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Regulation of Variable Contracts
The Commission, The Financial Service Professional and the Big Picture
by Joseph C. Cascarelli, JD, CFS
Copyright © 2001. Reprinted with permission of the Society of Financial Service Professionals
n June 5th, 2000, the Securities and Exchange Commission (SEC) released an on-line brochure to help investors better understand the benefits, risks, and costs of variable annuities. The brochure is entitled Variables Annuities: What You Should Know.1
Throughout the brochure, the SEC injects cautionary remarks relating to suitability of variable annuities for certain investors. For instance, the SEC suggests that investors who purchase variable annuities through a tax-advantaged retirement plan (such as an IRA) receive no additional tax advantage from the annuity. According to the SEC, such investors should have a different investment objective in mind-lifetime income payments and/or death benefit protection, for example-rather than that of deferring payment of income taxes on current income growth and accumulation.
Because of these "cautionary remarks," a number of newswire services categorized this release as an "investor alert." The Associated Press, for instance, writes, "… federal regulators warn that variable annuities, an increasingly popular way to save for retirement, also have pitfalls…" The SEC would probably agree with this categorization. Some members of the financial services community will most likely see this investor alert as another regulatory intrusion into an already highly-competitive market that will become heightened once the repercussions of Gramm-Leach-Bliley are fully felt.2
Two years ago, the Committee of Annuity Insurers commented, "Annuity writers face fierce competition from other financial institutions for retirement dollars … Committee members have a vital interest in their continued ability to offer innovative retirement savings products within the bounds of … the Securities Act of 1933 … Innovation is the lifeblood of the financial services industry."3
Touché.
What is the basis for SEC apprehension?
The same day that the SEC released its on-line brochure, it also released The Changing Landscape of Variable Annuities.4 SEC Director Paul Roye remarks that the SEC "understand(s) that [the annuities industry] operates in a competitive environment; however, increasing sales at the expense of this for whom these products are not suited will not be tolerated" by the SEC. He recommends that industry leaders examine the NASD Notice to Members 99-35.
This notice reminds members of their responsibilities when selling variable annuities.5 Curiously, the notice concludes citing a notable disciplinary action case involving sales of variable life insurance contracts rather than variable annuities. Notwithstanding genuine differences between variable life and variable annuities contracts, there is a common ground shared by both-suitability. Market conduct when selling variable contracts is central to SEC concerns.
Case in point: A client declares that his investment objective is to save money and plan for retirement. He wants to save the $250 check received monthly for military service. He is a 28-year-old postal employee, married with one child, two years of college, and no prior investment experience. He has $4,000 in a government savings plan, $2,800 in an IRA, and $1,400 in government bonds. He already has a $500,000 term insurance policy, and expressly tells the agent that he is not interested in purchasing another insurance policy. The client nonetheless purchases a variable product, of which $432,000 is in life insurance, only because the agent claims the insurance component of the product is "incidental to the financial plan." To make the financial plan work (according to the agent), the investment must be wrapped with insurance so that "we could get from point A to point B without being taxed on it or taxed later on it." Thus $432,000 in additional life insurance was sold to a client who clearly said that he neither wants nor needs additional insurance.
Yet another case in point: A client declares that his objective is to eliminate some debt, begin a savings program, enroll in college, invest $5,000, and save money to purchase a home. He is 22 years old and married without children. The married couple expressly tells the agent that, although they would consider purchasing some life insurance, it is definitely not a priority at this time since they do not own a house or have children. The priority is education, as the client is "going to need to start school soon and … needed to generate something to help with school costs." Knowing this, the agent sold this couple a $366,299 face amount variable life contract with a $500 initial premium and a $500 planned quarterly premium. Together, the couple was earning, at that time, only $34,000 annually. They purchased a variable life contract on the agent's claim that virtually all initial premiums would be placed in the investment portion of the policy, leading the clients to believe that "almost all" of their premium would be invested in various investments, net of fees. Their express objective was to save money and receive a return on their investment in the near term to eliminate debt and purchase a house, in addition to paying for education. Instead, the agent sold them a variable contract that would not be fully liquid until policy year 10, requiring long-term commitment because of contingent deferred sales load-in short, an illiquid investment with an insurance component.
