Term Replacement Funded by Surrendering a Variable Annuity
A 58-year-old nonsmoker owns a $400,000 15-year level term policy with seven years remaining; the annual premium is $620. His agent proposes surrendering a $60,000 variable annuity (cost basis $38,000, surrender charge $4,800) to help fund a new $400,000 whole life policy with an annual premium of $9,800. The client has $1.1 million in an IRA, $250,000 in savings, a 56-year-old spouse, and no dependent children. He says he wants "permanent coverage and no more premium increases." The annuity is not needed for income, and he has not annuitized it. He is in good health.
1. Identify the regulatory and suitability issues raised by replacing the term policy and surrendering the annuity.
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The proposal triggers replacement regulation: the agent must present a replacement notice and comparison, obtain a signed statement, notify the existing insurer, and preserve the client's free-look right. Suitability review is also required because the recommendation must be in the client's best interest, not merely suitable.
The annuity surrender creates an immediate cost: $4,800 surrender charge plus ordinary income tax on the $22,000 gain. Because he is 58 and has not annuitized, a 10% penalty of $2,200 also applies unless an exception exists. A 1035 exchange cannot move annuity money into a life policy, so the tax cannot be deferred by the exchange. The immediate cost is therefore roughly $7,000 plus income tax, before any new policy premium is paid.
The suitability problem is that the client already has $1.35 million in liquid and retirement assets, no dependents, and a spouse who is provided for. Permanent coverage may be a legacy or estate-liquidity choice, not an income-replacement necessity. The agent should document needs, alternatives, and the cost of surrender rather than treating the annuity as free money.
2. Evaluate whether the replacement meets the client's stated goals, using a cost and needs analysis.
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Cost comparison: the remaining term coverage costs $620 x 7 = $4,340. The proposed whole life costs $9,800 annually; over 20 years that is $196,000, plus the annuity surrender cost. The term policy is inexpensive because the need is temporary, while the permanent policy is expensive because it builds cash value and guarantees a death benefit for life.
Needs analysis: with a $1.1 million IRA, $250,000 savings, a working spouse, and no dependent children, the economic need for $400,000 of permanent death benefit is weak. The stated goal is emotional ("no more premium increases") rather than a quantified need. A better-reasoned recommendation is to keep the term policy and, if he wants permanence, convert only a portion or buy a smaller permanent policy. He should not drop the term until the new coverage is issued and in force. The new policy will restart its two-year incontestability and suicide provisions, so replacing existing coverage also resets those protections.
3. If the client proceeds anyway, what disclosures, time frames, and policy clauses apply?
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Required steps include a replacement notice to the client, a comparison or policy summary, a signed statement acknowledging the replacement, notification to the existing insurer, delivery of the new policy, and the free-look period. The annuity sale also requires disclosure of surrender charges, market-value adjustment if any, tax consequences, and the free-look right.
The new life policy will have a new contestability period and a new suicide clause, typically two years. The old term policy's remaining seven years of coverage should not be cancelled until the new policy is delivered and the free look has run. The client should receive a written explanation that the $22,000 annuity gain is taxable and that the 10% penalty applies at age 58. The file should document the alternatives considered, the client's reasons for proceeding, and the fact that the annuity was not needed for income.