Variable
Annuities: The new frontier in investor abuse
By Robert S. Banks, Jr.
Banks Law Office, P.C.
October, 2004
Variable annuities are a growing source of investor abuse. The NASD and the SEC both
have issued recent warnings to investors about these products, and they have received a lot ofattention in the financial press. In May, 2004, the NASD fined three brokerage firms, including American Express Financial Advisors, Nationwide Securities, Inc., and Nationwide Investment Services Corporation, $475,000 for NASD rule violations relating to variable annuities. The NASD has filed more than 80 disciplinary actions in the last two years involving variable annuity sales. The NASD has also issued notices to its members imposing suitability guidelines and sales practice warnings relating to variable annuity sales.
Investor claims involving improper variable annuity sales are among the fastest growing
new investor claims. In 2000, there were only 85 annuity cases filed with in NASD arbitration.
For 2004, it is estimated that more than 650 claims will be filed in NASD arbitration, based upon the number of filings through July, 2004. In the last year, Banks Law Office has filed several cases for investors who were sold variable annuities when they clearly were inappropriate for clients.
While there is no rule that can be applied to every situation, as a general principal, it is
difficult to justify the sale of variable annuities to:
Investors in lower tax
brackets
Investors who may need the money in less than seven years
Investors who purchase their investments in a qualified retirement account
Senior citizens
Investors who put more than 25% of their liquid assets into the variable
annuity
Below I have provided some basic information about variable annuities. It is designed
for investors who have already purchased variable annuities and are
left wondering what they bought and why they are not getting the
benefits they expected. Investors who are having second thoughts
about their
recently purchased variable annuity may be entitled to cancel the
purchase under a "free look" provision in the policy. You
should consult your prospectuses to determine whether you have any
rights under that provision.
Investors who are already locked in to variable annuity purchases
may have claims to unwind the purchases.
WHAT IS A VARIABLE ANNUITY?
A variable annuity is an investment contract between you and the annuity
company. It generally involves two phases: the accumulation phase and
the payout phase. During the
accumulation phase, the investor pays into the annuity. The accumulation phase can consist of a single payment, or a series of payments over time. During the payout phase, investors receive payments, either in a lump sum or as a series of payments over time. The amount of your payment will vary with the performance of the underlying mutual funds in the sub-accounts that were selected when you purchased the annuity.
The variable annuity funds are allocated among available mutual funds, or placed in a
fixed account, which pays a level interest rate. These are referred
to as the sub-accounts of the variable annuity. The mutual funds
include various degrees of risk, and investors and their advisors
are supposed to select those funds based on their risk tolerance.
Abuse occurs where the salesperson suggests or selects the funds
without proper regard for the investor’s risk tolerance. Any
investor who purchases a variable annuity that has mutual fund sub-accounts
must be made to understand that their investment is quite different
than a fixed annuity, and its payout will depend upon market performance.
Variable annuities typically include a death benefit. The death benefit may be nothing
more than a payment to your beneficiary of the value of the variable annuity. Investors may be asked to purchase additional death benefits which increase the payout to their designated beneficiary upon death. The death benefit can be a guaranteed minimum payment tied to the amount invested, for example. There is a charge for any increased purchase of the death benefit.
The underlying question for investors is whether the cost is worth the benefit, or whether it would be smarter simply to buy a basic life insurance product.
Some variable annuities also carry a guaranteed minimum income benefit (GMIB) which
provides a guaranteed income at some level tied to the amount of the investment or the value of the variable annuity at a particular time. There is a cost for this benefit as well.
Investors are sometimes offered a bonus program as an inducement to make their
variable annuity investment. Bonus programs can promise an investor a higher percentage
payout on their investment. But, as the SEC's Paul Roye warned in
2000, those bonuses can be illusory if the insurer simultaneously
increases
the surrender charges, increases the surrender fee period, and increases
the other asset-based fees. As Mr. Roye observed, "There is
no such thing as a free bonus."
There are other add-ons that are sold with variable annuities. Some of the more recent
offerings include long term care insurance. These benefits, too, cost money. All benefits should be compared to the cost of obtaining them through stand alone products.
TAX CONSIDERATIONS
The tax considerations related to variable annuity purchases are complex. Investors with
specific tax questions should ask qualified tax professionals. As an investment attorney who has been involved with a number of variable annuity claims, I can provide the following general considerations that all investment salespersons should discuss with the investor before recommending a variable annuity.