In a final case, a 50-year-old recently-divorced woman wanted to invest her $20,000 divorce settlement for retirement. She expressly told the agent that she had absolutely no interest in purchasing life insurance and did not want to devote any of her funds towards buying life insurance. She wanted a product that satisfied her retirement needs and would not erode her investment with imposed fees. The agent sold her a $246,305 face amount variable contract with a $6,560 initial premium and $4,000 planned annual premium. The agent described the variable contract as a mutual fund with little or no insurance component. Exactly one year later the client surrendered her policy because she could not afford the premiums.6 She got what she didn't bargain for-a financial product with fees that eroded her investment.
With regards to the aforementioned "cautionary remarks" relating to "charges" in the SEC's variable annuities brochure, the SEC suggests that investors ensure that, before they invest, they comprehend the charges associated with a variable contract. In addition to mortality and expense risk charges, administrative fees, and expenses associated with mutual fund investment options, these charges also include sales charges payable on surrender. As is evident in the case of the 50-year-old divorcee, the agent did not adequately explain (or did not explain at all) the surrender charges in the variable contract.
True, annuity writers face fierce competition for retirement dollars and agents in the field face tough competition with each other for the same retirement dollars. Nonetheless, the legal reality is that the SEC is charged with a Congressional mandate to prevent fraud in the securities industry.
When the need to compete causes harm to the customer, we must expect that the SEC will do its job. According to Roye; "The SEC has an obligation as a cop on the beat to see what's going on."7
Guideposts for the Variable Guideposts Practitioner
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NASD Interpretive Materials IM 2210-2 (March 1994)
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NASD Notice to Members 96-86 (December 1996)
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NASD Notice to Members 99-35 (May 1999)
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NASD Notice to Members 99-103 (October 1999)
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NASD Notice to Members 00-44 (July 2000)
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Communications with the Public About Variable Life Insurance and Variable Annuities
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NASD Reminds Members and Associated Persons that Sale of Variable Contracts are Subject to NASD Suitability Requirements
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NASD Reminds Members of their Responsibilities Regarding the Sale of Variable Annuities
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SEC Approves Rule Change Relating to Sales Charges for Investment Companies & Variable Contracts
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NASD Reminds Members of their Responsibilities Regarding the Sale of Variable Life Insurance
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Web Site Links
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http://secure.nasdr.com
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http://www.nasdr.com/
pdf-text/9686ntm.pdf
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http://www.nasdr.com/
pdf-text/9935ntm.pdf
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http://www.nasdr.com/
pdf-text/99103ntm.pdf
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http://www.nasdr.com/
pdf-text/0044ntm.pdf
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Because variable products require contract owners to assume investment risk, variable products are securities subject to the Securities Act of 1933; because variable life insurance and variable annuities are securities, their distribution is, according to NASD Notice to Members 99-35, subject to NASD rules.
NASD Notice to Members 96-86 reminds us that members and associated persons are subject to suitability requirements of NASD Conduct Rule 2310. These apply to the recommendation and sale of any security, including a variable contract, to every client and prospective customer.8 When recommending the purchase, sale, or exchange of any such security to a customer, members must have reasonable grounds for believing that a recommendation is suitable for the customer based on facts disclosed by the customer's securities holding, financial situation and needs, or by the customer during interview.
