As a securities fraud attorney, one of the products that I see over and over again in FINRA arbitration claims is variable annuities. Like with most products, there is a time and place where variable annuities can be appropriate. For example, as a small part of a high net worth portfolio, their tax features can be put to good use for estate planning. Unfortunately, too often the products are oversold by unscrupulous financial advisors who taught the benefits and ignore the costs and downsides in order to maximize their own commissions. The following is a brief overview of variable annuities - the products themselves, the pros and cons, the risks, and the FINRA guidance that dictates how these products should be sold.
A. So what Are Variable Annuities?
A variable annuity is a contract between you and an insurance company, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date. You can choose to invest your purchase payments in a range of investment options, which are typically mutual funds. The value of your account in a variable annuity will vary, depending on the performance of the investment options you have chosen.
Variable annuities also offer many of the features of other types of annuities. These include:
- Tax deferral on earnings;
- A death benefit that will pay to your beneficiary either your account value or the greater of your account value and a minimum amount, such as your total purchase payments; and
- The option of receiving a stream of periodic payments for either a definite period such as 20 years, or for an indefinite period such as your lifetime or the life of your spouse.
Variable annuities also often offer optional living benefit features that provide certain protections for payouts, withdrawals or account values, against the effect of investment losses and/or unexpected longevity.
Generally, variable annuities have two phases:
- The "accumulation" phase when investor contributions-premiums-are allocated among investment portfolios-subaccounts-and earnings accumulate.
- The "distribution" phase when you withdraw money, typically as a lump sum or through various annuity payment options.
If the payments are delayed to the future, you have a deferred annuity. If the payments start immediately, you have an immediate annuity.
As its name implies, a variable annuity's rate of return is not stable, but varies with the stock, bond and money market subaccounts that you choose investment options. As such, regardless of what your financial advisor tells you, there is no guarantee that you will earn any return on your investment and there is a risk that you will lose money. Because of this risk, variable annuities are securities registered with the Securities and Exchange Commission (SEC) and their sales by broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA).
B. Things to Know Before Purchasing a Variable Annuity
The variety of features offered by variable annuity products can be confusing. For this reason, it can be difficult for investors to understand what's being recommended for them to buy-especially when facing a savvy salesperson.
Before you consider purchasing a variable annuity, make sure you fully understand all of its terms and features. Here are a few factors you should bear in mind before investing:
1. Liquidity and Early Withdrawals
Variable annuities are long-term, illiquid investments. Getting out early can mean taking a loss. Many variable annuities assess high surrender charges for withdrawals within a specified period, which can be as long as six to eight years. These penalties can make variable annuities unsuitable for investors that may need to access their funds for unforeseen expenses, particularly if the annuity is a substantial portion of your net worth.
2. Sales and Surrender Charges
Most variable annuities have a sales charge. Many variable annuity shares typically do not charge a front-end sales charge, but they do impose asset-based sales charges or surrender charges. These charges normally decline and eventually are eliminated the longer you hold your shares. For example, a surrender charge could start at 7 percent in the first year and decline by 1 percent per year until it reaches zero. Again, making variable annuities extremely costly investments if you think you may need to access your funds in the short term.
3. Fees and Expenses
In addition to sales and surrender charges, variable annuities may impose a variety of fees and expenses when you invest in them, such as:
Mortality and expense risk charges, which the insurance company charges for the insurance to cover: guaranteed death benefits; Annuity payout options that can provide guaranteed income for life; or guaranteed caps on administrative charges.
Administrative fees, for record-keeping and other administrative expenses.
Underlying fund expenses, relating to the investment subaccounts.
Charges for special features, such as: stepped-up death benefits; guaranteed minimum income benefits; long-term health insurance; or principal protection.
These annual fees on variable annuities can reach 2 percent or more of the annuity's value. There are a number of studies that suggest that these costs make variable annuities unsuitable in every instance since the objectives of the clients can always be accomplished through less costly investments.
While earnings in a variable annuity accrue on a tax-deferred basis-typically a big selling point-they do not provide all the tax advantages of 401(k)s and other before-tax retirement plans. 401(k)s and other before-tax retirement plans not only allow you to defer taxes on income and investment gains, but allow your contributions to reduce your current taxable income. That's why most investors should consider annuity products only after they make their maximum contributions to their 401(k)s and other before-tax retirement plans.
Once you start withdrawing money from your variable annuity, earnings (but not principal) will be taxed at the ordinary income rate, rather than at the lower capital gains rates applied to investments in stocks, bonds, mutual funds or other non-tax-deferred vehicles in which funds are held for more than one year.
Furthermore, proceeds of most variable annuities do not receive a "step-up" in cost basis when the owner dies. Other types of investments, such as stocks, bonds, and mutual funds, do provide a step up in tax basis upon the owner's death. This can be a significant factor if the source of the funds used to purchase the annuity is investments that have been held for a long time and which selling will cause a significant taxable event.
