Take Heed If Your Clients Are Buying or Selling Annuities: 2009 Brings More Regulatory and Product Changes
David B. Cosgrove1
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Christopher T. O'Connor2 |
The investment landscape has rapidly evolved over recent years, with complex financial products, depleted 401(k) accounts, scarce pensions, and doubts about the viability of the Social Security system. One genre of financial product, annuities, have been touted for the last decade as an answer to investor confusion and insecurity. Variable and indexed annuities combine the opportunity to invest in the stock market, death benefits, and lifetime periodic payments of income. Throughout the country, some 22 million variable annuity contracts are currently in force, with an aggregate asset value of $1.4 trillion.
3 Equity-indexed annuities even provide a guaranteed rate of return. Indeed, the three percent guaranteed minimum return rate common in equity-indexed annuities has been appealing against the backdrop of recent cataclysmic stock market declines. While the terms “variable annuity” and “equity-indexed annuity” are discussed in the media, many attorneys are unfamiliar with the key facts that underlie their performance and their suitability as to individual investors, including trusts. They are truly a blend of insurance, mutual funds, and annuities wrapped up as one product.
The rate of return and the associated stream of income for variable and equity-indexed annuities products are not fixed or predictable like a pension payment. Furthermore, commissions on the sale of the investment are usually sizeable, encouraging unscrupulous marketing. Finally, the ongoing costs of ownership and tax deferral of annuity gains are both rarely useful to investors. Investment advisors, including broker-dealers, are expected to inquire into the objectives and tolerances of their clients and follow the “know your customer” rule in recommending only suitable investments, looking at the unique facts and circumstances of each individual investor.4
Attorneys commonly serve as trustees who invest and manage trust assets, thereby subjecting themselves to meeting a fiduciary duty owed to beneficiaries to comply with the prudent investor rule set out at § 469.902, RSMo Supp. 2008.5 Specifically, trustees must consider nine factors when making decisions in investing and managing trust assets, including “needs for liquidity, regularity of income, and preservation or appreciation of capital.”6 Also, trustees have a duty to monitor brokers investing trust assets.7 On the other hand, attorneys are typically the first person consulted by potentially aggrieved investors or financial professionals facing an accusation or inquiry by their employer or a regulator. All of this underscores the need for attorneys to be informed and proceed with caution.
So, what are the criteria you, acting in a fiduciary capacity as a trustee for your clients, should examine in considering these annuities? When might a valid case lie in favor of a damaged investor against his or her broker, investment or insurance advisor based on suitability allegations? What is the effect of the current regulatory environment at the state – and now turning to the federal – level on this industry? How will the recent final rules issued by the Securities and Exchange Commission (SEC) impact investment advisors and brokers by now classifying equity-indexed annuities as “securities” under the federal securities laws? This article will cover these areas of inquiry and provide the reader with a guide for expectations in the regulatory thicket going forward, as well as a practical checklist for considering variable annuities and equity-indexed annuities as investment options.
I. Common Characteristics of Variable Annuity and Equity-Indexed Annuity
An annuity contract is a written agreement which agrees to pay an income to the annuitant during a certain period of time or during his or her lifetime.8 An annuity is a contract in which an insurance company makes a series of income payments at regular intervals in return for a premium or premiums paid.9 Variable annuities have been called mutual funds wrapped in an insurance policy. They are sold through brokerage firms and insurance agencies. Their performance is predominantly based on that of the underlying investments held in their mutual funds. A variable annuity allows for premiums to be invested in equity securities and kept in a separate account by the insurance company underwriting them.10 A variable annuity holds the investor’s premiums in an account that is invested, at the investor’s choice, in stocks or bonds.11 The face amount of a variable annuity contract fluctuates as the market fluctuates. It carries no guaranteed minimum rate of return and no guaranteed minimum value. It has higher earnings and loss potential versus an equity-indexed annuity.
“An equity-indexed annuity is an annuity … that earns interest or provides benefits that are linked to an external equity reference or an equity index.”12 The value of the index is often tied to a stock or other equity index, the most common being the S&P 500.13 Equity-indexed annuities promise to pay a minimum interest rate, with the minimum interest rate to apply, even if the index-linked interest rate is lower.14 The value of the annuity also will not drop below a guaranteed minimum. For example, many equity-indexed annuities “guarantee the minimum value will never be less than 90 percent of the premium paid, plus at least 3% in annual interest….”15 For these reasons, equity-indexed annuities are less volatile than variable annuities.
The “death benefit” term of the annuity is a promise that if the account is worth less than the investor’s original investment when the investor dies, then the investor’s heirs will receive the original principal amount less withdrawals made by the investor during his or her lifetime.16 Investment performance guarantees within annuities are often termed “living benefits” because they apply while the annuity investor is still alive.17 For instance, a “guaranteed lifetime withdrawal benefit” promises investors “can withdraw up to a specified percentage of their money each year for life.”18
In the recent bear stock market, insurers have faced losses as a result of previously issued variable annuities that guaranteed investors a certain minimum rate of return.19 This minimum, positive rate applies, even when the stock market itself declines. As a result, market conditions have raised the cost of offering many of the features associated with these annuities, causing issuers to often respond by raising fees or offering less attractive terms for investors.20 For example, due to losses from variable annuity guarantees, Hartford Financial will offer new variable annuities products that offer Hartford less risk.21 This, of course, has created an incentive for annuities issuers to try to get investors to exchange from older annuities contracts with more pro-investor terms into the new annuities with fewer guarantees.
