Annuity Switching: Everything Investors Need to Know About Section 1035 Exchanges
Annuity switching is on the rise. What is annuity switching? Let’s start with the basics. Variable annuities combine elements of insurance with elements of securities and can act as a retirement savings vehicle. Variable annuities have many drawbacks, however, and are complex investment products that are not suitable for every investor. If you decide that a variable annuity is right for you, your broker will place you into a variable annuity, which contains mutual funds and which pays you monthly depending on the performance of those investments.
In reality, investment professionals often recommend variable annuities because they generate high commissions for themselves. It is little wonder then, that investment professionals often engage in “annuity switching.” Even after placing a customer in one variable annuity, investment advisors may come back to customers later and try to convince them to “switch” to a new and “better” variable annuity.
If your advisor approaches you with an annuity switching proposal, proceed with caution. Annuity switching is also known as a “Section 1035 Exchange” because you can exchange a variable annuity for a new one without paying any taxes on the income and the investment gains. Investment advisors may try to entice you to switch to a new annuity by offering “bonus credits.” According to FINRA, “Many annuity contracts now offer premium — sometimes called bonus — credits toward the value of your contract, of a specified percentage ranging from 1–5% for each purchase payment you make.” These bonus credits can quickly be offset by the potentially higher fees of a new annuity, however. Even back in 2001, the SEC warned of these bonus annuities, writing, “Exchanges into bonus annuities often result in the payment of substantial commissions to the brokers who handle these transactions.” Potentially higher fees and the questionable motivations of investment advisors are just two of the many drawbacks of annuity switching. Even though you can switch annuities without incurring new tax implications, you will enter into a new surrender charge period on the new annuity. This means that your money is now locked up for a new extended period of time. While your broker may try to dazzle you with the prospect of improved features in a new annuity, you may not need these new features and could end up in a worse overall financial position instead.
Given these drawbacks, what motivates investment professionals to recommend an annuity switch? FINRA explains it as follows:
Caution! Variable annuity sales have dropped along with the decline in the equity marketplace. A recommendation for the exchange of an existing annuity contract for a new annuity contract may be the only way a salesperson can generate additional business. However, the new variable annuity contract may have a lower contract value and a small death benefit. As in any circumstances, you should exchange your annuity only when it is better for you and not just better for the person trying to sell you a new annuity.
In May 2016, FINRA ordered MetLife Securities to pay a $20 million fine, plus an additional $5 million to customers. Fortune reported that, between 2009 and 2014, MetLife Securities “misrepresented or omitted at least one significant fact about costs and certain features of customers’ existing variable annuities in nearly three-quarters of 36,000 applications for switches.” The result? $152 million in commissions for the firm.
Because the investment advisors who recommend annuity switching are not fiduciaries, they can recommend a new variable annuity even if it is not in their client’s best interest. Some investment advisors even go so far as to conceal their behavior by skirting the tax code. In certain cases of fraud, “not only did clients incur higher annuity fees and surrender charges (sometimes in the tens of thousands of dollars) due to the exchanges, but they also had significant tax liabilities because the brokers, in trying to conceal their abuse, didn’t categorize the annuity replacements as 1035 exchanges,” reported InvestmentNews.
If your broker has come to you proposing that you switch to a new annuity, you should ask them the following questions:
· How much will this 1035 exchange cost me?
· What new features does the new annuity have? Why might I want or need these new features?
· What will it mean for me to enter into a new surrender period?
· Will you receive a commission for this annuity switch? If so, how much money will you get?
While the prospect of a shiny new annuity with the latest features might be appealing, it is important to use caution. Your broker may only be recommending an annuity switch to generate a large commission for themselves. If you fear your broker may have misled you into switching your annuity, don’t hesitate to come forward and speak with a securities attorney. Call (877) 238–4175, email info@fkesq.com, or visit our website at www.stopbrokerfraud.com for your free case consultation with the securities attorneys of Fitapelli Kurta.
