Scrutiny of Variable Annuity Sales Practices Intensifies
ecurities regulators have intensified their scrutiny of variable annuity sales practices. Consider that in June, the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) issued a joint report that identified "weak practices" regarding the suitability of those products for investors and the lack of adequate disclosure of the risks, fees and tax consequences. The NASD that month also proposed a rule imposing stringent sales practice standards and supervisory requirements. Let's examine the reasons for the regulators' concern.
In its rule proposal the NASD stated that it has brought 80 disciplinary actions in just the past two years regarding variable annuity sales abuses. The NASD states that these abuses include "excessive switching [of policies], misleading marketing, failure to disclose material facts, unsuitable sales, inadequate training and supervision of salespeople and deficient supervisory procedures." The SEC / NASD joint report notes that, "[h]igh commissions, typically above 5% for variable annuities, help drive sales of these products", and that the SEC, NASD and other regulators have received a "large number of complaints" from investors.
The SEC/NASD joint report lists several "weak practices". For example, they found that brokers gave "unfounded, false or misleading justifications" to customers to convince them to switch variable annuities, generating new commissions. Second, recommendations were unsuitable because of the customer's age, investment objectives, risk tolerance, need for liquidity, lack of need or desire for life insurance, and tax situation.
Lawyers counseling their clients should note that both the NASD and the SEC have issued informative guidance for investors on their websites. For example, the NASD has published an investor alert entitled, "Variable Annuities: Beyond the Hard Sell", available at www.nasd.com/investor/alerts/alert_variable_annuities.htm. Among other things, the alert details why the tax deferral feature of variable annuities may not be so valuable given that, during the distribution phase, earnings are taxed at the ordinary income tax rate (versus the lower capital gains tax rate on other investments). Likewise, proceeds of most variable annuities, the alert cautions, do not receive the "step up" in cost basis when the owner dies, unlike with other types of investments.
Another helpful publication is, "Variable Annuities: What You Should Know", available at www.sec.gov/investor/pubs/varannty.htm. In this publication the SEC discusses key features of variable annuities, including the recently popular "Bonus Credit" and why that may not be a bonus at all. These credits range from 1% to 5% of the variable annuity purchase and are added to the account value on the purchase date. Unfortunately, the SEC cautions that the bonus credit may carry a downside, in the form of higher expenses that can outweigh the benefit of the credit. The SEC notes that typically there are three ways that insurers charge investors for the bonus credit. They are higher surrender charges, longer surrender periods and higher mortality and expense risk charges.
A third helpful publication is, "Variable Annuities and Variable Life Products: Questions to Ask", available at www.sec.gov/investor/pubs/varaquestions.htm. There are five questions to ask. First, will the investor need the investment money in the next few years? If so, variable annuities are not appropriate because of their substantial taxes and charges that will apply.
Second, does the investor have enough money to purchase the annuity? The SEC cautions that if the investor does not, and, for example, needs to mortgage his or her home to purchase the annuity, then the annuity is not suitable.
The third question to ask, according to the SEC, is whether the investor is being urged to purchase the variable annuity (or variable insurance product) for his or her IRA, 401(k) or other retirement account. The SEC states that the tax benefit of the variable annuity (earnings accumulate tax deferred) is "of no value" in these accounts because they already are tax-advantaged.
Fourth, does the firm recommend this variable annuity product to all of its customers? The SEC recommends asking this question because everyone has different investment objectives, such that there should be no "one size fits all" investment recommendation.
The fifth and final question to ask, according to the SEC, is what will the investor lose if he or she is being asked to exchange a previously purchased variable annuity to purchase another variable annuity. These exchanges are highly suspect. Investors must compare the two products carefully. Factors to consider are that the new variable annuity may have a shorter guaranteed death benefit, may impose higher annual fees, and may impose a new "surrender charge" as well as a longer surrender charge period. Additionally, the old variable annuity may charge a surrender charge for leaving.
Investors, and their lawyers, need to be wary of variable annuity sales practices and disclosures. Heed the regulators' advice!
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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