II. Missouri’s Complex and Active Regulatory Environment
In 1969, the Missouri General Assembly passed enabling legislation permitting the sale of variable annuities within the state of Missouri.22 The Missouri Secretary of State, however, has cast a watchful eye on both variable and equity-indexed annuities. Secretary of State Robin Carnahan named “Variable and Equity-Indexed Annuities” to her list of “Top 10 Threats to Missouri Investors in 2008.”23 The Secretary of State appoints the Missouri Commissioner of Securities, who administers and investigates compliance with Missouri securities laws.24
The heart of Missouri’s “blue sky” securities law is the Missouri Securities Act of 2003.25 This act includes, among other crucial investor safeguards: a securities registration requirement;26 broker-dealer registration requirement;27 investment advisers registration requirement;28 general securities fraud prohibition in the offer, sale, or purchase of securities;29 and prohibition on fraud in the rendering of investment advice as to the value of securities or the advisability of investing in securities.30 It should be emphasized, however, that these laws only apply to investments deemed to be “securities.” As a general rule, insurance contracts and annuity contracts have traditionally been exempt from the securities laws, and instead subject to the insurance commissioner of the various states.31 The regulation of insurance has traditionally been under the control of the states.32 For some time, both variable annuities and equity-indexed annuities were regulated as insurance, rather than as securities. That is now changing.
The Missouri Securities Commissioner’s investigative, subpoena, and enforcement powers are broad. These include: compelling the production of testimony, statements, and records;33 publishing rules adopted under the Missouri Securities Act of 2003;34 seeking the issuance of an injunction or restraining order from a court to prevent the commission or continuation of securities violations;35 freezing a defendant’s assets;36 and imposing a civil penalty of up to $10,000 for a single violation or up to $1,000,000 for multiple violations.37
Missouri insurance law establishes certain qualification criteria for insurance companies that must be met before they may issue variable annuity contracts within the state of Missouri, including (1) licensing and application review, (2) minimum capital and surplus amounts to be maintained, (3) contract language review, and (4) state licensing exams that must be passed by personnel making sales in Missouri.38 To obtain a license to sell variable annuities, one must pass either the Series 6 or Series 7 examination administered by the financial industry’s self-regulatory organization, the Financial Industry Regulatory Authority (FINRA),39 previously the National Association of Securities Dealers (NASD). Missouri law also regulates the replacement of annuity contracts, including variable annuities, by prescribing how a new annuity may be sold in its place with minimal standards of conduct to be met.40 This requires the insurance sales person to present the replacement annuity buyer with a “Notice Regarding Replacement,” have the buyer sign it, and then present it to the insurer with the application for the replacement policy.41
Missouri insurance regulations govern the disclosure of certain material facts in annuity sales.42 Prior to submission of the application of purchase, annuity applicants must be given both a disclosure document summarizing the crucial terms of the specific annuity contract at issue, as well as a copy of the “Fixed Deferred Annuity Buyer’s Guide” prepared by the National Association of Insurance Commissioners.43 Missouri law mandates that salespeople must have reasonable grounds for believing their recommendation to an individual to purchase an annuity is suitable for that specific customer based on the facts disclosed by the customer.44 Specifically, the sales person must make reasonable efforts to obtain the following information from the customer prior to the sale of a variable annuity or equity-indexed annuity: (1) financial status, including annual income, financial situation, and needs and existing assets; (2) tax status; (3) financial objectives, including investment objectives, reasonably anticipated income needs, and risk tolerance; (4) investment time horizon, liquid net worth, and current and reasonably anticipated needs for liquidity; and (5) such other information used or considered to be reasonable by such producer in making recommendations to the customer.45
No salesperson shall recommend the purchase or exchange of a variable annuity or equity-indexed annuity unless they have a reasonable basis to believe the transaction is suitable for the customer.46 Finally, each individual licensed by Missouri to sell variable annuities must be supervised by a member of FINRA, who must also be licensed as a business entity producer with Missouri.47 Specifically, each supervising FINRA member firm must establish and maintain a system to supervise the activities of each individual sales person that is reasonably designed to achieve compliance with applicable state insurance laws and regulations, federal securities laws and regulations, and FINRA rules.48 Final responsibility for proper supervision rests with the supervising member.49 Written procedures must be established by each such member to supervise their variable annuity business.50 Similarly, under the Missouri state insurance regulations, each individual insurer, prior to recommending or selling any indexed or fixed annuity contract, must be part of a supervisory system.51 Those selling indexed annuities must also maintain suitability records to document information used in recommending indexed annuities,52 as well as supervision records to evidence all supervisory actions taken.53
III. Annuities Enforcement Actions by Three Different State Regulators
Enforcement actions in policing variable annuities and equity-indexed annuities sales are accelerating as a hot bed of activity. Three separate regulators in state government are involved. Their overlapping jurisdiction and competitive efforts, mixed with a strain of political intrigue, creates a hazardous landscape for members of the financial services industry. The Missouri Department of Insurance has jurisdiction over insurance and annuities products and their actual producers, as well as salespersons licensed with that department. While the definition of “securities” under the Missouri Securities Act of 2003 excludes “annuity contract under which an insurance company promises to pay money either in a lump sum or periodically for life or other specified period,”54 the Missouri Secretary of State, via the Division of Securities, has regulated the sellers and sale practices of the products under statutes disallowing “dishonest or unethical business practices” by individuals licensed with that division – “broker dealers and agents”55 and “investment advisors and investment advisor representatives.”56 The Missouri Attorney General now also seems increasingly ready, willing, and able to enter into the enforcement arena as well through its mandate to enforce the Missouri Merchandising Act. In sum, all three regulators report to a different statewide office holder and all have a stake, and hammer, in the game.
