Elena, 79, and the 'Free Money' Bonus
Elena is 79 and lives on $1,900 a month in Social Security plus a small pension. She has $150,000 in a fixed deferred annuity that is nine years old, past its surrender charge period, and crediting 3%. Her daughter's adviser proposes a 1035 exchange into an indexed annuity with a 10-year surrender schedule (9% in year one, declining 1% per year), a 7% premium bonus, and a market value adjustment. He tells her 'you never lose money' and that the bonus is 'free money.' Elena has hypertension and diabetes, and her physician has said she may need assisted living within three years at about $4,500 a month. She has $6,000 in the bank.
1. Identify the suitability factors that control this recommendation and state whether the exchange is suitable.
Read the worked answer
The controlling factors are liquidity, time horizon, and need for income, not the bonus.
- Liquidity: $6,000 in the bank against a possible $4,500/month care cost within three years. Her annuity is her only substantial asset, so she needs it accessible.
- Time horizon: three years to a probable liquidity event versus a ten-year surrender schedule. This is a direct mismatch.
- Income need: she needs reliable income, not index-linked crediting she may never realize. Her current contract may already offer annuitization or systematic withdrawals with no surrender charge.
- Age and health: 79 with hypertension and diabetes. A 10-year surrender period extends past her likely need for the money.
- Complexity: an MVA, a participation rate, a cap, and a bonus vesting schedule are not features a 79-year-old with a three-year horizon should have to manage.
Conclusion: unsuitable. The recommendation fails the reasonable-basis and customer-specific suitability tests, and the 'never lose money' and 'free money' statements are misleading: an MVA and surrender charges can produce a loss on surrender, and the bonus is commonly recovered through lower caps, longer surrender periods, or a recapture charge.
2. Quantify what happens if Elena needs to surrender the contract in year two.
Read the worked answer
Illustrative calculation (values would be confirmed in the contract):
- Premium paid by 1035 exchange: $150,000. With a 7% bonus credited to the accumulation value, the starting value is about $160,500.
- Year-two surrender charge: 8% of the accumulation value ≈ $12,840.
- A market value adjustment would be applied on top of that in a rising-rate environment, and many contracts impose a bonus recapture charge if the contract is surrendered inside the vesting period.
- If she takes a partial withdrawal instead, most contracts permit 10% free withdrawal; 10% of $160,500 is about $16,050, but withdrawals above that trigger charges, and some contracts assess charges on a first-in basis.
- The $150,000 exchanged is basis, so a full surrender at a net value above $150,000 produces taxable gain; she is over 59½, so the 10% federal penalty does not apply, but income tax does.
Net effect: a plausible outcome is roughly $145,000 to $148,000 back from a $150,000 exchange after charges and MVA, precisely when she needs the money for care. That is the opposite of 'you never lose money.'
3. What alternatives and documentation should the adviser have produced?
Read the worked answer
Alternatives to consider, in order:
- Leave the existing annuity in place. It is past its surrender period, so it is fully liquid and crediting 3% with no downside risk.
- Use the existing contract's income features: annuitize a portion, or set up systematic withdrawals matched to her income gap, preserving liquidity for care costs.
- A short-term, low-cost income solution if she needs guaranteed monthly income, such as a single premium immediate annuity funded with part of the $150,000, keeping the rest accessible.
- Only then consider a new contract, and only one with a surrender period shorter than her liquidity horizon and no MVA.
Documentation: a written suitability analysis showing income needs, liquid reserves, health outlook, time horizon, the surrender charge and MVA comparison between the old and new contracts, and the specific reasons any replacement is or is not in her interest. The 1035 exchange itself is not the issue; the loss of liquidity and the new surrender period are. If the client insists after being fully informed, record the advice given and the client's acknowledgment.