5. Bonus Credits
In an attempt to attract investors, many variable annuities now offer bonus credits that can add a specified percentage to the amount invested in the variable annuity, generally ranging from 1 percent to 5 percent for each premium payment you make. Bonus credits are usually not free. In order to fund them, insurance companies typically impose high mortality and expense charges and lengthy surrender charge periods.
Insurance companies issuing variable annuities provide a number of specific guarantees. For example, they may guarantee a death benefit or an annuity payout option that can provide income for life. These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company's financial strength.
Some of the largest variable annuity providers are Prudential Annuities, Jackson National Life, MetLife, TIAA-CREF, Lincoln Financial Group, AXA Equitable, AIG Companies, Transamerica, RiverSource Life Insurance, Nationwide Financial, Pacific Life, Allianz Life of North America, Thrivent Financial for Lutherans, Protective Life, New York Life, Fidelity Investments Life, Guardian Life of America, Northwestern Mutual Life, Principal Financial Group, and Hartford Life.
7. Variable Annuities within IRAs
Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson.
C. Financial Advisors Responsibilities
Financial advisors recommending variable annuities must explain to you important facts, including liquidity issues, such as potential surrender charges and 10 percent tax penalties; fees, including mortality and expense charges, administrative charges, and investment advisory fees; and market risk.
Brokers also must collect important general suitability information from you about your age, marital status, occupation, financial and tax status, investment objectives, and risk tolerance to assess whether a variable annuity is suitable for you.
If your financial advisor fails to do this, do not purchase the investment!
Before purchasing a variable annuity make sure to ask the following questions, at minimum:
How long will my money be tied up?
Are there surrender charges or other penalties if I withdraw funds from the investment earlier than I anticipated?
Will you be paid a commission or receive any type of compensation for selling the variable annuity?
How much is the commission relative to say a mutual fund or bond?
What are the risks that my investment could decrease in value?
What are all the fees and expenses?
When can I access my money without penalty?
Remember, because these are high cost investments, you need to make sure the recommendation is in your best interests and not in the best interest of your advisor who may be trying to maximize commissions.
D. Should you switch one annuity for another?
Switching from one annuity to another is rarely a good idea because you are essentially restarting the clock on all the high expenses of variable annuities by buying a new annuity. Variable annuity switching is a hot button issue for regulators and broker-dealers who recommend a switch must demonstrate that the new annuity is significantly better for the client to justify the increased expenses that will be incurred from the switch.
Here are a few reasons why switching may make sense:
Many annuity contracts now offer premium-sometimes called bonus-credits toward the value of your contract, of a specified percentage ranging from 1-5% for each purchase payment you make.
Also, in recent years, there have been new developments in annuity features, especially in variable annuities, that are valid reasons to consider an exchange. The number of investment options has increased. Less expensive variable annuity contracts have been created. Death and living benefits have been enhanced. Also, with the growth in the stock market in the 1990s, many insurance contract holders have wanted to take part in that growth. These are all valid reasons for considering exchanging one insurance contract for another.
Here are a few reasons why switching may not make sense:
Generally, the exchange or replacement of insurance or annuity contracts is not a good idea, for a variety of reasons.
"Bonus" or "premium" payments made to you are usually offset by the insurance company's adding other charges it makes to you.
Other contract provisions, like surrender charges, eventually expire with an existing contract. However, new charges may be imposed with a new contract or may increase the period of time for which the surrender charge applies.
You may also have to pay higher charges, such as annual fees for the new contract.
You may not need the costly new features of the new contract.
In many instances your broker is getting paid a higher commission for a variable annuity than he or she would for the sale of another securities product, such as a stock, bond, or mutual fund.
In short, you should exchange your annuity only when you determine, after knowing all the facts, that it is better for you and not just better for the person who is trying to sell the new contract to you.
Much of the sales growth of variable annuities in recent years has been from Section 1035 Exchanges (or switches). Even though some variable annuity enhancements have made variable annuities more attractive, you need to be sure that the exchange meets your objectives and benefits you. Variable annuities are long-term, retirement-oriented investment vehicles, and exchanging them may not benefit you.
E. FINRA Guidance Pertaining to Variable Annuities:
FINRA Rule 2821
Rule 2821 pertains directly to the sale of deferred variable annuities. Rule 2821 has four main requirements:
First, a registered representative must have a reasonable basis to believe that the customer has been informed, in general terms, of the material features of a deferred variable annuity, such as potential surrender period and surrender charge, potential tax penalty, mortality and expense fees, charges for and features of enhanced riders, insurance and investment components and market risk. Although the rule requires only generic disclosure, registered representatives and principals may not ignore product-specific features. For example, a firm and its brokers cannot adequately determine the suitability of a transaction without knowing the material features of the deferred variable annuity in question.