A. Missouri Securities Division
The Missouri Securities Commissioner has been active in recent years with regard to variable annuities. On March 25, 2005, former Missouri Securities Commissioner David B. Cosgrove ordered the suspension of the broker-dealer registration of Waddell & Reed, Inc., a seller of variable annuities to Missouri investors, as well as those of 20 employees of the company.57 This suspension was on the grounds that the variable annuities seller and its representatives contacted Missouri investors, soliciting them to sell their variable annuity policies and switch to new variable annuity policies. This resulted in additional commissions of $1.6 million for the sales staff, but cost investors $400,000 in surrender fees, a reset surrender charge period, a lower guaranteed death benefit, and additional annual fees. In short, the switches were not allegedly suitable or beneficial to the particular investors, but rather were instigated by a contract dispute between Waddell & Reed and its original annuity producer.
A few months after the initiation of the Missouri enforcement action against Waddell & Reed, Inc., the firm settled the actions brought against it by Missouri and other members of the North American Securities Administration Association (NASAA) and NASD.58 The Missouri Securities Commissioner is a member of NASAA, a voluntary association whose membership consists of 67 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico.59 The NASAA works with state securities administrators to further investor protection by monitoring issuers and intermediaries who offer and sell securities to the public. It provides a forum for state securities administrators to share enforcement and rule-making strategies. Missouri, however, was the first state to initiate formal legal action against Waddell & Reed “for recommending variable annuity exchanges to its customers without determining the suitability of the transactions.”60
In late 2006 and 2007, the Missouri Securities Division brought similar suitability charges against variable annuities sellers. The 2006 case involved sales by World Group Securities, Inc., of $1.2 million in unsuitable variable annuities investments, resulting in salesperson commissions of $98,000.61 The sales were made to eight Missouri investors who were in their 70s and 80s. However, because these investments are long-term commitments of money with high fees, minimum surrender holding periods, and risk, variable annuities tend to be inappropriate investment vehicles for senior citizens. The 2007 case involved the firm of Berthel, Fisher & Company Financial Services, Inc., who recommended some of their clients continually switch their variable and equity-indexed annuities, even though these switches resulted in detrimental surrender penalties, higher fees, longer lock-up periods, and tax issues. In addition to more than $225,000 in restitution and civil penalties, the offending salesperson was suspended from acting as an agent or representative for one year and prohibited from selling variable annuities or equity-indexed annuities for two years.62
Two additional enforcement consent orders of the Missouri Securities Division were issued in mid-February as part of the Securities Division’s effort to address sales of variable annuities to Missouri senior citizens.63 Two investors in their late 70s wanted to invest the proceeds from selling their home to generate income for living expenses, but were sold a variable annuity by Michael Bennitt, a registered representative of Raymond James.64 The investors’ age, length of time before they could surrender the annuity penalty-free, and high percentage of their savings invested in the annuity caused the Missouri Securities Division to seek penalties for the sale of unsuitable securities in violation of § 409.4-412(d)(13), RSMo Supp. 2008. Mr. Bennitt was ordered to pay a total of $5,000 for disgorgement of the commission earned on the annuities sale and to cover the state’s investigative costs, while Raymond James paid $52,300 to resolve allegations it failed to properly supervise its registered representative.65
Beyond enforcement of the above-noted current Missouri laws, Secretary of State Robin Carnahan endorsed66 Missouri Senate Bill Number 92 (2009),67 commonly known as the “Investors First Act.” This bill, which did not gain passage during the 2009 legislative session, would have provided the Missouri Securities Commissioner with additional tools to penalize violations of the Missouri securities laws. Specifically, it would have allowed the commissioner to issue orders that include civil penalties for individual violators and the ability to censure individual violators for a variety of enumerated reasons, even if the individual did not engage in an act that was dishonest or unethical. The bill also would have (1) ensured that variable annuities sellers play by the rules, (2) clearly defined variable annuities as securities, and (3) brought state law into conformity with federal law.68
B. Missouri Department of Insurance
While the Missouri Secretary of State, via the Division of Securities, has regulated its licensees’ sales practices with these annuities, the Missouri Department of Insurance clearly holds jurisdiction over the product and its producers as part of its charge to execute all laws in force “in relation to insurance and insurance companies doing business in this state.”69 It also has jurisdiction over those individuals to whom it issues a license to sell variable insurance products. The Department of Insurance is an executive branch agency, ultimately the province of the Governor and his or her policy directives. For example, in 2006, the Missouri Department of Insurance revoked the insurance producer license of an insurance salesman who misrepresented variable annuities to customers who purchased from him.70 Despite investors telling him they did not want their insurance policies tied to the stock market, the salesman nevertheless invested their money in variable annuities, knowing variable annuities were subject to stock market fluctuations.71
To date, equity-indexed annuities have been primarily regulated by state insurance departments, to the exclusion of federal authorities at the SEC and FINRA.72 For example, § 376.669 RSMo, administered by the Department of Insurance, mandates the manner in which annuity benefits and cash surrender benefits are calculated.73 Also, disclosure of the specific morality table and interest rates used by the issuer in calculating any guaranteed cash surrender or death benefits under an annuity is required.74 All annuity contracts must contain accurate information regarding all coverages and benefits for which annuity payments are being made.75 An annuity applicant must be informed within 60 days of the submission date of the application regarding whether the application has been accepted.76 Any annuity contract providing for benefits payable in variable amounts must contain a statement of the essential features of the procedures to be followed by the insurance company in determining the dollar amount of the variable benefit.77 Any variable annuity contracts delivered or issued within Missouri must stipulate the investment increment factor to be used in computing the dollar amount of variable benefits.78 Finally, in order to obtain an insurance license to sell variable annuity products, one must also be licensed by FINRA and subsequently supervised by one of its members.79 The Commissioner of Securities incorporates a violation of FINRA rules into the ambit of Chapter 409, which requires the commissioner to turn to the Attorney General to bring a civil case in circuit court.