There are specific NASD suitability factors that should be considered when recommending variable contracts:
representation by the customer that life insurance needs are already adequately met;
customer's express preference for an investment other than an insurance product;
customer's willingness to invest a set amount on a yearly basis;
customer's need for liquidity and short-term investment;
customer's immediate need for retirement income;
customer's investment sophistication;
whether he or she is able to monitor the investment experience of separate accounts;
customer's inability to fully appreciate how much of the purchase payment premium is allocated to cover insurance or other costs; and
customer's ability to understand the complexity of variable products in general.9
This last factor is particularly relevant to the SEC brochure's discussion of "bonus credits" in connection with variable contracts. Bonus credits bear witness to the fact that "innovation is the lifeblood of the financial services industry." These annuities promise to add a bonus to contract value based on specific percentages (typically, 1% to 5%) of the purchase payments. If a variable contract is purchased offering a bonus credit of 3% on each purchase payment, and, if a purchase payment of $20,000 is made, the insurer issuing a contract will extend a "bonus" of $600 to a separate account.
From a marketing perspective, this has substantial appeal. Bonus credits offer investors opportunities to put their entire investment, plus a little extra, to work immediately. This is the upside. The downside is the amount insurers must charge for offering these bonus credits to investors.
Insurers frequently recapture bonus credits by charging investors a surrender charge that may be higher for a variable contract that pays bonus credits than for similar contracts that pay none. Or, the period subject to surrender charges may be extended to a period of time longer than a similar contract offering no bonus credits. Finally, bonus credit contracts frequently charge higher mortality and expense risk charges than similar variable contracts not offering bonus credits. Some insurers impose separate fees for the specific purpose of paying for the bonus credit.10 When bonus credits are extended to investors, there is usually an increased charge somewhere in the variable contract.
The focus of debate over bonus credit annuities, therefore, is " … whether they are merely income bonanzas for unscrupulous producers with little worth to the customer, or items whose features can add genuine overall value to an investor's portfolio."11 According to The Wall Street Journal, "One executive said the SEC expressed that they are more curious about how the annuities are being marketed and sold than in the annuities [themselves]…"12
Suitability Factor #7 of NASD Rule 2310 applies here: (a) Is the customer able to fully appreciate how much of the purchase payment premium is allocated to cover insurance or other costs? (b) What is the customer's ability to understand the complexity of variable products generally?
Factor 7(a) applied to the sale of a $246,305 variable contract and $6,560 initial premium to the 50-year-old divorcee.
Factor 7(b) relates to the complexity of annuities contracts. Thomas F. Streiff is on target with what he wrote for the National Underwriter, "Expertise in annuities is often overlooked. Many agents and planners feel that annuities and related issues are fairly straightforward and easy to understand. Typically, these are the same agents and planners that are not very close to the subject."13
Annuities are sophisticated financial vehicles. Even if not overly complex for agents (Mr. Streiff's caveat notwithstanding), annuities are complex for average customers. A prime example is the impact of "1035 exchanges" on "bonus credits" contracts.
Investors who own one annuity and are looking to exchange it for a different annuity with bonus credit features should be careful. Even if surrender periods on current annuity contracts have expired, new surrender periods will usually begin when former contracts are exchanged for newer ones. Customers could end up paying surrender charges on new contracts, as well as incur other fees and expenses higher than bonus credits earned on newer policies. Even if this concept is easy to understand, doing the math is a different story.
When customers come to a professional, they are looking for the "right" and best possible solution to their investment problems. On the market side, Mr. Streiff says, "Awareness and expertise breed the trust that your clients are searching for."14 On the regulatory side, Director Royce reverberates the same idea, "The future of your business lies in the trust of your customers."15
Are bonus credit variable contracts inherently wrong? No. Is it unethical to exchange one variable contract for "bonus credit" variable contracts? Not necessarily.16 Suitability and proper disclosure are the order of the day.
