[EDIT: See the edit at the bottom of the piece that was added to reflect that a settlement was reached.]
I recently worked with an elderly woman (who I will call Beatrice) to evaluate whether or not the variable annuity she purchased less than a year ago was a good buy.
Beatrice, then 78, was convinced to roll $200,000 of her 403(b) plan into a variable annuity from a large mutual company that I will call Company X.
A "plain" variable annuity - that is, one without any guaranteed riders - sold to a 78-year-old inside of a qualified plan would typically be considered unsuitable both because of the relatively short time horizon and because the qualified plan already provides tax deferral, which is typically considered the biggest benefit of a "plain" variable annuity.
In this case, what allowed the agent to overcome these obvious objections is that a guaranteed withdrawal rider was attached to the annuity. In essence, the guarantee states that in 10 years a benchmark value will be double the original premium amount, at which point the benchmark value will be referenced in determining a guaranteed lifetime income.
That guarantee costs 115 bps (1.15%) annually. In addition, Beatrice was sold an unnecessary death benefit guarantee at the cost of 50 bps annually. This is on top of 110 bps for mortality and expense charges, 75 bps in investment expense, and 20 bps in administrative expense. All told, the annual expenses for this variable annuity are 370 bps. [In contrast, the weighted average expenses for the elected funds within the 403(b) plan prior to the rollover were 41 bps.]
A close reading of the product literature reveals that the income guarantee will be voided if a single distribution is made from the policy prior to the election of the guaranteed withdrawal benefit (i.e, 10 years), even if such a distribution is a required minimum distribution (RMD).
Given Beatrice's financial situation, it is debatable whether or not she could have made it 10 years without tapping into the $200,000 annuity, and it is also very debatable whether or not she would have enough other IRA assets to satisfy RMD rules during that 10-year period.
While the above already seems to indicate a borderline inappropriate sale due to the doubt about whether or not Beatrice could satisfy the 10-year moratorium on distributions in order to qualify for the guarantee, her situation is even worse. Due to a mistake in the purchase paperwork (it’s unclear which financial institution was responsible but it clearly was not Beatrice’s mistake), the variable annuity was issued using a larger rollover amount of $325,000 rather than the originally requested amount of $200,000.
After the erroneous amount was used, the agent telephoned Beatrice to verify that she was OK with the larger purchase amount. He emphasized that the policy had performed quite well in the short amount of time since it had been purchased, and she would forfeit some of those gains if she reversed some of the purchase. Based on that explanation, Beatrice could see no reason why she wouldn’t want to keep the larger amount in the annuity, and she agreed to do so.
What was not pointed out to her in that phone call is that because of the larger amount devoted to the annuity, it would now be impossible for Beatrice to have sufficient income to live on over the next 10 years without tapping into the $325,000 annuity – and equally as egregious she would not be able to satisfy RMD rules without taking income from the annuity over the next 10 years.
Because any distribution over the next 10 years will void the guaranteed income feature, increasing the annuity amount to $325,000 by definition voided the only rational justification (slim as it may have been) for purchasing the policy in the first place. (Of course, agent compensation was increased by 62.5% just for allowing the policy to go from borderline unsuitable to completely unsuitable.)
Obviously, Beatrice no longer wants the annuity. She can’t satisfy the conditions necessary to keep the income guarantee in place (both because of income needs and RMD rules), and in fact the income guarantee has already been voided because Beatrice had to take an RMD from the annuity. The tax deferral provided by the annuity is redundant as her money is already inside a plan that provides tax deferral. And she doesn’t want to pay 370 bps of expenses annually for something that she was getting for 41 bps previously. Even when both guarantees are dropped from the policy she will still be saddled with 215 bps of annual expense.
The final insult is that the policy has a surrender charge of roughly $25,000 (which in essence are the total acquisition expenses, the bulk of which is attributable to agent compensation), so Company X is going to make itself whole for the hefty agent compensation one way or the other – either via the surrender charge or via the heavy expenses assessed if Beatrice maintains the policy until the surrender charge grades to zero in 7 years .
We sent a letter to Company X and its broker-dealer outlining the above issues and asked them to provide Beatrice with a full withdrawal of funds with no surrender penalty. Company X and the broker-dealer refused to do so, indicating that Beatrice had indicated in the applications that she had read the prospectus and that she had the opportunity during the 10-day free-look period to examine the contract and return it if she felt it was unsuitable. Furthermore, they alluded to the follow-up phone call (which they erroneously describe as a meeting) with the agent where she indicated that she was agreeable to the larger purchase amount. In essence, they said that this 78-year-old woman knew what she was getting into, and it’s not their fault that she now has buyer’s remorse.
I generally hold Company X in high regard, but I think they (and their agent) missed the mark badly here on multiple occasions – at the time of sale, at the time of the follow-up conversation between the agent and client related to the erroneous transfer of the larger amount, and then again in their refusal to make amends. I think the sale of the $200,000 annuity was borderline unsuitable, and once the amount was allowed to increase to $325,000 and thereby ensure that the primary appeal of the policy would be destroyed, then the policy was clearly unsuitable. It is particularly disappointing to see this behavior from a mutual company; I understand that unsuitable sales are going to happen and that a company cannot completely prevent them – but it’s hard to imagine how a mutual company that prides itself in treating its policyholders fairly cannot find a way to make Beatrice whole, even if it means rescinding the compensation to the agent for the unsuitable sale.
[EDIT: I am pleased to report that the case reached a favorable conclusion. And while my opinion about the sutitability of the original purchase is unchanged, my generally favorable impression of Company X overall is also unchanged.]