The 50 states’ departments of insurance have traditionally been the weakest and least active regulators of annuity sales practices throughout the nation. It is no coincidence that, in the absence of a federal regulator, and in the face of the notoriously well-financed state insurance industry lobby, the Missouri Department of Insurance has continued to swim against the regulatory tide, professing its good intentions along the way. Despite the national trend to both accurately define, and move, variable and indexed annuities within the ambit of stronger and more experienced securities regulators, the Missouri Department of Insurance has repeatedly amended its state regulations to protect its turf by designating as “insurance” investment products which instead carry significant market exposure. Indeed, the insurance department’s new indexed annuity regulation and its 2006 lawsuit to derail Secretary of State Carnahan’s nationally praised legal action against Waddell & Reed speaks volumes. As a result, your aggrieved client should not assume that a discussion with one state regulator is a discussion with all, and a trustee checking the background of any outside financial manager should interface with both regulators. Most important, however, is the fact that Chapter 409 includes a private cause of action, while the insurance statutes do not.
C. Missouri Consumer Protection Division
The Missouri Attorney General’s authority to enforce laws in favor of investors in variable annuities or equity-indexed annuities is drawn primarily from three statutes: (1) § 407.010(4),80 (2) § 407.125,81 and (3) § 409.6-608.82 Historically, enforcement actions in the investment fraud arena have been filed by the Attorney General’s Consumer Protection Division in the form of alleged violations of the Missouri Merchandising Act at Chapter 407, over which the Attorney General has primary jurisdiction. The Attorney General also has original criminal jurisdiction regarding scienter-driven securities violations under Chapter 409.
In 2006, the Missouri Attorney General filed suit against a company that sold $3.8 million in unregistered securities, while promising rates of return of 500-800 percent within 4-24 months.83 The suit alleged numerous violations by Global Power Global Wealth of both the Missouri Securities Act of 2003 and the Missouri Merchandising Act.84 It sought a permanent injunction against the defendants to ensure they did not continue to engage in unlawful, unfair, and deceptive acts while selling securities.85 The Attorney General ultimately obtained an injunction and a judgment in excess of $5 million.86
In 2002, the Missouri Attorney General likewise filed suit for unlawful merchandising practices and securities fraud against a Missouri insurance agent who misrepresented how his clients’ money was used for their investments, when in fact the funds were diverted for the agent’s own personal use.87
Thus, the Missouri Attorney General has power under Chapter 407 to bring actions against variable annuity and equity-indexed annuities sellers when sales are made pursuant to allegedly fraudulent actions or mere unfair practices. This power is in connection with the Attorney General’s explicit authority to investigate and prosecute the use of an unfair practice in connection with the sale or advertisement of any merchandise, including intangibles and services, in trade or commerce.88 “Merchandise” has been interpreted broadly by the Attorney General and the courts. Moreover, new Missouri Attorney General Chris Koster has highlighted securities fraud and financial fraud as top priorities for his office during 2009.89
IV. The Federal Government’s Entry by Classifying Equity-Indexed Annuities as “Securities” under the Federal Securities Laws
Many decades ago, the United States Supreme Court held that variable annuities were “securities” under the federal securities laws,90 thereby subjecting variable annuity contracts to the federal securities laws, most notably the statutes and regulations of the SEC.91 In SEC v. United Benefit Life Ins. Co., the variable annuities seller attempted to cast their product as “insurance” in order to avoid the rigorous federal securities regulations, seeking instead to be subject only to each state’s insurance department laws. While the Supreme Court rejected that argument long ago as to variable annuities, up to the present time the sellers of equity-indexed annuities have still successfully asserted a similar rationale for non-compliance with the federal securities laws.
A. SEC Regulation
The insurance industry’s effort to avoid federal securities law jurisdiction will likely meet its demise, however, due to the recent actions of the SEC. On December 17, 2008, the SEC passed two final rules that explicitly state the SEC will in the future consider equity-indexed annuities to be “securities” within the meaning of the federal securities laws.92 This will soon introduce federal regulation into an area that was previously exclusive to Missouri state law regulations. It will also demand evolution in the industry and its attorneys.
The new rules are found at Rule 151A under the Securities Act of 1933 (the “Securities Act”),93 which will be effective as of January 12, 2011, and Rule 12h-7 under the Securities Exchange Act of 1934.94 Rule 151A will soon require all insurance companies issuing equity-indexed annuities to register them as securities under the Securities Act and sell them pursuant to a prospectus. Some two years have been built into the effective date of Rule 151A to allow the industry time to adjust to these changes. The rule applies on a prospective basis only to annuities contracts issued on or after the effective date.95 Rule 151A will soon require insurance agents who now sell equity-indexed annuities with a state insurance license to also pass FINRA tests and become registered representatives associated with a broker-dealer. Finally, the new rule will subject equity-indexed annuities sales practices to the antifraud provisions of the federal securities laws, such as Rule 10b-5.
The new rules define equity-indexed annuities as “securities” because their purchasers are exposed to significant investment risk due to the volatility of their underlying securities index. Allocation of investment risk between the insurance company and the annuity purchaser is a significant factor in distinguishing a security from a contract of insurance.96 The new rule defines “equity-indexed annuities” as “securities” subject to federal securities laws “when the amounts payable by an insurer under an indexed annuity are more likely than not to exceed the amounts guaranteed under the contract,” as this indicates that the majority of the investment risk for the fluctuating, securities-linked portion of the return is being borne by the annuity purchaser, not the insurance company.97 The federal interest in providing investors with disclosure, anti-fraud, and sales practice protections arises when individuals are offered indexed annuities that expose them to investment risk.98 In summary, the SEC determined the features of equity-indexed annuities were much more similar to securities than to an insurance policy. Hence, no exemption from securities status should be allowed to them under § 3(a)(8) of the Securities Act, which exempts traditional fixed annuities from the definition of “securities.”
