Dangerous Curves (Disintermediation) Ahead!

"Everybody knows that the plague is coming, everybody knows that it's moving fast" - Everybody Knows, Leonard Cohen/Sharon Robinson

Disintermediation: The?risk?of having to sell assets at a loss, to fund substantial cash outflows.?Now there is a word we need to dust off and all get to know again.?It was always the life insurance industry's fervent hope when, interest rates did start to reverse and move upwards, it would be very slowly and over a long period of time affording them a convenient opportunity to adjust for their in-force annuity book guarantees. Yah, well, that’s not happening.?Recent interest rate increases have been nothing short of titanic and the trend looks to be even more titanic. So, while .25% and .50% “nominal” increases don’t sound like much, it’s all about the percentage change. That’s the dynamic. On a $1,000 30 year US Govt bond when market interest rates change from 2.50% to 3.00% that’s a 20% increase.?All things else being equal, that equates to that US Govt bond dropping to about $825 in "market value" in other words, a loss of $175 (17.50%), ouch! Really ouch!

Because life insurance companies buy lot’s of bonds to back their annuity guarantees, this is where the disintermediation challenge begins.?And this has also been exacerbated by the annuity industry itself.?Over the last 15 or so years, instead of stop issuing new annuity business and exercising some measure of self-restraint (although a hand full of smart carriers did), the life insurance industry continued to issue billions and billions (maybe even a thousand billion?) of annuity contracts with crap (ultra low) interest rate guarantees. Because the interest rate guarantees are so low, in a rapidly rising interest rate market, these annuity contracts have very little chance of staying on the books because they are at extreme risk of being "replaced" by other annuity contracts with much higher rates of interest.

And to make matters worse, if that is even possible, many major carriers who issued the crappiest of the crap guarantees over the last 15 years or so are no longer in the annuity business!?Many of these carriers sold their annuity blocks or had them re-insured by PE or other groups.??Mostly these insurance companies remain as mere administrators of the annuity blocs while the real annuity liability now resides with others.

I know insurance companies (I can cite them but, not publicly) who issued annuity contracts with .50% (point 5%) lifetime interest rate guarantees.?There is absolutely no hope such contracts will ever stay on the books when new annuity contracts are crediting 2.00% - 3.00% or higher interest rates.??Upon a consumer “replacement request” placed by their agent, the ceding carrier will have to sell their bonds (at a loss) or perhaps borrow money; hopefully the borrowing cost will not be too high and send the cash from bond sale or loan proceeds to the new life insurance company to fund their prior client’s new annuity purchase reflecting the new annuity contract's higher interest rate appeal.

I personally know 10,000 annuity agents licking their chops having patiently waited decades to surf a tsunami of annuity contract replacement transactions and it’s all about to wash ashore on the annuity industry.?I only hope the carriers and or their “re-insurers” have their liquidity and capital mojo ready.?It’s one thing for life insurance companies and everyone else for that matter to make money and survive in “easy money” times, it’s quite another to survive in “tight money” times. I’m sure the ratings agencies are right now, moving life insurance company “liquidity studies” to the top of the check off list.

As carriers begin to stare down the maw of “disintermediation” and revitalize their in-force annuity contract “conservation” departments, agents, after decades, are finally about to get the opportunity to obtain better interest rates for their clients.?But agents will need to brush up on partial 1035s exchanges, partial annuitization and the serial contract income tax rules all of which; we really haven’t had to deal with for 15 or so years either.?

One thing agents need to keep in mind, if things start to get out of hand (client escalating liquidity demands); carriers can always shut down partial 1035 exchange and partial annuitization activity to help dampen this demand.?Besides enacting powerful annuity contract “conservation strategies” that drag client contract exchange activity over many, many months to complete (remember those days! Get ready. ) This liquidity is not guaranteed by client deferred annuity contracts. Everyone is dependent on the good graces of the annuity industry for such requests.??

Instead, agents need to brush up on the “serial contract” (see example below) tax rules and go “old school”.?Old school started after 1982 when the income tax code changed taxing annuity gains based on FIFO to LIFO. Agents responded by writing multiple smaller face contracts (deferred annuities - only, immediate annuities or deferred income annuities are not affected by the serial contract rule – thank God!) with different insurance companies to better manage withdrawal income tax issues vs having one large face contract with a single carrier. ?(So, instead of one $500,00 contract, the agent might have placed five $100,000 contracts with different carriers. A lot of work for the agent. Also, these five contracts would inevitability have; different interest rates, different terms and and conditions and different agent compensation. So, harder for the client to absorb all the differences.)

The IRS then, attempted to fix this loop hole in (TAMRA 1988) and then a further adjustment in (OBRA 1989).?The fix basically said; deferred annuity contracts issued by the same carrier or affiliate carrier within the last 12 months (TAMRA 1988) then, later changed to “last calendar year” (OBRA 1989) have to be “aggregated” to determine what portion of any contract withdrawal will be considered taxable.??This became known as; the “serial contract” rule.

Today, utilizing multiple smaller contracts and multiple carriers, not only will agents get better client diversified deferred annuity holdings vs just one large face amount contract from a single carrier, clients will be able to better exercise long term contract “disposition control” over their contracts. This results in more efficient income tax management without carrier interference. Your client shouldn't be damaged and suffer inconvenience accessing their cash value merely because the carrier or the industry is having some liquidity problems.?The bad news is; agents will have to do more applications for a single case but, the good news is; it will prevent the carriers from shutting your liquidity down later. ?

Serial Contract Example (But, let’s not let this happen)

A Client purchases new deferred annuity in January for cash and with the intention of withdrawing their gains (taxable) and some cost basis (capital sum) from the contract after the first year.?The client is “expecting” to make a $10,000 total withdrawal with only $4,000 from gains (interest earned) being taxed and it’s extremely important to this particular client his/her taxable gain be limited solely to these gains.?That’s what the agent told the client based on the first year guaranteed interest rate.

However, later that March, the agent also did a 1035 exchange for the same client from another annuity company to the new annuity company (a second contract) to get better/higher interest rates.?Sounds good so far, right? But this second contract, being an "old" contract, having a much lower interest rate also had a “low cost basis”. In other words, a lot of untaxed deferred gains vs its original capital/funding cost.?An income tax problem is about to ensue and ensnare the parties.

After the client gets a 1099R for the entire $10,000 withdrawal and trying to hunt down the agent who went into hiding, the now complaining/whiny annuity agent sneaks a cell phone call using a burner phone to the insurance company.?The insurance company says; ‘Hey, wait a minute, bonehead." "We have this second contract with all these deferred gains you also placed for the client last March to get a higher interest rate”.?You created a serial contract!” So, the $6,000 non-taxable portion withdraw the client was expecting from the first contract was tax reported as if it came from the second contract containing all the deferred gains. Bye!”

So the moral or the story is, if 1035 exchange activity heats up agents are going to have to pay close attention to the “tax basis” or the “untaxed” deferred gain amounts in old contracts when trying to maximize client post tax withdrawals and income benefits and not just to the really low interest rate.

Now, there could be good reasons to do a serial contract (not discussed) but if you, or if some “other agent” (and now you have a new client!) create an “unplanned” serial contract that ends up being a “surprise income tax moment” for the client, here is how you can break the serial https://garysmettler.com/deferred-annuities-breaking-the-serial-spia-rescue/

That’s it. "Always Keep Your Hands Up” – The Immediate Annuity Book