John Duval Associates, Securities Arbitration Consultants and Experts in Securities Litigation.

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period of time or does not immediately take payments and simply lets the contract grow on a tax-deferred basis until withdrawn, usually after age 59 1/2.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.