New Rule 12h-7, however, softens the blow of Rule 151A by exempting insurance companies from the reporting requirements of the Securities Exchange Act of 1934 with respect to equity-indexed annuities and other annuities “registered under the Securities Act, provided certain conditions are satisfied, including that the securities are regulated under state insurance law, issuing insurance company and its financial condition are subject to supervision and examination by a state insurance regulator, and the securities are not publicly traded.”99 The rationale underlying this exemption is that the concerns underlying periodic and current financial disclosures are not implicated when (1) the insurer’s financial condition and ability to meet its financial obligations are already subject to state law oversight, and (2) there is no trading interest in the insurance contract.100
The SEC noted that the growth in sales in equity-indexed annuities in recent years has been accompanied by complaints of abusive sales practices such as complaints of inadequate disclosure of the annuity’s terms and increased sales to seniors fueled by the large sales commission underlying equity-indexed annuities.101 This was drawn in part from the 2004 findings of the SEC, in conjunction with the NASD, which investigated broker-dealer sales of variable annuities and issued its report detailing improper variable annuities sales practices by some brokers.102 The report noted that “[h]igh commissions, typically above 5% for variable annuities, help drive sales of these products.”103 It also stated:
The Commission, NASD, and other regulators have received a large number of complaints from individual investors about variable annuities products. Many of these complaints indicate that the customer was sold a variable product without fully understanding the product, and express concerns that the product was not appropriate for them, given their investment objections.104
While the report detailed both strong and weak sales practices identified by examiners, the weak practices included unsuitable product recommendations made without a reasonable basis, unsuitable switching or replacement of policies, inadequate policies or procedures, and inadequate supervisory review.105 In any event, these sales practices have led the SEC and NASD to bring enforcement actions in the past for excessive switching, misleading marketing, failure to disclose material facts, unsuitable sales, inadequate written supervisory procedures, failure to maintain adequate documentation, and/or failure to supervise variable product transactions.106 Certainly, the additional disclosure and sales practice protections should result from the future enforcement of Rule 151A by the SEC.
B. FINRA Regulation
The practical effect of the SEC’s action to define equity-indexed annuities as securities is that, like variable annuities, their sellers will soon be unequivocally subject to the oversight of FINRA.107 FINRA, a non-government regulator of U.S. securities firms, was created in July of 2007 through the consolidation of the NASD and the member regulation, enforcement, and arbitration functions of the New York Stock Exchange (NYSE).108 FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services.109 In addition, FINRA provides an arbitration forum for investors aggrieved by the sale of unsuitable investment products by brokerage firms and registered securities representatives.110
FINRA has cautioned variable annuities holders against exchanges for new variable annuities.111 “Generally, the exchange or replacement of annuity contracts is not a good idea for a variety of reasons.”112 Some of these reasons include (1) new surrender charges may be imposed with a new contract or may increase the time period for which the surrender charge applies, (2) higher charges may apply through annual fees for the new contract, (3) costly new features may be added which are not needed, (4) brokers get paid a higher commission for variable annuities sales as opposed to the sale of any other securities product, and (5) the new variable annuity contract may have a lower contract value and a smaller death benefit.113 Investors should beware sales pitches made for annuities exchanges and be absolutely certain the new terms and ramifications are in their best interest.
V. Suitability—A Checklist for Practitioners
The following are some of the key issues for a client’s investment in, or sale of, variable annuities and/or equity-indexed annuities:
1. Periodic Payments for the Rest of Life. Both variable annuities and equity-indexed annuities allow an investor to receive regular – usually monthly – payments for their entire lifetime. This offers protection against an annuity owner outliving his or her assets.114
2. Tool for Tempering Risk of Electing Early S.S. Benefits. Both variable annuities and equity-indexed annuities can be utilized to temper the risk of its owner electing to take Social Security (S.S.) benefits at their earliest possible age. Early election of S.S. benefits triggers the payment of permanently lower S.S. monthly benefit checks. This can become a problem if the owner’s lifespan turns out to be much longer than anticipated. However, by owning a variable or equity-indexed annuity, the owner can choose to hold off in taking the first payment from the annuity until later, perhaps at age 70, thereby permanently locking in complementary and larger annual annuity payments for the remainder of his lifetime.
3. Deferral of Annuity Gains. Variable annuity and equity-indexed annuity gains are tax-deferred, meaning no taxes are due on their income or investment gains until money is taken out of the annuity.115 In addition, § 1035 of the Internal Revenue Code allows the investment gains built up in the annuity to enjoy tax-deferred treatment, even if the investor chooses to swap the annuity for a similar annuity.116 No tax consequences typically result from such an exchange; however, the surrender period will be reset. Moreover, no additional tax benefit is conferred by this tax treatment if the funds invested in the annuity come from an already tax-advantaged source, such as a 401(k) or IRA.
4. Death Benefit. Many variable annuities and equity-indexed annuities offer an enhanced death benefit. This means that if the owner dies prior to receiving any annuities payments, then their beneficiary will still receive a sum of money in a guaranteed amount. This amount is often at least the amount of total contributions paid into the annuity.117
5. Guaranteed Minimum Value. Equity-indexed annuities often “provide a guaranteed minimum value, which serves as a floor on the amount paid upon withdrawal, as a death benefit, or in determining the amount of annuity payments. The guaranteed minimum value is typically a percentage of purchase payments, accumulated at a specified interest rate.”118 Often the guaranteed minimum value is equal to at least 87.5 percent of the purchase payments, accumulated at an annual interest rate of between 1 percent and 3 percent.119
6. Guaranteed Minimum Rate of Return. Equity-indexed annuities also typically provide a guaranteed annual rate of return such that their value will increase at the minimum interest rate, even if the underlying index itself decreases in value. This feature is outstanding in years when the stock market declines.
