Investment decisions are always made within the context of a client’s current needs and objectives, and the market circumstances that exist in that moment in time. In the case of variable annuities (VAs) that were purchased by your clients years ago, the changes in industry product offerings may warrant your review of your clients’ old VA positions to see if they may benefit from considering one of the new products that have been developed in recent years. If a client feels that exchanging out an existing VA may offer financial benefit to him or her, here are factors to consider when making a tax-free 1035 exchange from one annuity to another.

The Potential Advantages of a 1035 Exchange

A 1035 exchange refers to the tax code provision that permits the direct transfer of funds in an annuity policy—as well as a life insurance policy—without the transaction being subject to taxation. Thus, annuity investors may be able to upgrade their annuity holdings without seeing their accumulated investment balance reduced by taxes. They may also realize some additional potential benefits, depending on the policy they own and the annuity they are considering.

• Product Features—Variable annuities have undergone many substantive changes in the last 10-plus years. While some pre-credit crisis annuities may actually offer more attractive benefits than today’s products, there remain a significant number of older policies that may have less advantageous stepped-up benefits, return of premium features and living benefits.
• Lower Costs—One of the evolutions in the VA industry in recent years has been toward lower cost fee-based and investment-only VAs. With this lower cost, the value of an annuity’s tax-deferral advantage rises, leading to greater wealth accumulation over time.
• More Investment Options—Not only do new annuity products generally come with a more robust investment selection universe, but many now offer asset classes that are less correlated to more traditional asset classes, which helps potentially lower market risk on retirement savings.

The Potential Disadvantages of a 1035 Exchange

There may be disadvantages to executing a 1035 exchange, including:

• Loss of Benefits—Any loss in benefits will need to be assessed in relation to the gains of making an exchange.
• Surrender Charge—If the existing policy is not yet out of its surrender charge period, the client may be assessed a charge for moving out his or her funds.
• New Surrender Period—If an exchange is made into a new annuity, your client may be subject to a new surrender fee schedule, which could adversely affect liquidity and withdrawal costs, depending on their withdrawal expectations.

Not All 1035 Exchanges are Created Equally

The general view of regulators is that there needs to be a tangible economic benefit to the annuity holder for undertaking an exchange. Poor service, out-of-date investment choices or even a fallen carrier rating is not sufficient for making a 1035 exchange. When presenting the idea of exchanging one annuity for another, be sure to fully explain the advantages and disadvantages of the transaction.

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