Variable annuities can offer tax deferrals. The gain in the value of the underlying
investments are not taxed until they are withdrawn by the investor.
However, if the investment money is already in a qualified investment
account, such as an IRA or 401(k), there is no additional benefit,
and the "value" of that advantage is lost. That is why
investments in variable annuities in an IRA accounts is problematic.
In addition,
the investment advisor must consider the tax bracket of the investor
to determine the value of the tax deferral. Those in lower tax brackets
are likely not to realize any significant tax benefits from the deferrals.
The withdrawals from a variable annuity are taxed at regular income rates. They are not
taxed at the lower capital gains rate that investments held more than one year normally enjoy.
Losses in variable annuities, like losses in IRA accounts, do not qualify as tax deductions
as they would if the investments were held in regular accounts.
There are some distinct tax disadvantages to variable annuities for tax planning purposes
as well. If, for example, the investor dies, his stocks are subject to an increased tax basis at death (based upon the value at death and not the purchase price). The result is to limit the tax to his heirs. If the assets pass to the beneficiaries of a variable annuity on death, there is no adjusted tax basis, and if the assets have increased in value, the beneficiaries can owe more in taxes.
COSTS AND FEES
The reason that variable annuities are being sold with increasing frequency and the
reason that they are disappointing investors are the same: a lot of fees, which are used to pay commissions substantially higher than those earned on sales of stocks, bonds or no load mutual funds. Bear in mind that a 6% fee means that the investment has to make 7% for the investor to make 1%. Fees make great sense for the issuing insurance company and the sellers, but are hard for the investor to justify. Variable annuity fees include the following:
Surrender charges. Like B mutual fund shares, variable annuities often have surrender
charges that apply if you wish to get out of the investment within the first 5-7 years of purchase. The fees start at 6% or even higher for the first year, and decrease 1% each year you are in the investment, until the fee disappears. In other words, if you find you need to sell the investment after the first year, you could pay a surrender charge of 6% of the amount withdrawn just in surrender charges, a very large fee. For that reason, anyone who may need the money before the surrender charges expire should not purchase a variable annuity.
Mortality and expense fees. M&E fees are typically over
1% per year. The justification
for these fees is the risk to the insurer that you will die and it
will have to pay the death benefit. However, some commentators and
regulators have said that the costs of the death benefit, including
the M&E fees, far exceed the costs of purchasing simple term
life insurance. That has been true in the cases I have handled.
Administrative fees. These fees are smaller administrative fees, and are typically a
fraction of a percent of the annuity value.
Mutual Fund fees. The mutual funds that are selected in the sub-accounts also assess fees
to investors, and investors will pay those fees as well.
Fees associated with riders purchased. As noted above, investors who agree to purchase
GMIB (guaranteed minimum income benefits) and death benefit riders will pay for them and for every other add-on to the variable annuity.
If salespersons and advisors fully explained all of the costs and fees associated with
variable annuities, it is highly unlikely that the sales figures would be as high as they are.
1035 EXCHANGES
The term "1035 Exchange" is a fancy way of saying rollover.
Section 1035 of the tax
code permits investors to exchange a variable annuity for a new variable annuity and avoid
paying taxes, just as an investor may roll an IRA account over to a new brokerage in a tax free transfer. 1035 exchanges might make sense for investors if their variable annuity is performing poorly, or if new features or better rates become available in new products. However, there are dangerous pitfalls as well. Even though the transfer may be tax free, the holder may well be subject to the surrender charges on the first account, which can be considerable. Also, the investor will be subject to new surrender periods which will begin to run anew. Also, the tax code requires there to be a true exchange in order to avoid a taxable event. An investor cannot sell his variable annuity and then use the funds to purchase a new one. There must be an actual exchange.
Before agreeing to a 1035 Exchange, investors understand the comparison of all the
features in the new and old variable annuities. As the NASD said
to investors in its February, 2001 Investor Alert on the subject, "You
should exchange your annuity only when it is better for you and not
just better for the person trying to sell you a new annuity."
If you have questions about the variable annuity that you purchased, please feel free to
contact our office. If you are considering a variable annuity purchase, I encourage you to discuss each of these points with your financial advisor and proceed with extreme caution before making a decision to purchase.
© Robert
S. Banks, Jr. 2004.
|
|