7. Annual Fees. Annual fees for variable annuities and equity-indexed annuities usually total “about 2.5 percent of the underlying mutual fund investments, plus nearly 1 percent of the guaranteed base. That adds up to about triple the average mutual fund fee.”120 The mortality and expense risk charge is equal to a percentage of the annuity account value (often about 1.25 percent) and compensates the insurance company for the risks it assumes under the annuity contract.121 Annual administrative fees are charged to each annuity account either as a flat account maintenance fee (often $25-30 per year) or as a percentage of account value (often 0.15 percent per year).122 Underlying fund expenses are paid for the services of the firm running the mutual fund investing the account value and are charged annually as a percentage of the account value.123 Extra charges and fees are imposed for options such as a stepped-up death benefit, guaranteed minimum income benefit, or long-term care insurance.124 In addition, cashing out one annuity to purchase another one tends to incur significant additional transaction costs, including additional sales commissions, surrender costs, and other penalties.
8. Sales Commissions. The sale of variable annuities or equity-indexed annuities to an investor carries significant sales commissions for brokers and investment advisors. This encourages sales of these annuities in factual circumstances entirely unsuitable for the investor. This upfront sales charge is, of course, ultimately borne by the annuity investor in the form of higher holding costs.
9. Relative Illiquidity. Investments in these annuities are not liquid. Withdrawals prior to age 59 1/2 may incur 10 percent tax penalties.125 The annuities’ terms typically require a mandatory holding period of six to eight years, measured from the investment’s purchase date. Violation of this holding time frame by cashing in the annuity results in a hefty surrender penalty. The maximum surrender penalties, which may be as high as 15-20 percent, are imposed on surrenders made during the early years of the contract and decline gradually to 0 percent at the end of a specified period, which may be in excess of 15 years.126 Most equity-indexed annuities contracts that promise annual growth encourage investors to hold off from starting their annuities payments income stream by stopping the guaranteed growth as soon as the first payment is taken by the investor. In addition, annual payments will be permanently lower if the first payment is taken at a younger age.127 For example, annuities commonly allow five percent a year withdrawals for 60-year-olds, but a much higher 6 percent per year withdrawal rate at age 70.128
10. Potential Volatility. Because the value of variable annuities and equity-indexed annuities are based on the values of their underlying bonds and stocks, like the stock market as a whole, they are sometimes volatile. Variable annuities are much more volatile as compared to equity-indexed annuities, as they lack guaranteed minimum values or guaranteed minimum returns. Therefore, their value and annual returns more closely resemble the actual value and returns of the stock market itself. This means both of these annuities are not advisable for short-term investors who cannot ride out potential bear markets. Therefore, investors with low risk tolerances should stay away.
11. Insurer Insolvency. The risk of the annuities issuer going out of business must be considered. While annuities owners’ fund holdings are separate from the insurer’s assets, the guaranteed portions of the policies can be lost. Moody’s currently has negative outlooks on units of four of the top 10 U.S. annuities sellers.129 If an insurer fails, regulators will attempt to get another company to take over its policies and annuities; however, if that is unsuccessful, investors will be left with a claim with their state’s guarantee fund. States commonly provide $100,000 in coverage per customer for guaranteed portions of annuity contracts.130 Anything above the state guarantee limit amount is lost by the investor.
12. Alternative Tax-Advantaged Savings Options. Most investors fail to max out the annual limits for contributions to their 401(k) account and Individual Retirement Account (IRA). These investments typically hold better tax treatment and a much lower fee structure. Therefore, variable annuities and equity-indexed annuities should be considered only if one has money left to invest after augmenting their 401(k) and IRA accounts to the full extent. The general contribution limit for 2009 to a 401(k) account is $16,500, while an investor at least 50 years old may instead contribute up to $22,000.131 The general contribution limit for 2009 for IRA investors is $5,000, while an investor at least 50 years old may instead contribute up to $6,000.132
VI. Conclusions
An ever-evolving tapestry of state and federal regulations have attempted to limit the explosive sale of variable annuities and equity-indexed annuities to only suitable investors. While lawyers acting as trust fiduciaries will most commonly confront these investment products, all attorneys must be able to recognize the basic considerations at play. Some investors who have been burned by unsuitable or excessive annuities sales will undoubtedly consult an attorney to determine if theirs is a case of stockbroker and/or adviser malpractice, for which damages can be recovered. Those maligned financial professionals, in turn, will need informed and financially literate counsel.
Variable annuities and equity-indexed annuities are truly complex investments. Various state regulators are striving to ensure the next Bernie Madoff is unable to ply his or her trade. Federal authorities entering this area will soon wield an even weightier hammer, rapidly transforming the regulatory landscape. As a result, those who sell investment products or render investment advisory services or financial planning must carefully follow developments in this area from the state securities division, state insurance department and Attorney General, as well as the federal authorities at the SEC and FINRA.
Footnotes
1 David B. Cosgrove, who may be reached at dcosgrove@cosgrovelawllc.com, practices commercial and securities litigation, as well as white collar defense at Cosgrove Law, LLC. He has previously served as chief counsel of the Missouri Attorney General’s Consumer Protection Division as well as the Missouri Securities Commissioner.
2 Christopher T. O’Connor, who may be reached at coconnor@mehanlaw.com, practices commercial, stockbroker malpractice, and personal injury litigation at Moline & Mehan, LLC, http://www.mehanlaw.com. He is a cum laude graduate of St. Louis University School of Law.