Second, the rule also requires that the registered representative have a reasonable basis to believe that the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization or a death or living benefit.10 The rule does not require that a registered representative determine that the customer would benefit from all of these features or that the customer, in hindsight, actually took advantage of one or more of them.
Third, the rule requires a registered representative to have a reasonable basis to believe that "the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable.…"11 Thus, the suitability determination must include careful consideration of the product in its entirety and its component parts, including initial subaccount allocations.
Finally, the rule requires a financial advisor to make reasonable efforts to ascertain and consider various other types of customer-specific information when recommending that a customer purchase or exchange a deferred variable annuity. This information includes the customer's "age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the deferred variable annuity, investment time horizon, existing assets (including investment and life insurance holdings), liquidity needs, liquid net worth, risk tolerance, tax status, and such other information used or considered to be reasonable by the member or person associated with the member in making recommendations to customers."
This is essentially a regurgitation of FINRA Rule 2111. Rule 2111 relates to suitability. Just like with any other investment, before recommending a variable annuity, a financial advisor must evaluate the client's age, investment experience, net worth, investment objectives, and income needs to determine whether the investment is appropriate for the client. Because of the liquidity problems and high costs associated with variable annuities, these investments are often not suitable for people, particularly in high concentrations.
Although suitability is an investor specific inquiry, variable annuities are often considered unsuitable in the following contexts:
1. When the age of the purchaser is above 70.
2. When the client's original objective was for immediate income.
3. When the assets invested are already tax deferred (i.e IRA funds).
4. When the purchaser has a high net worth (and therefore has little need for insurance)
5. When the annuity is being purchased through an exchange (including a 1035 exchange).
FINRA Rule 2330
The pertinent parts of FINRA Rule 2330 are as follows:
No member or person associated with a member shall recommend to any customer the purchase or exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe:
(NYSE:A) that the transaction is suitable in accordance with NASD Rule 2310 and, in particular, that there is a reasonable basis to believe that
(i) the customer has been informed, in general terms, of various features of deferred variable annuities, such as the potential surrender period and surrender charge; potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of 59½; mortality and expense fees; investment advisory fees; potential charges for and features of riders; the insurance and investment components of deferred variable annuities; and market risk;
(ii) the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization, or a death or living benefit; and
(iii) the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable (and, in the case of an exchange, the transaction as a whole also is suitable) for the particular customer based on the information required by paragraph (b)(2) of this Rule; and
(NYSE:B) in the case of an exchange of a deferred variable annuity, the exchange also is consistent with the suitability determination required by paragraph (b)(1)(A) of this Rule, taking into consideration whether:
(i) the customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), or be subject to increased fees or charges (such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements);
(ii) the customer would benefit from product enhancements and improvements; and
(iii) the customer has had another deferred variable annuity exchange within the preceding 36months.
FINRA Notice to Member 96-96 - reminds FINRA members that sales of variable contracts are subject to NASD (now FINRA) suitability requirements.
FINRA Notice to Member 99-35 - reminds FINRA members of their responsibilities regarding the sales of variable annuities.
FINRA Notice to Member 07-53 - reminds FINRA members of their requirements when selling deferred variable annuities.
FINRA Notice to Member 08-39 - reminds FINRA members of the rules governing communications about variable insurance products. Specifically, FINRA states, "Communications concerning variable insurance products frequently emphasize guarantees or riders, particularly to the extent that they protect an investor in a down market. FINRA recognizes the need to communicate the features of these guarantees and riders through sales material. However, it is equally important that these communications discuss guarantees and riders in a fair and balanced manner." FINRA goes on to caution firms from exaggerating the relative benefits of a guarantee, or an insurance company's financial strength or credit rating.
FINRA Notice to Member 10-05 - reminds FINRA members of their Rule 2330 obligations.
F. Litigation Options
Financial advisor have two main obligations to their clients. The first is a duty to perform due diligence on any investment they recommend. The second is to ensure that any investment recommendation made is appropriate for the client in light of that client's age, investment experience, investment objectives, and net worth.
If a broker or brokerage firm makes a recommendation that is unsuitable or without performing adequate due diligence they may be responsible for any losses.
Most brokerage firms insert in to their customer agreement an arbitration provision that requires investors to file any claims with FINRA dispute resolution (instead of in court). As such, if you believe that your brokerage firm or financial advisor improperly sold you a variable annuity, your claim is likely a FINRA arbitration claim.
The White Law Group is a national securities fraud, securities arbitration, and investor protection law firm with offices in Chicago, Illinois and Boca Raton, Florida. The firm represents individuals in FINRA arbitration claims throughout the country.
For a free consultation with a securities attorney, please call the firm at 312/238-9650. For more information on The White Law Group, visit www.whitesecuritieslaw.com.
For some more helpful sources on variable annuities, visit:
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.