The professional is keeper of the gate. He stands sentinel over the assets a customer is willing to part with, along with trust. He owes his client independent judgment. Suitability means that such professionals will make independent determinations whether this investment is suitable for this customer, taking into consideration this customer's investment objectives and financial needs.17
It is no defense to the charge of unsuitability that an unsophisticated customer received a prospectus.18 Nor is it a defense that an agent determined his customer met the firm's internal suitability or underwriting guidelines. Fulfilling suitability obligations means the agent must make an independent determination that the investment recommended is suitable.19
Suitability, not profitability, is the measure of market conduct. NASD Interpretive Material 2310.2(a)(2) insists that "… sales efforts must be judged on the basis of whether they can be reasonably said to represent fair treatment from the persons to whom sales efforts are directed, rather than … [whether] they result in profit to customers." The SEC will enforce this principle.
On the positive, this is central to being a professional.
Is the recent SEC "investor alert" a shot across the bow? Probably. Recent examinations of 52 investment and insurance companies selling variable annuities in 1999 resulted in approximately 80% of these companies being cited for failing to adhere to sales practice regulations.20 Does the SEC brochure suggest that the variable annuities industry may be targeted for closer scrutiny? Likely. Cerulli Associates, a Boston financial consulting firm, estimates that approximately 40% of tax-free exchanges come from "questionable broker-driven sales."21 One stockbroker's complaint about annuities: "We've asked several big producers to find another firm because of their variable annuity business. It's not the products that are the problem; it's the way they are sold."22 The SEC wants to know whether these sales are suitable and whether costs are fully disclosed.
The big picture is this: regulators and financial service industry participants share a common interest in maintaining integrity in our dynamic industry. Regulation is the trade-off for being acknowledged as professionals-we "observe high standards of commercial honor and equitable principles of trade" in accordance with NASD Rule 2110.
Joseph C. Cascarelli, JD is director of Professional Development at the Society of Financial Service Professionals.
Notes:
1
http://www.sec.gov/pdf/varannty.pdf [pdf] or
http://www.sec.gov/investor/pubs/varannty.htm [text].
2
Popularly known as the Financial Services Modernization Act of 1999, Pub.L.No. 106-102, 133 Stat. 1338 (1999), Gramm-Leach-Bliley (GLB) repealed the Glass-Steagall Act (a depression-era law that separated investment banking from commercial banking) and opened the door to full integration of banking, insurance, and securities services into "one-stop shopping." In time, GLB may lead to the creation of the new, modern financial services company.
3
Reference is no longer available (http://www.sablaw.com/bros/corpart/mjweip.html).
4
http://www.sec.gov/news/speech/spch379.htm.
5
http://www.nasdr.com/pdf-text/9935ntm.txt.
6
In re Miguel Angel Cruz, No. C8A930048 (31 Oct. 1997). Reference is no longer available (http://www.nasdr.com/pdf-ext/nac1197_02.txt).
7
http://www.bestreview.com/2000-07/lhcanannuities.html#sec.
8
http://www.nasdr.com/pdf-text/9686ntm.txt.
9
Id.
10
http://library.northernlight.com/SM20000505060000080.html?cb=0&sc=0#doc.
11
http://library.northernlight.com/TP20000224020000055.html?cb=0&sc=0#doc.
12
http://library.northernlight.com/ WS2000012504 0000044. html? cb=0&sc=0#doc.
13
See National Underwriter at 16 (8 May 2000).
14
Id. at 17.
15
Supra note 3.
16
See NASD Notice to Members 00-44 for helpful guidelines when supervising variable life sales and replacement of variable annuities. http://www.nasdr.com/pdf-text/0044ntm.txt.
17
Supra note 6.
18
In re Larry Ira Klein, http://www.sec.gov/litigation/opinions/3437835.txt.
19
In re Nazmi C. Hassanieh, Exchange Act Release No. 35029 (30 Nov. 1994).
20
http://www.bestreview.com/2000-07/lhcanannuities.html#sec.
21
Reference is no longer available (http://library.northernlight.com/UU2000713030054274.html?cb=0&sc=0#doc).
22
http://library.northernlight.com/PB20000320140000233.html?cb=0&sc=0#doc.
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