PUBLICATIONS
VARIABLE ANNUITIES: A PRIMER FOR CLAIMANTS'
COUNSEL
Published in the PIABA Law Journal 2003 and The Practicing Law
Institute, 2003
As an expert witness, mediator, and arbitrator,
most of the cases in which I’ve been involved have concerned
suitability or supervision in the context of the usual retail
disputes between brokers and customers. But because I formerly
held a unique management position with Merrill Lynch as the District
Annuity Specialist in their New York City District, I also am
being retained in a lot of cases involving the sale of variable
annuities. Since variable annuity cases seem to be becoming more
prevalent, I believe it behooves a claimant’s attorney to
have at least a basic familiarity with certain concepts and problems
surrounding this unique form of investment. While the subject
of variable annuities can be explored with differing degrees of
complexity, this article is intended as a primer.
An annuity is a contract between an insurance
company and a customer who, as purchaser, is designated as the
“owner.” The owner pays the insurer a specified amount
and, in return, can receive regular payments either for life or
for a stated period of time or does not immediately take payments
and simply lets the contract grow on a tax-deferred basis until
withdrawn, usually after age 59 1/2. At that point, one can mitigate
the tax bite by "annuitizing" the money--in other words,
converting the assets into a monthly stream of income which enjoys
only partial taxation (the monthly payment will consist of interest
which is taxable and principal, which is not).
There are two broad categories of
annuities–-fixed and variable. Fixed annuities provide a
specified rate of return. But variable annuities contain numerous
investment choices known as sub-accounts, which are similar to
mutual funds. With the exception of various money market selections
made available to variable annuity owners, the value of assets
allocated to the sub-accounts will fluctuate according to the
performance of their underlying securities. This daily fluctuation
renders the annuity “variable” in value from day to
day. The sub-accounts are priced at the close of each trading
day, just like mutual funds. Variable annuities are registered
with and approved by state insurance commissioners. But because
these annuities are investment contracts, the broker selling them
must also be registered and licensed to sell securities in the
states in which they are sold.
Variable annuities are a notorious vehicle
for abusive sales practices. The reason many brokers are prone
to commit these abuses is that the combined commissions from the
sale of a typical variable annuity are higher than commissions
from almost any other product. Not only does the broker get a
sales commission, but the broker-dealer also gets sales credits
or “trailers” which in turn are partially passed on
to the registered representative on a quarterly basis. These additional
payments consist of a percentage of the asset base, usually .25%
or higher. But since there is no front-load to variable annuities--100%
of the principal goes into the contract--one might wonder where
the insurer gets the money from which to pay these higher commissions.
The answer is that the insurance carrier “fronts”
the commission to the broker-dealer and recoups this money through
the death benefit charge, known as the “mortality and expense
risk” or “M&E.”
In order to ensure that the M&E will
be in place long enough to compensate the insurer for the fronted
commission expense, the insurer includes a contract feature called
a Contingent Deferred Sales Charge or “CDSC.” (It
is also known as an Early Surrender Charge). If, for carrier six
or seven years to recover the commission and turn a profit. Thus,
most variable annuities carry a longer surrender period. The owner
must pay a penalty for premature withdrawals or surrendering the
contract during this period. The penalty decreases each year until
it disappears completely in the pre-specified year of ownership.
Recently, variable annuities without surrender charges have begun
to emerge, but most contracts still contain some form of penalty
to impede immediate and unfettered liquidity.
The M&E charge isn’t the only
reason variable annuities are expensive. They also are loaded
with other costs as well, including annual administrative fees
and sub-account management fees. The combination of all standard
fees associated with a variable annuity usually will cost the
owner in the neighborhood of 2.5% annually. With the election
of certain optional features, that cost can go even higher. In
comparison, the fees for mutual funds are typically 1.5% a year
or less. It obviously is a disadvantage for any investor to start
out in the hole by the amount of these fees.
Unfortunately, a lot of customers aren’t
told about the surrender period and the high charges. Financial
professionals called to task for failure in this regard often
will argue that the information was disclosed in a prospectus,
but all too often clients rely on the broker and don’t read
or fully understand prospectuses.
Another significant abuse can occur when
the customer is told that the contract is “guaranteed,”
meaning he or she supposedly will receive at a minimum the amount
of purchase payments less sums withdrawn. The problem is that
brokers and advisors don’t always explain that the owner
(or third-party annuitant) must die before that money is payable.
