Devil In The Details

Are your clients’ variable annuity contracts properly titled? There is reason for concern.

Are your clients’ variable annuity contracts properly titled? There is reason for concern.

A whopping 38 percent of variable annuities are improperly titled, according to research released last summer by Annuity Intelligence, an Oakbrook Terrace, Ill., variable annuity research company. Annuity Intelligence, whose clients include 165 broker/dealers and more than 100,000 advisors, analyzed 20,000 variable annuity contracts of 12 different carriers.

Improper titling can cause all kinds of problems: Client beneficiaries may run into inheritance problems and tax difficulties, and the registered rep and his or her broker/dealer could also face serious trouble. They could be found to run afoul of FINRA Rule 2821, which governs the sale of variable annuities.

Annuity Intelligence’s analysis, released last summer, indicated that one in four contract owners could experience serious problems. And one of 10 contracts could wind up in arbitration due to inheritance or tax disputes.

Annuity contracts, like life insurance, can avoid the costly process of probate upon the death of the owner. Some 2 million variable annuity contracts are sold every year, says Kevin Loffredi, executive vice president with Annuity Intelligence. And the variable annuity industry manages $1.4 trillion in assets, according to the National Association of Variable Annuities.

These contracts are complex. For example, 78 percent of contracts offer a return-of-premium death benefit as a standard part of the contract. And 81 percent offer optional lifetime income withdrawals, some of which may be “age banded,” according to Annuity Intelligence. This means the guarantee changes with the policy owner’s age.

“Almost 25 percent (of variable annuity contracts) are disasters waiting to happen,” Loffredi says. The mistakes, he says, are spread across all distribution channels. The bottom line: Registered representatives need more training on contract structuring and titling.

“Rule 2821 states that member firms must develop and implement special training programs designed to ensure that the both the registered representative and registered principals understand the variable annuity products they are selling or approving,” Loffredi says. “However, the training component rule of 2821 does not specify any specific content area.”

Frequently, titling foul ups involve who gets the annuity payout when different parties on the contract die. Loffredi says one chief reason such a large number of contracts have arbitration potential is because of the way they are titled, which could result in the disinheritance of a spouse. If the spouse is listed as an owner on the variable annuity contract and the children are listed as beneficiaries, this can happen fairly easily. When the first spouse dies, the money goes to the children instead of being paid out to the surviving spouse as was intended. To avoid cutting out the spouse, a contract should be titled with a joint-and- survivor option, with the children as secondary beneficiaries.

In some cases, Loffredi says, a variable annuity contract lists the children as the beneficiaries, but the individual’s trust, set up for estate or tax planning purposes, states that the proceeds should go charity. Mistakes like these can lead to major legal headaches.

Lack of financial planning can also trigger tax problems, particularly for someone who moves an existing annuity into a trust. A change of title is necessary before an annuity can be transferred to a trust. However, taxes must be paid to Uncle Sam upon change of ownership. So it pays in advance to make sure the contract is titled properly and all tax issues considered.

In other instances, people put their variable annuities into living trusts and may designate a trust as beneficiary. When an annuity owner dies, the proceeds are paid to the trust. The trust then determines to whom the money is paid. The surviving spouse has to pay taxes on the money she receives from the trust. In hindsight, one or both spouses should be named as owner(s) and the surviving spouse as primary beneficiary, with the trust as the contingent beneficiary. This way, variable annuity investments continue to grow tax-deferred for spouses based on Internal Revenue Code 72(s), Loffredi said.

“I have seen trust and annuity contracts that both have different beneficiaries, and the cases have gone to arbitration,” he said. “The broker/dealer has to know his (or her) client’s financial situation to avoid problems.”

Contrary to popular belief, Loffredi said that a client or representative can’t rely on a lawyer for guidance on annuity titling. Reason: Many attorneys are not familiar with variable annuity products and their designs.

Death Benefit?

Another issue: Whose death triggers the death benefit to payout? When the annuity owner dies, the beneficiary to a variable annuity’s enhanced death benefit may get the principal, or stepped-up market value—whichever is higher. But if both spouses are listed as contract owners, there can be trouble. When one spouse dies, the surviving spouse may be stuck with the current contract value—not the enhanced death benefit value—depending on the insurance contract.

Similarly, some contracts with guaranteed lifetime withdrawal benefits are filled out wrong. The guaranteed lifetime withdrawal benefit may pay the policyholder 5 percent in annual income from the annuity for life—no matter how the underlying mutual funds perform.
But for the surviving spouse to continue to receive the 5 percent in annual income, a spousal continuation rider must have been selected. Otherwise, the surviving spouse, if listed as a beneficiary, will inherit the annuity proceeds.

Withdrawals from contracts with spousal continuation also can affect both death and living benefit guarantees. So before the client signs on the dotted line, he or she must know if the benefits are reduced dollar-for-dollar, based on the amount withdrawn.

Registered reps need to consider Medicaid rules when dealing with older clients, who may some day go into a nursing home.
A policyholder who has exhausted his or her funds due to a nursing home stay may have no choice but to apply for Medicaid—the state-and federally-funded public assistance program.

Quality nursing home costs can run upwards of $80,000—not including drug and medical expenses. So it’s possible even for an affluent individual to exhaust his or her resources.

To qualify for Medicaid, persons needing long-term care typically must “spend down” assets to $2,000. The “community spouse,” who remains at home, generally is permitted to keep some $100,000 in resources.

According to a 2007 report published by Annuity Market News, a deferred annuity policyholder may have to convert the investment into an immediate annuity. But Medicaid rules require that the immediate annuity name the state as the “remainder beneficiary,” so the state gets reimbursed for medical assistance, long-term care and community services. Otherwise, an annuity is a “countable asset,” hindering a policyholder’s ability to reach the asset thresholds needed to qualify for Medicaid. The remainder beneficiary is the beneficiary who will become a current beneficiary after a specific event, such as the death of another beneficiary.

The Center for Medicare and Medicaid Services states that, “If there is a community spouse and/or minor or disabled child, the state may be named in the next position after those individuals.” Loffredi recommends that a registered rep explain to clients the consequences of titling contracts. For example: If the contract is spousally continued, what happens to the various benefits? Do they terminate? Do they reset? Do they continue uninterrupted? Do different parties to the contract cause different consequences? And how do withdrawals impact different living and death benefit guarantees?

Clients also need to take responsibility for reviewing their financial situations, including income, cash flow and expenses and investments. They need to review the beneficiaries listed on life insurance, annuities, savings and investment accounts and trusts.

“Don’t try to work with every carrier out there,” Loffredi warned. Stick with three or four and become familiar with how the contracts work. Know the wholesalers and make sure they understand this part of the business. If you need help, they should work with you on the information. Don’t try to be an expert on everything.”


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