Should I Exchange My Annuity?

February 19, 2017
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Q: Several years ago, I went to roll over a CD at my bank. While I was there, the gentleman suggested I talk with the bank’s investment expert to see what other options were available. In the end, I decided to put my money in a variable annuity. It seems to have done okay (I don’t really know), but the bank recently contacted me about exchanging my old annuity for a better one. Does an exchange make sense?

A: It is pretty common for bank investment officers to push variable annuities. Variable annuities are often designed to appeal to inexperienced investors, especially those with low risk tolerances, so owners of bank CDs are prime targets. Brokers love to sell them because they earn juicy commissions—sometimes as high as 8 percent. Insurance companies love them because they earn higher fees on variable annuities than most other products.

Unfortunately, I find that most people who own variable annuities don’t really understand what they have. Variable annuities can be very complex and the fees are not always transparent.

One of the primary benefits of fixed-indexed annuities is tax deferral. Much like an IRA, the money you place in a fixed-indexed annuity grows tax-free as long as it stays in the fixed-indexed annuity. However, with hidden fees and market fluctuations of a variable annuity, you may be putting your assets at risk.

Section 1035 of the Internal Revenue Code provides a way for investors to exchange insurance contracts (including variable annuities) without triggering a tax event. However, if you exchange an annuity for a different type of insurance contract or product, you will end up with a taxable transaction.

There are several reasons why a1035 exchange is attractive. For example, insurance companies sometimes offer “bonus credits” of between 1 and 5 percent. Let’s suppose your old annuity is worth $100,000 and you exchange it for a new annuity with a bonus credit of 3 percent. Just by doing the exchange, your new annuity would earn an additional $3,000.

Another reason could be the availability of new features, including features that provide increased protection from market risk. These features can be quite complex and are not always as they seem, so take time to thoroughly understand them. The broker who is proposing the exchange should be able to explain everything clearly. If he can’t, do not make the exchange.

There is one exchange I have little problem recommending. In recent years, a number of low-cost annuities have been created allowing investors to cut their annual fees dramatically while retaining the benefits of tax-deferral. If you are already invested in a annuity, ask your financial consultant to show you some low-cost 1035 exchange options. Tax-deferred savings with low fees sounds like a winning combination to me.