A person who buys the annuity solely or primarily as a means of
funding retirement rather than as a substitute for life insurance
would obviously be unwilling to incur substantial example, the
M&E is 1.25%, it will take theadditionat expense for a death
benefit. Moreover, the guarantee is illusory for most customers
since the industry only experiences about a 2% mortality rate
among holders of variable annuities.
Consequently, the M&E expense is a
tremendous moneymaker for insurance companies.
Another frequent abuse in the variable annuity arena is the practice
of soliciting exchanges of annuity contracts primarily for the
purpose of generating commissions. This is equivalent to the practice
of “twisting” in the sale of life insurance policies.
With respect to customers whose surrender period in the original
contract has partially or completely expired, this practice can
be totally inappropriate and a serious sales abuse since it can
subject that customer to a new long-term holding period encumbered
by a new CDSC.
With all of these negative qualities and
the incentives presented for sales abuses, one might wonder if
variable annuities have anything going for them. In fact, they
do have several attractive features. But, unfortunately, these
features sometimes are accompanied by other problems or play a
role in additional potential abuses.
The key benefit of variable annuities, without doubt, is tax deferral.
Growth in both the fixed and variable annuity sub-accounts is
not subject to income tax until it is withdrawn. (Of course, if
the value of the contract has depreciated, withdrawals will be
from original capital and are not subject to tax for that reason.)
While tax deferral is a seductive benefit,
there are also tax drawbacks to variable annuities. Withdrawals
from gains (or growth) in variable annuities do not enjoy the
potential capital gains treatment from profits earned from mutual
funds, bonds, or stocks. Rather, withdrawals from variable annuities
are taxed as ordinary income. Moreover, the entire value of the
annuity will be included in the estate tax calculation. This combination
of income tax and estate tax constitutes double taxation without
the luxury of the stepped-up cost basis that occurs with most
other investments. For this reason, variable annuities are almost
always unsuitable for high net worth individuals. In fact, during
my tenure as an annuities specialist in the wealthy New York City
District, I discouraged many annuity sales for this very reason.
A second attractive feature of variable
annuities is the opportunity they present for guaranteed income.
An owner obtains this income stream by “annuitizing”
the contract. When the contract is annuitized, the principal is
transferred, usually irrevocably, to the carrier in exchange for
income for the life of either the owner or a non-owner annuitant.
An annuitant is the person on whose life expectancy the annuity
payments will be calculated. The annuitant and the owner usually
are one and the same, but they need not be. Most annuity contracts
can be annuitized at any time. Insurance companies generally offer
several income selections in addition to a life-only option.
For example, the customer might choose
life with 20 years certain: if death occurs during the first 20
years, the income is guaranteed to the beneficiary for the balance
of the 20 years. In any event, once the customer has selected
an income option, payments begin based on prevailing interest
rates and the age of the annuitant. Again, this decision is irrevocable.
Having a guaranteed income scheme is great
for some people, but annuitizing the contract has a serious drawback
in that it renders the investment entirely illiquid. Since the
balance in the account must be irrevocably transferred to the
carrier, there would be no recourse to the annuitized principal
in the event the client should need capital.
The third key selling point to a variable
annuity is the death benefit. A guaranteed death benefit pays
to the beneficiary the greater of the principal deposits, less
withdrawals, or the value on the date of death (or the ‘stepped-up’
value). But again,death benefits are rarely paid and the feature
is very expensive. Even after the death benefit levels off at
age 80 or less, as is the case with most contracts, the M&E
cost continues to rise over time as the value of the investment
increases. And, of course, the death benefit is no benefit at
all absent a death. This seemingly obvious fact has been purposely
obscured by rogue financial professionals who refer to the “guaranteed
value” of the contract, confusing the purchaser into believing
that the value of his or her principal payments are guaranteed
during the purchaser’s life. This is a particularly egregious
sales abuse.
In sum, the three primary selling points
for investing non-qualified funds in an annuity are tax deferral,
income stream, and death benefit. And, as now should be clear,
each of these features carries baggage.
What about variable annuities in IRA’s
or ERISA accounts? About one-third of total sales go into ERISA
accounts, excluding TIAA-CREF. Here the need for justification
and close supervision is greater. Why use tax-deferred funds in
a tax-deferred vehicle?