3 Leslie Scism, Added Value-and Anxiety-For Variable Annuity Owners, Wall St. J., Feb. 2, 2009, at R1.
4 See NASD Rule 2310 (“Recommendations to Customers”); see also NYSE incorporated Rule 405 (“Diligence as to Accounts”).
5
See, e.g., Saigh v. Saigh, 218 S.W.3d 556, 561 (Mo. App. E.D. 2007),
quoting Ramsey v. Boatmen’s First Nat. Bank of Kansas City, N.A., 914 S.W.2d 384, 387 (Mo. App. W.D. 1996) (“A trustee is a fiduciary of the highest order and is required to exercise a high standard of conduct and loyalty in administration of the trust.”); § 469.901(1), RSMo Supp. 2008 (“a trustee who invests and manages trust assets owes a duty to the beneficiaries of the trust to comply with the prudent investor rule set forth in this act.”); § 469.902, RSMo Supp. 2008 (“A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.”).
6 Section 469.902(3), RSMo Supp. 2008
7 O’Neill v. O’Neill, 865 NE 2d 917, 921 (Oh. App. 2006)
8 I Mo. Insurance Practice § 3.28 (MoBar 5th ed. 2004).
9 20 C.S.R. § 400-5.410(5) (2008).
10 I Mo. Insurance Practice § 3.28 (MoBar 5th ed. 2004).
11 20 C.S.R. § 400-5.410(5) (2008).
12 Id.
13 Id.
14 Id.
15 Id.
16 Leslie Scism, Added Value-and Anxiety-For Variable Annuity Owners, Wall St. J., Feb, 2, 2009, at R1.
17 Id.
18 Id. at R7.
19 Lavonne Kuykendall, Hartford: New Variable Annuity: Lower Cost, Simpler Structure (Feb. 6, 2009), http://www.morningstar.com/newsnet/ViewNews.aspx?article=/DJ/200902061138DOWJONESDJONLINE000576_univ.xml; see also Lavonne Kuykendall, Variable-Annuity Business is Adding to Life Insurers’ Woes, Wall St. J., October 13, 2008, at C2.
20 Eleanor Laise, ‘Safe’ Products May Pose Risks for Investors, Wall St. J., Feb. 25, 2009, at D1.
21 See Kuykendall, note 19.
22 I Mo. Insurance Practice § 3.28 (MoBar 5th ed. 2004).
23 Ryan Hobart, Carnahan Warns of the Top 10 Threats to Missouri Investors for 2008 (June 4, 2008), http://www.sos.mo.gov/securities/mipc/newsRelease.asp?nID=710.
24 Section 409.6-601(a), RSMo 2008.
25 Sections 409.1-101-409.7-703, RSMo Supp. 2008.
26 Section 409.3-301, RSMo Supp. 2008.
27 Section 409.4-401, RSMo Supp. 2008.
28 Section 409.4-403, RSMo Supp. 2008.
29 Section 409.5-501, RSMo Supp. 2008.
30 Section 409.5-502, RSMo Supp. 2008.
31 Securities and Exchange Comm’n v. Variable Annuity Life Ins. Co. of America, 359 U.S. 65, 67 (1959).
32 Securities and Exchange Comm’n v. Variable Annuity Life Ins. Co. of America, 359 U.S. 65, 68-69 (1959).
33 Section 409.6-602(a)(2), RSMo 2008; § 409.6-602(b), RSMo 2008; § 409.6-602(c), RSMo 2008.
34 Section 409.6-602(a)(3), RSMo Supp. 2008.
35 Section 409.6-603(b)(1), RSMo Supp. 2008.
36 Section 409.6-603(b)(2)(A), RSMo Supp. 2008.
37 Section 409.6-603(b)(2)(C), RSMo Supp. 2008.
38 20 C.S.R. § 400-1.020 (2008); 20 C.S.R. § 700-1.010 (2008); 20 C.S.R. § 700-1.012 (2008).
39 20 C.S.R. § 700-1.020(2) (2008).
40 20 C.S.R. § 400-5.400 (2008).
41 20 C.S.R. § 400-5.400(5)(B) (2008).
42 20 C.S.R. § 400-5.410 (2008).
43 20 C.S.R. § 400-5.410(3)(A)(1) (2008).
44 20 C.S.R. § 700-1.146(1)(A)(1) (2008).
45 20 C.S.R. § 700-1.146(1)(A)(2) (2008); see also 20 C.S.R. § 700-1.146(1)(B)(2) (2008).
46 20 C.S.R. § 700-1.146(1)(A)(3) (2008); see also 20 C.S.R. § 700-1.146(1)(B)(3) (2008).
47 20 C.S.R. § 700-1.147(1)(A) (2008).
48 20 C.S.R. § 700-1.147(1)(B)(1) (2008).
49 Id.
50 20 C.S.R. § 700-1.147(1)(B)(2) (2008).
51 20 C.S.R. § 700-1.148(1)(B) (2008).
52 20 C.S.R. § 700-1.148(1)(E)(1) (2008).
53 20 C.S.R. § 700-1.148(1)(E)(2) (2008).
54 Section 409.1-102(28)(B), RSMo Supp. 2008.
55 15 C.S.R. § 30-51.170(1)(B) (2008); see also 15 C.S.R. § 30-51.170(1)(E) (2008).
56 15 C.S.R. § 30-51.172(1)(a) (2008); see also 15 C.S.R. § 30-51.172(1)(u) (2008).
57 Summary Order of Suspension of Waddell & Reed’s Broker-Dealer Registration, Summary Order to Suspend the Above-Listed Representatives and Order to Show Cause Why Waddell & Reed, Inc., Tucker, Williams, Hechler, Buyle and the Above Listed Registered Representatives Should Not Be Barred and/or Censured, State of Missouri, Commissioner of Securities (March 25, 2005), In the Matter of Waddell & Reed, Inc., et al., Case No. AP-05-13, http://www.sos.mo.gov/securities/orders/AP-05-13.asp.
