Ethical Marker Buoys in Annuity Sales

Ethical “Marker Buoys” In Annuity Sales by John L. Olsen, CLU, ChFC, AEP

Navigating the sale of an annuity is tricky business these days. The products are complicated, making them hard to understand and explain properly and the tax aspects are at least as complex. Moreover, the regulatory environment is becoming increasingly more demanding. The responsible advisor, who wishes to sell, or offer advice regarding, an annuity must be aware of, and must comply with, relevant standards of suitability - or face the consequences. “Suitability” is, alas, not clearly defined, despite numerous attempts on the part of various regulatory entities to do so. What’s acceptable in California may not be in Missouri, and your Broker/Dealer’s compliance department may impose additional requirements. It’s not always easy to determine “suitability”. Sometimes, it’s a matter of whether the facts and circumstances of the case fit a published standard. But often, it’s simply a question of ethics. Acknowledging the peril of putting “simply” and “ethics” in the same sentence, the author believes that it is possible to pose the question “would this annuity sale be ethical?” and arrive at a meaningful answer. He suggests that we can stay within the “ethical channel”, so to speak, by observing certain guideposts – “ethical marker buoys”, to strain the metaphor further.

Buoy #1: “Whose Money Is This?

If our client informs us that the money we’re suggesting she invest in a deferred annuity is “for my kids”, we ought to bring our presentation to a full stop. Why? Because a deferred annuity is, generally speaking, a terrible instrument for passing wealth to the next generation. “Tax deferred” doesn’t mean “tax free”. The beneficiaries will pay tax on all untaxed gain, and at Ordinary Income rates. There will be no “step up in basis”, as with the untaxed gain in, say, an appreciated stock, bond, or mutual fund. If “net value passing to heirs” is the client’s chief concern, a life insurance policy might be a far better choice. One might argue that this isn’t really an ethical question, but one of product selection. It is that, certainly. But in the author’s experience, advisors sometimes recommend a deferred annuity rather than a life policy because annuities don’t require underwriting and are easier to sell as “investments”.

Buoy #2: Which Annuity Product Should I Recommend?

Product selection, for the ethical advisor, rarely comes down to a simple and obvious choice; the market is far too competitive for that. Yet, for some advisors, it does – and the choice is driven by the commission rate. If an advisor is considering fixed annuities for a client and two contracts offer the same guaranteed and current interest rates but one pays a higher commission, does that product impose greater surrender charges? If so, is it ethical for that advisor to ask the client to bear those greater charges? Some “consumerists” would answer with a resounding “NO!”. In the author’s view, that’s overly simplistic. If the advisor will be providing the client with additional services (other than as an annuity sales person) that would not be properly “paid for” by the lower commission, the higher-commissioned product might be ethically appropriate, provided the client understands and consents to that trade-off.

Buoy #3: The Surrender Charge Period Has Expired. Is It 1035 Time?

Many advisors, in the author’s experience, seem to regard the expiry of an annuity surrender charge period as an invitation to exchange that contract for a new one, via a tax-free exchange under IRC §1035. Those who accept that invitation may offer, as justification, something like the following: “I continue to manage this contract for the client’s benefit and I can’t do that for little

1 or no compensation. Besides, the client doesn’t intend to tap this money in the next 6 years anyway.”

The first sentence above amounts to this: “I gotta get paid!”. It ignores the fact that the advisor has already been paid. If the total commission on the annuity was, say, 6%, payable up front, then that was the deal. As to the second sentence, if it’s a valid justification, then it should withstand the scrutiny of a fully informed client. If the advisor believes he’s ethically entitled to earn a new commission by causing the client to accept a new surrender charge schedule, then why not put the question before the client – like this:

“You can make no changes, and be exempt from surrender charges or you can switch contracts, and shoulder new charges. In the first instance, I will receive no commissions, beyond those I earned when you bought the contract. In the second, I will earn new commissions. Which do you prefer?”

But doesn’t this approach ignore the potential advantages offered by switching to a “better” annuity? Not necessarily. If a new annuity offers new advantages, then those advantages can be explained and the client asked if they’re worth the new costs. It’s simply full disclosure. And good ethics.

One way to avoid this ethical problem from the outset would be for the advisor to elect “C share- type” commissions, if available. If that arrangement isn’t available, perhaps use of a no- commission contract, in connection with an ongoing advisory fee, would be appropriate.

In the foregoing discussion, we’ve looked at three “ethical marker buoys” that can help the responsible advisor navigate annuity sales for the benefit of all concerned. There are, of course, many more, some of which the author discusses in “Some Ethical Implications Of Full Disclosure In Annuity Sales” (Tax Facts Ethics, Dec, 2006) and “Annuities and Suitability: Some Reflections on the State of the Debate” (Journal of the Society of FSP, Nov., 2006), “A Suitable Match, Unsuitably Made” (“FinancialPro Viewpoints: www.financialpro.org, Jan., 2007), and in The Annuity Advisor, by the author and Michael E. Kitces, CFP, CLU, ChFC, MSFS (National Underwriter Co., 2005).

John L. Olsen, CLU, ChFC, AEP Principal: Olsen Financial Group 131 Hollywood Lane Kirkwood, MO 63122-2901 314-909-8818 [email protected]