brokers can receive hefty commissions when they sell a new product. For annuities, they may pocket up to 7% of the contract’s value – and even more for more exotic products like equity-indexed annuities.

Needless to say, there’s a big incentive for sales reps to sign you up for a new annuity to replace the one you already have. Is it ever worth it? Sure. But much of the time, it’s not.

One current trend that has regulators worried is the substitution of deferred annuities – those that don’t start paying out until a future date – with immediate annuities. In many cases, the replacement benefits not only the agent, but the insurance firm. (See Immediate Annuities: More Income and Lower Taxes.)

Older products often provided higher payouts, in part because they were sold when interest rates were much higher than they are today. Insurers started realizing they could achieve significant savings by substituting them with newer, immediate annuities.

Full Disclosure Required

The problem became big enough to rouse the interest of New York State’s Department of Financial Services. Last year, it warned life insurance companies and fraternal benefit societies, as well as those selling annuities on their behalf, of the need to comply with disclosure and suitability regulations when swapping out existing contracts.

The replacement of an annuity requires the seller “to have reasonable grounds for believing that the recommended annuity contract is suitable for the consumer on the basis of the facts disclosed by the consumer as to the consumer’s investments, other insurance policies or contracts, and other ‘suitability information,’” the agency noted.

In particular, the regulator said, customers must be informed of the new contract’s key features, including any surrender charges, the availability of cash value, guaranteed interest returns and the potential tax implications if the consumer sells or surrenders the annuity. In some cases, it said, “consumers are receiving thousands of dollars less in lifetime retirement income by replacing such contracts.”

Trading in Variable Annuities – the Risk

The replacement of fixed annuities has been the most widespread problem of late, given today’s low interest rates. But, in some cases, insurers may also have a reason to trade in on variable annuities, whose payments are based on the performance of “sub-accounts” – essentially baskets of stocks and bonds – selected by the contract owner. It usually happens after the stock market heads south.   

Why? Variable annuities typically allow investors to withdraw funds based on the highest value that the contract has reached. Say you invested $50,000 in a contract that subsequently went up in value to $75,000 before falling to $40,000.

Each year, the company allows you to take out a percentage of that $75,000 “guaranteed value” – not the $40,000 it’s worth after the downturn. So the company saves a lot of money by simply replacing your existing contract with a new one valued at the current market price.

What to Ask

What’s the best way to make sure you’re really better off with a new annuity? Asking the right questions is crucial. Here’s what you’ll want to know from the salesperson:

  • Which features are offered in this new annuity that make it a better deal for me?
  • Will I be subject to any surrender charges from my existing annuity?
  • Are you making a commission off the sale? If so, how much?

Should you decide to go through with a replacement, you’ll want to take advantage of something called a “1035 Exchange.” It’s named after a section of the IRS code that lets you replace an existing annuity contract or life insurance policy for an equivalent new one, without getting taxed for any investment gains (although the rule does not allow you to swap out an annuity for a life insurance policy tax-free).

Ask the salesperson whether the new policy would qualify under the 1035 Exchange and be sure to fill out the appropriate paperwork with the new carrier.

The Bottom Line

There are times when a different annuity product may lead to greater lifetime benefits than the one you already own. But keep in mind that annuities are generally sold by people who make a commission if they can sell you on a new contract. So being cautious and asking the right questions can help ensure you’re making a sound decision, one way or the other. (For more, see An Overview of Annuities.)

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