58 Stephen Roth, Regulatory Crosscurrents Buffet Waddell & Reed (April 8, 2005), http://www.bizjournals.com/kansascity/stories/2005/04/11/story5.html; and NASAA Insight, NASD Chairman and CEO Mary Schapiro [now the head of the SEC] Delivers Conference Keynote Address ((Fall, 2006), http://www.nasaa.org/content/Files/NASAA_INSIGHT_Fall06.pdf at p. 6
59 www.nasaa.org/About_NASAA/
60 Roy Temple, Waddell & Reed Settles…Carnahan Announces $11 Million Recovery From Kansas City Brokerage Firm (June 30, 2005), http://www.firedupmissouri.com/node/1924.
61 Consent Order, State of Missouri, Office of Secretary of State (Nov. 27, 2006), In the Matter of World Group Securities, Inc., Case No. AP-06-48, http://www.sos.mo.gov/securities/orders/AP-06-48.asp
62 Consent Order, State of Missouri, Office of Secretary of State (May 17, 2007), In the Matter of Berthel, Fisher, & Company Financial Services, Case No. AP-07-21, http://www.sos.mo.gov/securities/orders/AP-07-21.asp
63 Consent Order, State of Missouri, Office of Secretary of State (Feb. 17, 2009), In the Matter of Raymond James Financial Services, Inc., Case No. AP-09-01, http://www.sos.mo.gov/securities/orders/AP-09--01.asp; see also Consent Order, State of Missouri, Office of Secretary of State (Feb. 17, 2009), In the Matter of Michael Bennitt, Case No. AP-09-01, http://www.sos.mo.gov/securities/orders/AP-08-30.asp
64 Ryan Hobart, Carnahan Targets Sale of Variable Annuities to Missouri Seniors (Feb. 18, 2009), http://www.sos.mo.gov/securities/news.asp?nID=781
65 Consent Order, State of Missouri, Office of Secretary of State (Feb. 17, 2009), In the Matter of Raymond James Financial Services, Inc., Case No. AP-09-01, http://www.sos.mo.gov/securities/orders/AP-09-01.asp; see also Consent Order, State of Missouri, Office of Secretary of State (Feb. 17, 2009), In the Matter of Michael Bennitt, Case No. AP-09-01, http://www.sos.mo.gov/securities/orders/AP-08-30.asp
66 Robin Carnahan, Office of Secretary of State, 2008 Legislative Package Overview: Bills to Better Protect Investors, http://www.sos.mo.gov/legislation/Legislative_Package_Overview_2008.pdf
67 S.B. No. 92 (2009)
68 Robin Carnahan, Office of Secretary of State, 2008 Legislative Package Overview: Bills to Better Protect Investors, http://www.sos.mo.gov/legislation/Legislative_Package_Overview_2008.pdf
69 Section 374.010, RSMo 2008 (“The department of insurance, financial institutions and professional registration shall be charged with the execution of all laws now in force, or which may be hereafter enacted, in relation to insurance and insurance companies doing business in this state, and such other duties as are provided for by law.”)
70 Missouri Department of Insurance Revokes Producer’s License, St. Louis Bus. J. (June 7, 2006), available at http://www.bizjournals.com/stlouis/stories/2006/06/05/daily31.html
71 Id.
72 The absence of a federal insurance regulator plays a key role in the distinct approaches taken by insurance and securities’ regulators.
73 Section 376.669, RSMo Supp. 2008.
74 Section 376.669(3), RSMo Supp. 2008.
75 20 C.S.R. § 400-1.010(1)(B) (2008).
76 20 C.S.R. § 400-1.010(6) (2008).
77 20 C.S.R. § 400-1.020(5)(A) (2008).
78 20 C.S.R. § 400-1.020(5)(D) (2008).
79 20 C.S.R. § 700-1.147 (2008) and 20 C.S.R. § 700-1.148 (2008)
80 Section 407.010(4), RSMo 2000 (the term “merchandise” under § 407.010-407.130 includes “any…commodities, intangibles, real estate or services”).
81 Section 407.125, RSMo 2000 (“The provisions of this chapter shall not bar the commissioner of securities from administering the provisions of chapter 409, RSMo.”)
82 Section 409.6-608, RSMo Supp. 2008 (the Missouri Securities Commissioner shall “cooperate, coordinate, consult, and…. share records and information with…the attorney general…to effectuate greater uniformity in securities matters”).
83 News Release, Missouri Attorney General, Nixon Files Lawsuit to Shut Down Investment Firm That Sold at Least $3.8 Million in Unregistered Securities, http://www.ago.mo.gov/newsreleases/2006/040306b.htm
84 Id.
85 Id.
86 http://www.courts.mo.gov/casenet
87 News Release, Missouri Attorney General, Former Springfield Insurance Agent Pleads Guilty to Six Felony Counts Related to Defrauding Investors of $375,000, http://www.ago.mo.gov/newsreleases/2002/072602.htm
88 Section 407.020, RSMo Supp. 2008.
89 Christopher Tritto, Koster Targets Medicaid Fraud, Illegal Workers, St. Louis Bus. J., January 30, 2009, available at http://stlouis.bizjournals.com; see also Michael Sorkin, New Missouri AG Koster Takes Aim at Health Care Fraud, St. Louis Post-Dispatch, January 23, 2009, available at http://www.stltoday.com.
90 SEC v. Variable Annuity Life Ins. Co. of America, 359 U.S. 65, 66-73 (1959); Prudential Ins. Co. of Am. v. SEC, 326 F.2d 383, 385-388 (3d. