Overdue Annuity Abuse Crackdowns

Regulators finally are focusing their efforts on some negative aspects of the variable annuity market that we’ve been discussing for years. Recently, several actions were taken by the National Association of Securities Dealers and the Securities and Exchange Commission.

The NASD, which regulates its broker members, in April proposed new rules governing variable annuity marketing. Previously, the NASD issued guidelines that it referred to as best practices for marketing annuities and encouraged brokers to follow them. The proposed rules closely follow the guidelines and will be required practices for brokers to follow.

The proposed rules require brokers and their representatives to provide customers with brief, plain English documents that highlight the main features of the annuity transaction. (Unfortunately, such documents usually aren’t provided until the deal is closed.) Customers also must receive a prospectus. In addition, all sales should be reviewed by a qualified supervisor. The rules also would require reps to receive more training on the products and the appropriate uses of them by investors.

The strongest part of the proposed rules requires the sales representative to determine that the annuity is appropriate for the customer. In addition, the rep must be sure that the customer is properly informed of the annuity’s features and that the annuity is a long-term investment.

The rule probably was proposed because the NASD knew the contents of a report that the NASD and SEC jointly issued in early June. The report concluded that too often brokers steer the elderly and other vulnerable investors into variable annuities that are expensive and inappropriate for those investors.

We’ve demonstrated in many past visits that variable annuities are not appropriate for many investors, especially older investors. Variable annuities have extra expenses, and all distributions from the annuities are taxed as ordinary income. Because of the expenses and the conversion of tax-advantaged long-term capital gains into ordinary income, income and gains must compound tax-deferred in the annuity for years for the annuity to make sense. A high-expense annuity must compound untouched for at least 15 years to achieve the same after-tax, after-expense return as a taxable account.  Even a low expense annuity, such as one from Vanguard, must compound for at least seven to 10 years to make sense.

Yet, the survey of 125 brokerage firms of all sizes found that customers often were not told about the higher taxes on annuities. Customers also weren’t told that most variable annuities impose penalties for early withdrawals, known as surrender fees.  The standard surrender fee is 7% of the account’s value if the withdrawal is made within the first year. That penalty falls by one percentage point each year. Surrender penalties create a real problem for an older person who might need to withdraw money from the annuity at any time to pay for medical expenses or other costs.

The study also found that sales reps encourage clients to mortgage their homes to buy annuities. Some brokers also switched customers from one annuity to another simply to generate commissions for the reps. Commissions for variable annuities often are 5% or higher. That level ordinarily is a red flag for regulators because commissions that high give reps a strong incentive to make inappropriate sales.

Representatives of the NASD and SEC said the study was done to stay ahead of the issue. In fact, they are quite a bit behind. Variable annuity sales increased 20% in 2003 to $985 billion. Annuities also generate more than 15% of all complaints to the NASD.

The National Association of Variable Annuities says that the report did not indicate that the abuses were widespread. It also said that annuities have additional benefits.  The most advertised benefit is that investors get some loss insurance. The guarantee is that when the owner passes away the beneficiary will receive no less than the owner’s investments in the annuity. The charge for this protection is high. Investors concerned about losing principal value should buy term insurance to cover a taxable account, unless they are uninsurable.

The new rules will be helpful to investors, but you are better off following our longstanding recommendations:

• Consider a variable annuity only after exhausting other tax-advantaged investment opportunities, such as 401(k)s and IRAs.
• A variable annuity is only for money you aren’t likely to need for at least 10 years, preferably at least 15 years. 
• For a variable annuity to pay off, the annuity must be invested for high returns. The lower the returns will be, the longer the pay-off period. Don’t purchase low-returning investments such as bonds in the annuity. 

Don’t use a variable annuity for investments that would earn long-term capital gains in a taxable account. Because of the low tax rate on long-term gains, a buy-and-hold investor almost always is better off using a taxable account than a variable annuity.