In my mind there are only two plausible rationales,
and neither is particularly strong in itself. One is the death
benefit. I’ve discussed that feature above, but there is
an additional problem that can mitigate this benefit for many
retirees. When income is withdrawn from the contract, the death
benefit is reduced by the amount of the withdrawal. Since people
who attain the age of 70 1/2 are required by the IRS to take mandatory
withdrawals, it is conceivable that the death benefit could be
substantially reduced in a relatively short period of time. Yet
the cost of the benefit remains predicated upon the initial investment.
This also would apply to people under age 59 1/2 who elect under
IRS 72-T to withdraw funds without the 10% excise tax.
The second rationale for investing qualified
funds in a variable annuity is the ability to reallocate or exchange
among sub-accounts involving multiple fund families. For example,
within the annuity one can quickly and easily transfer money out
of a sub-account managed by American Funds. Outside of an annuity,
such a transfer between fund families would be a more complicated
and time-consuming procedure and would probably cause the customer
to incur new charges. While this multi-family exchange feature
inside annuities is an advantage, it hardly seems to be sufficient
grounds in itself for purchasing a variable annuity to invest
qualified funds.
Consequently, there appears to be little justification
for placing qualified funds in a variable annuity or vice-versa.
Reasons can be mustered, but when one eliminates the primary benefit–tax
deferral– the higher costs and disadvantages of variable
annuities renders them suspicious for qualified accounts.
Having discussed many of the standard features
of variable annuities, I wish to briefly mention some of the new
wrinkles beginning to appear in these contracts. One of these
is a bonus credit feature. The insurance company promises to add
a bonus to the customer’s purchase payments in some pre-stated
percentage. For example, if the contracts calls for a 3% bonus,
and the customer deposits $50,000.00, the insurer will add a bonus
of $1,500.00 to the account.
But bonus credits come at a cost, usually in
the form of higher surrender charges, longer surrender periods,
increased M&E expenses, or other fees.The customer may eventually
pay more in the way of penalties and fees than he or she has received
as a credit. Moreove, unscrupulous or even careless brokers often
use promises of bonus credits to entice annuities owners to engage
in tax-free Section 1035 exchanges from one carrier to another.
The broker gets a commission, but the customer frequently will
be hit with a CDSC from the original carrier, and the new contract
may start a new surrender period running. I say “may”
because contracts without surrender charges do exist. They can
be freely surrendered at any time without penalty, although they
still have higher fees than alternatives like mutual funds.
The most eyebrow-raising feature to appear lately
is the “living” performance guarantee or “guaranteed
minimum income benefit.” Different carriers have different
names for it, but the feature generally is described as providing
a 6% per year minimum performance guarantee, regardless of actual
performance. Customers are told they will receive that 6%, even
if the account loses money, but can receive the actual value if
that proves to be higher than the 6% guarantee. Talk about seductive–-this
guarantee seems like a no-lose proposition. Unfortunately, not
every broker makes clear that the feature requires the contract
to be kept in force for a long time, usually 10 years, before
it can be utilized. Furthermore, the client must annuitize the
contract in order to get the guarantee. In other words, the customer
must irrevocably transfer the principal to the carrier in exchange
for payments (factored at a very low interest rate) during a selected
optional period such as life or 10 years certain. Of course, if
the client dies before the value of the funds has been paid out,
the insurance carrier wins the mathematics game. And this feature
adds an extra cost above the regular M&E fees, putting the
total contract fees at around 3%, a staggering expense.
In conclusion, variable annuities are not completely
devoid of beneficial features and are not unsuitable for everyone.
Yet sales abuses abound, the features of variable annuities have
often been misrepresented or not properly explained, and there
usually are alternative choices for most investors with lower
costs. If you are called upon to review a client matter involving
possible misconduct in the sale of variable annuities, the following
check lists might be helpful in determining whether the seller
has engaged in sales abuses:
1. Age of purchasers. Above 70 is highly questionable.
2. Need for income. If the client’s original
objective was for immediate income then the purchase of a variable
annuity is definitely unsuitable.
3. Use of qualified funds. It is extremely difficult
to justify the higher costs of variable annuities versus mutual
funds when investment assets are already tax deferred, especially
if income is needed soon via IRS 72-T.
4. High net worth purchasers? Variable annuities
generally are not suitable.
5. “Bonus” contracts as a rationale
for 1035 exchanges. The exchange is improper if it could result
in surrender penalties, even if the bonus is greater than the
penalty.
6. Performance “living” guarantees.
These are really expensive and the access to the principal is
denied if this option is actually exercised.
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