Expiring surrender charges force clients to make tough choices

Mitchell Kauffman is getting ready to go annuity shopping. Mr. Kauffman, managing director of Kauffman Wealth Services Inc., has several clients whose annuities, which were purchased around 2005, have surrender charges that are about to expire.

“The current annuity did a lot of good protecting our clients during the downturn, but looking forward, it’s not a very competitive contract,” he said.

Mr. Kauffman isn’t alone in having to make a decision regarding annuities. Nearly two-thirds of all retail-sold annuities carry a surrender charge. The most popular share class of annuities, B shares, typically carries a 7% surrender fee that decreases by 1 percentage point every year.

Because annuities already are quite costly — the average B share has an annual expense ratio of 2.4% — most investors find it too expensive to make a change before the surrender fee has expired. Once it does, though, they’re apt to start looking at other options.

The problem Mr. Kauffman and other advisers are facing is that the low-interest-rate environment and increased volatility are making newer products much less attractive.

DECLINING INTEREST

Rob Seigmann, chief operating officer and senior adviser at Financial Management Group Inc., said one of his clients had an annuity that offered a fixed-rate distribution of 6.5% for 10 years. When the 10-year period ended recently, the insurance company came back and offered a 3.5% fixed-rate distribution for the next 10 years, Mr. Seigmann said.

“It was very generous of them,” he said dryly. “In this environment, locking in 3% or 4% just doesn’t make sense.”

Mr. Seigmann’s client held the annuity within his individual retirement account, so rather than rolling the assets into another annuity, he added them to his existing portfolio, particularly on the equity side, since it’s less costly.

Mr. Kauffman likes to move assets from a qualified plan into the overall portfolio, as well, since there’s no tax consequence. But for clients that have cash flow needs, the limits of fixed income make it a challenge to figure out exactly where to put the assets.

“In a normal climate, fixed income would be an easy choice,” Mr. Kauffman said. “Now we have to look at something like a dividend equity fund.”

Annuities that aren’t held within a qualified plan generally have to go through a 1035 conversion, which allows them to be transferred to another annuity tax-free, or be subject to taxes.

The annuity choices aren’t what they used to be, Mr. Kauffman said. “Low interest rates take fixed-rate and a lot of equity index annuities off the table,” he said. “We’re really confined to the variable annuity space, [but] we’re not seeing as generous benefits as in the past.”

There’s been a substantial shift of risk from insurers to investors, which is why the benefits are starting to look less attractive, said Frank O’Connor, managing director at Morningstar Inc.

“Today’s economics are making it a lot tougher on insurers,” he said. “Insurers are earning less on portfolios now, and that makes it more difficult to offer benefits that are as generous as in the past,” he said.

One change that has had an effect on the cost of annuities has been fees tied to the Chicago Board Options Exchange Market Volatility Index, a popular measure of market volatility, Mr. O’Connor said. As volatility goes up, so do the fees, because that is when hedging against the portfolio becomes more expensive for the insurer. Other annuities are starting to tie withdrawal benefits to the 10-year Treasury, which currently is yielding 2%, a stomach-churning number for retirees.

MORE OPTIONS

By switching to a new annuity, though, advisers may be opening up more investment options for the underlying funds, said Tamiko Toland, managing director of retirement income consulting at Strategic Insight. “A lot of older contracts do have restrictions on which funds can be used,” she said.

Even so, switching to a new annuity or into other investments isn’t always the best choice, Ms. Toland warned. If the current contract has a good living benefit, it may be better to stick with that plan. If the assets in the plan are underwater or worth less than the guaranteed floor, it doesn’t make sense to switch, she said.

On the flip side, if the assets in the annuity are higher than they were when it was first purchased, thanks to market returns, it makes a lot of sense to roll over into a new one, just to set a higher guaranteed floor, Mr. O’Connor said.

Rett Dean, principal at River Chase Financial Planning LLC, said when he has a client whose surrender fee is up, the most important thing he has to decide is whether or not an annuity still meets the client’s goals.

“It’s a critical conversation to make sure the original intent is still there,” he said. “If they’re the type that has the annuity for its safety net, then we may not make any changes.”

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