Attorneys often split contracts in divorce settlements, unaware of the potentially costly impact
March 18, 2012
When a client came to his office bearing her new divorce decree, adviser Dale Russell became the bearer of bad news.
During the divorce proceedings, the couple’s lawyers decided that their chief financial asset, a $500,000 variable annuity inside one of their individual retirement accounts, was to be split among the two. But that Solomon-like decision was made without the attorneys’ awareness of its dire financial consequences.
Splitting the variable annuity meant that Mr. Russell’s client had to pay an 8% surrender charge and a 10% penalty for an early withdrawal from the IRA.
For Mr. Russell, vice president of Gallo & Russell Inc., the experience is hardly uncommon.
With nearly one in two marriages ending in divorce, financial advisers who deal with divorcing couples often face complex problems connected with untangling annuities that are in the pool of shared assets.
With divorce attorneys typically unaware of the nuances of annuity contracts and the various ways insurers treat contracts in the context of divorce, and with advisers typically out of the loop when settlements are hammered out, the problem lands in the lap of advisers.
“In the case of my client, there wasn’t much I could do in the way of alternatives,” said Mr. Russell, who hadn’t been consulted before the couple began preparing for the split.
“This was essentially the only asset they had, and instead of my client’s getting the $250,000 she expected, she’s getting almost $50,000 less,” he said,
“It’s a big problem, said adviser Lili A. Vasileff, president of Divorce and Money Matters LLC and president of the Association of Divorce Financial Planners Inc. “Most attorneys think these annuities can be divided, and don’t wait for the consequences.”
Couples who work out divorce agreements on their own are even less likely to consider the financial consequences of splitting an annuity, and typically face surrender charges and loss of accrued living or death benefits due to excess withdrawals.
What makes annuities peculiar is the fact that they usually are not liquid in the immediate term, and each contract has its own rules on how it can be divided.
Contract terms vary wildly among insurers, with some prohibiting partial tax-free exchanges into other annuities, which potentially could be a way to apportion an annuity in a divorce. Exchanges into a new annuity, however, generally involve the beginning of a new surrender period.
Ideally, an adviser would intercede early in the split, analyze the shared pool of assets and communicate with life insurers about the annuities. This would also entail ensuring that if an annuity split involved a partial Section 1035 exchange, the division would be performed without the risk of taxes.
“I had an incident with an accountant who thought the client would pay thousands more in taxes because the contract was split,” said Barbara Shapiro, president of HMS Financial Group. “We called the annuity company and they assured us that the division was nontaxable because it was incident to divorce.”
Ms. Shapiro added that when dividing annuities in this manner, she takes the extra step of noting in bold print that the transfer is nontaxable because it is in the context of a divorce — just to be safe.
It pays to be attentive to these details, advisers said, as insurers adhere strictly to the terms of the divorce decree.
“If the court says the contract needs to be split a certain way, we have our hands tied,” said Brian L. Kunkel, national director of advanced planning and solutions at Prudential Financial Inc.
“If the client calls us, we can outline the options available to comply with the court agreement and still be as contract-friendly as possible,” he said. “If people just process the agreement, then we merely follow the instructions.”
In most cases, a divorce decree absolves the attorneys involved from responsibility for any financial consequences.
If a court order of divorce specifies how an annuity is treated, then the liability on the attorney is mostly eliminated, even if there is economic harm to the client, said Steven B. Caruso, partner at Maddox Hargett & Caruso PC.
Determining the best way to treat an annuity with living benefits presents another series of problems.
Riders contain separate contractual provisions governing how they are treated in a divorce, and as insurers are always adding and removing riders, advisers need to be in the know. This is crucial because living benefits in an existing annuity may no longer be available on a new annuity, should the owner decide to share the asset through a partial exchange.
“There could very well be an actuarial value in a living benefit that’s beyond the value of the contract,” Mr. Kunkel said. “You may want to hire a valuation expert on the annuity, especially if there’s a large discrepancy.”
It might make sense to leave the annuity intact and allow one party to keep it while the other gets something of equivalent value.
Such was the conclusion reached by Scott Stolz, president of Raymond James Insurance Group, after he was called in by attorneys to testify as an expert witness in a divorce that involved four insurers and the division of 20 annuities.
Each insurer had its own terms for dealing with divorces, and the ordeal encouraged him to begin working on a resource manual on this topic for advisers.
“There were so many policies, it was easier to come up with a combination that made sense,” Mr. Stolz said of the divorce case.
“If you have one or two policies, you have to say, “You take the annuity and I’ll take the house.’ It never makes sense to divide the annuities up,” Mr. Stolz said.