Question

Annuities are one of the most used of the valuation formulas in finance. There are 7 characteristics or factors that we need to look for when determining the correct formula to use. Name 5 of the characteristics that you need to look for and explain their importance when solving a problem.

Answer 1

1. Age. The age of the buyer of an annuity is an extremely important factor in any determination of whether that annuity is suitable. In the case of an immediate annuity payable for life, the age of the annuitant will determine the amount of each annuity payment. If the proposed annuitant is not in good health or if his or her family health history suggests a shorter than average life expectancy, the advisor should question whether a non-underwritten life annuity is appropriate. For such an applicant, a fully underwritten annuity — where the amount of annuity payments would take into account the annuitant’s health status — might offer a substantially greater benefit than a non-underwritten contract.

If the contract being proposed is a deferred annuity, the age of the prospective owner and of the prospective annuitant, if different, are relevant factors. Many insurers will not issue a deferred annuity contract if the proposed annuitant is older than a certain age, which, in the authors’ experience, accounts for many contracts where the annuitant and owner are different individuals. This can create problems.

Even where the prospective owner and annuitant are the same individual, the age of that person is relevant to the suitability of a deferred annuity. The NAIC and insurance regulators of many states have issued consumer alerts, warning seniors of deceptive sales practices, and, in many states, special suitability requirements apply when the applicant of a deferred annuity is a senior citizen. That said, no state regulation of which the authors are aware states that an annuity is inappropriate merely because the prospective buyer has reached a certain age.

Where the proposed deferred annuity includes either a guaranteed minimum death benefit or a living benefit rider, the age of the owner and/or annuitant often determines the availability or the terms of that benefit.

2. Annual income. The annual income of the buyer of an annuity is relevant to the suitability of that contract for several reasons. If the contract is a flexible premium one, contemplating ongoing contributions, the applicant should be able to make those contributions.

3. Financial situation and needs, including the financial resources used for the funding of the annuity. An annuity is a tool designed to meet specific financial needs; therefore, the nature and extent of those needs are relevant to the annuity’s suitability to do the job. Moreover, the source of funds is of particular concern when securities are involved. The agent recommending the annuity must be appropriately licensed, not only for the annuity contract being proposed, but also for securities, if the source of funds for the annuity is securities and if he or she is recommending that those securities be sold to fund the annuity.

It is widely believed that if the source of funds includes securities, that anyone recommending an annuity must necessarily be registered to sell the type of securities involved. Sources such as the Joint Bulletin No. 14-2009 issued by the Arkansas Insurance and Securities departments in September, 2009, are often cited to support this position. However, a close reading of the ruling in question may indicate otherwise. For example, the Arkansas ruling states:

“The recommendation to replace securities such as mutual funds, stocks, bonds and various other investment vehicles defined as securities under the Arkansas Securities Act is the offering of investment advice. It is unlawful to offer investment advice unless one is registered (licensed) with the Arkansas Securities Department as an investment adviser or investment adviser representative.”

This does not say that the proceeds of the sale of securities may never be used to purchase an annuity unless the agent recommending that annuity is securities registered. It says only that the agent may not recommend such liquidation without being registered as an investment advisor, or investment advisor representative. Even a Series 6 or Series 7 registration might not suffice in Arkansas because the regulators in that state have defined a recommendation to replace securities as the rendering of investment advice. In another state, that same recommendation might be considered to fall within the solely incidental exception of Section 202(a)(11)(C) of the Investment Advisers Act of 1940. Generally, however, an advisor recommending a non-variable annuity, to be funded with the proceeds of securities sales, must be registered to sell the type of securities involved, but need not be securities registered if he or she does not actually recommend the sale of securities to purchase the annuity. But this may not be a reliable safe harbor. Can an advisor whose client purchased the annuity he recommended with funds from securities sales rely upon the defense that “I did not know where the money was coming from”? If he or she is obliged to consider “Financial Situation and Needs, Including the Financial Resources Used for the Funding of the Annuity,” and SATMR imposes that obligation, the answer would appear to be a flat “no,” absent evidence that the client deliberately misled the advisor as to the source of funds.

4. Financial experience. The financial experience of a consumer is important, especially if the financial product being recommended is complicated or appropriate only for sophisticated buyers. A complaint often made by plaintiffs in annuity-related litigations, is “I did not understand what I was buying.” The more complicated the annuity, the more likely this complaint — or, at the least, the more reasonable it may sound to a jury or arbitrator.

5. Financial objectives. As the authors have noted earlier, an annuity is just a tool. Any assessment of its suitability must necessarily consider the job to be done. It is vital that everyone involved in the sale of an annuity — the applicant, the recommending advisor, and the insurance company issuing the annuity — understand what financial objectives that annuity is being purchased to achieve. In the authors’ opinion, it is probably impossible to over-emphasize the importance of this factor or to over-document its consideration. A thorough documentation of why the annuity is, in the opinion of the advisor, the right tool for the job can be invaluable to the defendant in litigation alleging a bad sale. More importantly, it may prevent that litigation by ensuring both that the consumer buys the right product and that he or she understands as much.

6. Intended use of the annuity. This is a variation on the theme addressed by factor No. 5, focusing less on, “is the annuity the right tool for the job?” and more on, “how will that tool be used to do the job?” Consideration of this factor can produce useful, and possibly unexpected, results. For example, if the proposed annuity includes a guaranteed minimum death benefit and the purchaser shows a special interest in this feature, a discussion of life insurance, which is usually a more efficient delivery instrument for death benefits than an annuity, may be in order.