Annuity sales can destroy estate planning strategies

Insurance agents and advisers are hawking annuities without grasping the adverse impact on clients' estate plans, industry observers said. The annuity industry brought in $189.4 billion in year-to-date sales by the end of the third quarter last year, a 6% gain from the same period in 2006, according to data from Limra International Inc., in Windsor, Conn. With those numbers in mind, a big concern among attorneys is that insurance agents are hailing the tax benefits of the policies to persuade clients to buy them, oftentimes without regard to the negative impact on estate plans. Additionally, some believe insurance agents aren't reading or understanding the contractual provisions of the annuities — which detail tax risks for trusts — that clients then sign.
"Many trusts are drawn to continue beyond the death of the owner," said David F. Sterling, a financial consultant and attorney at Sterling Capital Resources of Sarasota, Fla. "When the trust receives and deposits the annuity profits, they could be subject to an onerous tax rate." It's not necessarily the annuity purchase that is the problem, but rather how it works in this context, lawyers said. For example, certain tax-deferred annuity contracts stipulate that an investor can designate a trust as the owner and beneficiary of an annuity as "an agent for a natural person." Since trusts are "non-natural" entities, the investor is still considered the owner of the contract, and the annuity remains tax-deferred. However, depending on the structure of the trust, a detail in the tax code could force the payout of the annuity in the trust within five years if that investor dies. In this case, the annuity's profits are then taxed at the rates for a trust, as opposed to the rates for an individual. Last year, for example, a trust needed to earn just $10,450 in order to be subject to the 35% income tax rate — which is higher than the tax rates assessed for individuals. The problem is especially serious for multigenerational trusts, Mr. Sterling said. Lawyers said they aren't always consulted about the policies. "The problem I have is that insurance agents sell a life insurance policy or an annuity, and then refer the case for tax advice," said Steven M. Chamberlain, a tax attorney in Cocoa, Fla. A classic situation is when a client purchases a life insurance policy or an annuity with a death benefit, transfers it to the trust to avoid estate taxes, but dies within the Internal Revenue Service's three-year "look back" period for asset transfers, he said. If this happens, the full proceeds are considered part of the taxable estate. "You don't go to the insurance agent to get tax advice, but a lot of people do because they get it for free if they buy the policy," Mr. Chamberlain said. "Then, agents don't want to refer cases [to the tax attorney], because they're afraid they'll lose the sale."

ACCOUNTABILITY

Liability for an improper annuity sale in the estate-planning context is foggy at best. The assumption is that a financial professional who sells an annuity also understands the product, particularly if he or she is selling it for a purpose, such as a tax benefit, regulators said. "If a broker recommends a product for tax effect, he must understand how it works for that product and understand why it's suitable for that customer," said Tom Selman, executive vice president of the Financial Industry Regulatory Authority Inc. of Washington and New York. The fiduciary responsibility of financial advisers requires them to ensure that the sale won't destroy estate-planning strategies. "I have to believe that you would need to do enough inquiry to know how the trust would be held with the annuity and to know if it's in the best interest of the customer," said Patricia D. Struck, administrator of the division of securities for the Wisconsin Department of Financial Institutions. She is also former president of the North American Securities Administrators Association in Washington. Proper comprehension of the annuity contract, however, calls for legal expertise beyond most planners' abilities. "You have to be competent to read that contract, and [agents] are not," said David Mendels, director of planning at Creative Financial Concepts LLC, a New York firm that manages $20 million. Financial professionals normally don't call an investor's estate- planning attorneys; the clients are expected to initiate that meeting. But customers may not know when it's time to request their attorney's help, and this turns the odds against them if they pursue action after a sale that harmed a trust, some financial advisers said. "The assumption in arbitration is that it's the client's responsibility to know this stuff," said Bedda D'Angelo, managing director of Fiduciary Solutions, a Durham, N.C.-based firm that has $25 million under management. She has participated in arbitration and mediation cases as an expert witness. "The person filing the claim has to prove that they were incompetent," Ms. D'Angelo said. Naivet is no excuse, because clients are saying when they sign the annuity contract that they have sought advice from their tax adviser or attorney, she said. Some advisers said that they encourage their clients to consult their lawyer before purchasing an annuity. "I never went to law school," Mr. Mendels said. "The adviser's job is that if they know they're using a sophisticated strategy, they need to urge the client to consult the attorney." Certain carriers have advanced sales teams with accounting and legal help. Planners can work with this team and clients' attorneys to address complex tax issues. "The main objective is to provide the adviser with the contract information in the annuity on the underlying tax codes," said Michael Berry, Des Moines, Iowa-based head of advanced-annuity sales for ING Groep NV of Amsterdam, Netherlands. The team will also notify the agent if the sale conflicts with a trust. At this point, the onus is on the registered rep if he or she pursues the purchase. However, it's up to the agent to enlist the group's help, Mr. Berry added. Mr. Sterling encourages his peers to work together, not only to serve clients better but to avoid litigation. "I haven't met a lawyer that has received a call from an adviser or a client on buying an annuity," he said. "If I, as your attorney, hand you a contract and you find out I haven't read it, that's malpractice," Mr. Sterling said. "If I do this as an adviser or broker with an annuity contract, it suggests financial malpractice." Darla Mercado can be reached at dmercado@crain.com.