Before you replace an annuity: what to check about what you lose

When someone proposes that you replace the annuity you own with a new one, the pitch usually describes what the new contract offers. This checklist works in the other direction: it lists what you would give up, what the swap would cost, and what you should have in writing before you sign anything. Each item comes with the reason it is there, so you can judge which ones matter for your contract.

Replacing an annuity is not wrong in itself. Some people have good reasons: a contract with high ongoing fees, a company they no longer trust, a feature they need that the old contract cannot provide. But the burden of proof belongs on the proposal. A replacement is a new contract with a new lock-up period, and it has to beat what you already hold after every cost is counted. The mechanics of an exchange are in the post on how to do an annuity 1035 exchange, step by step; this post is about the decision that comes first.

How to use the checklist

Work through the groups in order and write the answers next to each item. If an answer is "I don't know" or "the agent said it's fine," the item is not done. Ask for the answer in writing from the company that issued the old contract and the one that would issue the new one. Take the finished page to someone with no commission at stake, such as a fee-only planner or a tax professional, before you sign.

A few groups apply only to certain contracts. A fixed annuity has no investment subaccounts to compare, and a contract without an income rider has no benefit base. Skip what does not apply, but do not skip a group because the seller says it does not matter.

Group 1: what leaving the old contract costs

1. The surrender charge that applies today. Ask for the exact percentage for the current contract year and the dollar amount. Why: it comes straight out of what you move, and it is the one cost that is certain. The mechanics are in annuity surrender charges and free withdrawals.
2. When the surrender charge ends. Ask for the date the schedule reaches zero. Why: waiting twelve months can sometimes be cheaper than leaving now, and a contract close to the end of its schedule is the least costly time to move.
3. The free-withdrawal amount. Ask how much can leave this year without a charge. Why: a free withdrawal may reduce the charged amount, but take the tax into account, because a withdrawal comes out gains-first in a non-qualified contract.
4. Any market value adjustment. Ask whether the contract has a market value adjustment and what it would be today, in dollars. Why: an MVA can add to or subtract from the value you receive, depending on interest rates since you bought.
5. Bonus recapture. If the old contract paid a premium bonus, ask whether leaving early forfeits part of it. Why: an unvested bonus can be taken back, and a recapture on top of a surrender charge is a double cost.
6. Interest not yet credited. Ask whether leaving mid-year forfeits interest for the current period. Why: some contracts credit interest only on anniversaries, and leaving the day before can mean losing it.

Group 2: what the new contract locks up

1. The new surrender period. Ask for its length and the percentage in each year. Why: a new exchange almost always starts a new schedule from year one. Moving a 6-year-old contract with 1 year left into a 10-year contract trades one year of lock-up for ten.
2. The new free-withdrawal terms. Ask whether the allowance is available in year one and whether unused amounts carry over. Why: you may need money for taxes, medical bills or required distributions.
3. Waivers. Ask whether the new contract waives charges for nursing-home confinement, terminal illness or death, and whether the old one did. Why: a waiver in the old contract that is missing in the new one is a lost protection.
4. Your age at the end of the lock-up. Add the new period to your age. Why: someone who is 76 and buys a 10-year contract is committing money until 86, and the older the buyer the more the length deserves scrutiny.

Group 3: guarantees you may give up

1. A guaranteed minimum interest rate. Compare the floor in each contract. Why: older contracts sometimes carry floors higher than anything on offer today, and that floor is a guarantee you cannot get back once you leave.
2. The crediting method and its limits. For indexed contracts, compare caps, participation rates and spreads, and ask which can change. Why: the figures in an illustration may not be guaranteed, and the old contract's terms may be more stable than the new one's.
3. Renewal rate history. Ask how often the old company has changed its renewal rates. Why: a company with a record of fair renewals is a better bet than a new company's first-year promises.
4. Declared versus guaranteed values. In any illustration, separate what is guaranteed from what is projected. Why: projections are not promises, and a replacement pitch is often built on projections.

Group 4: income riders and the benefit base

This group matters if either contract has a lifetime withdrawal rider.

1. The old rider's benefit base. Ask for it and for the way it has grown. Why: the benefit base is a calculation used to set the income, not an amount you can withdraw. It may be higher than your account value, and it does not move to a new contract.
2. The new rider's starting base. Ask what the base will be on day one. Why: a new rider usually starts from the amount transferred.
3. The payout percentage at your age. Ask for the rider's percentage at your age now and the rules that raise it. Why: the difference in percentage and base together is the real comparison.
4. Rider fees. Ask for the annual rider charge as a percentage of which amount (base or value). Why: a charge on the base is larger in dollars than the same percentage on the account value.

A hypothetical shows how this can look. Say your old contract has an account value of $100,000 and a benefit base of $140,000, and the rider pays an illustrative 5 percent of the base each year: $7,000 ($140,000 times 0.05). You pay a 3 percent surrender charge to leave, so $97,000 reaches the new contract ($100,000 times 0.97). The new rider starts with a base of $97,000. Even if it pays 5 percent, that is $4,850 a year, which is $2,150 less. To match $7,000 from a $97,000 base, the new rider would need to pay about 7.2 percent ($7,000 divided by $97,000), and you would have to find out whether such a percentage exists and what it costs. The figures are invented, but the lesson is real: the benefit base that disappears in a swap can be worth more than any feature on the other side.

Group 5: the death benefit

1. The old death benefit formula. Ask what the beneficiary would get today. Why: some contracts pay the greater of account value or premiums, and some include a step-up. A swap can lose it. The guide on what happens to an annuity when you die explains the common forms.
2. The new death benefit. Ask the same question and what it costs. Why: a richer benefit often costs a rider fee every year.
3. Beneficiary forms. Confirm you will complete a new beneficiary form for the new contract. Why: the old designation does not carry over.

Group 6: tax

1. Basis and gain. Ask for the cost basis and the gain. Why: the gain is what the exchange defers, and it must carry over correctly.
2. Whether the exchange qualifies. Confirm the new contract will be owned and annuitized by the same people, and that the move will go straight from one company to the other. Why: a check payable to you ends the deferral, as covered in the guide on 1035 exchanges: swapping policies without tax.
3. Retirement accounts. If the contract is in an IRA, ask how the transfer will be made. Why: a trustee-to-trustee transfer is different from a 1035 exchange, and required distributions may apply.
4. A second opinion on tax. Ask a tax professional to read the proposal. Why: the agent is not a tax adviser, and a mistake can turn a deferred gain into a bill this year.

Group 7: who is selling, and how they are paid

1. Commission on the new contract. Ask the seller, in writing, what they will be paid and by whom. Why: a new sale usually pays a new commission, and that is an incentive to recommend a swap even when the old contract is fine. See how annuity commissions shape the advice you hear.
2. Commission on the alternatives. Ask what the seller would earn if you kept the old contract or chose a different one. Why: the incentive is clearest when you see the alternatives side by side.
3. The seller's role and duty. Ask what licenses the seller holds and what standard applies to the recommendation. Why: the best-interest rules in most states require care and disclosure, and the details are in best interest rules for annuity sales. Variable annuities and registered index-linked annuities are also securities, which brings different oversight.
4. The reason for replacing. Ask the seller to write one paragraph on why the swap is in your interest. Why: a vague paragraph tells you something; so does an unwillingness to write one.

Group 8: forms, timing and your health

1. The replacement disclosure. Expect a form that lists the contracts being replaced and a notice read to you and signed by both of you. Why: in most states these safeguards are required, and a seller who skips them is breaking the rule. The related rules for life insurance are described in twisting and churning: replacement sales abuses.
2. The comparison in writing. Ask for a side-by-side that shows the old and new costs, guarantees and surrender schedules. Why: if the comparison does not exist, the recommendation has not been checked.
3. Time to think. Ask for at least a few days with the paperwork before signing. Why: urgency is the commonest warning sign in annuity sales to older buyers, as the guide on annuity sales abuses targeting seniors describes.
4. The free-look period. Ask how many days you have to cancel the new contract, and what happens to the exchange if you do. Why: the length varies by state and sometimes by age.
5. Your health and liquidity. Ask whether you may need long-term care, large medical bills or a move soon. Why: a lock-up you cannot afford is the worst outcome of a swap.

A worked comparison: move now or wait a year

Numbers make the cost of timing visible. This hypothetical ignores taxes, riders and any bonus so the arithmetic stays clear, and every rate is an illustration, not a quote.

Say your old annuity is worth $100,000 and credits an illustrative 3.00 percent a year. Its surrender charge is 3 percent this year and drops to zero next year. A new contract credits an illustrative 3.75 percent.

• Move now. The charge is $3,000 (3 percent of $100,000), so $97,000 reaches the new contract. After one year at 3.75 percent it is worth $100,637.50. After two years it is worth $104,411.41.
• Wait one year, then move. The old contract grows to $103,000 in year one (3 percent of $100,000 is $3,000). With no charge, the full $103,000 moves. After a second year at 3.75 percent it is worth $106,862.50.

At the end of year two, waiting leads by $2,451.09 ($106,862.50 minus $104,411.41). The faster rate on the new contract was worth $727.50 in the first year on the reduced balance ($97,000 times 0.0075), which did not come close to covering the $3,000 charge. In other words, the 0.75-point advantage needs more than four years to pay back a $3,000 cost, and a seller who talks only about the new rate leaves the cost out.

The example does not prove that waiting is always better. If the old contract's rate were poor, the new rate much higher, or the old company's strength in doubt, the answer could change. It shows the method: put both paths on the same page, to the same end date, with the cost of leaving included.

Alternatives to replacing

Before a swap, three smaller moves deserve a look.

• Wait out the schedule. If the charge ends in a year or two, staying put can be the cheapest step, as in the example above.
• Use the free withdrawals. Taking the allowed amount each year moves money gradually without a charge, though the withdrawals are taxed gains-first in a non-qualified contract and may carry an additional tax before 59½.
• Add instead of swap. New money can go into a new contract while the old one stays in place, which keeps the old guarantees. The cost is a second lock-up, so it makes sense only if you want the extra contract anyway.

When the checklist says no

If several items point the wrong way, the answer may be to keep the old contract. That is a legitimate result. Other options exist: wait until the surrender charge falls, use free withdrawals to move money gradually, or leave the contract in place and add a new one with new money.

If the list says yes, the answer should still be recorded in writing. Keep the signed forms, the comparison and the seller's explanation together with the contract. If you later believe you were misled, your state insurance department takes complaints, and the steps are in how to file a complaint against a life insurer.

Key takeaways

• A replacement should be judged by what you lose as well as what you gain: the surrender charge, the benefit base, the guarantees and the death benefit.
• A new contract nearly always starts a new surrender period, so compare the new lock-up with your age and your need for cash.
• An income rider's benefit base does not move with your money; the comparison must use the dollars each rider would pay.
• Ask in writing what the seller earns on the new contract and on the alternatives, and insist on the replacement forms and a written comparison.
• Keeping the old contract is a valid outcome, and a delay of a year can be cheaper than leaving now.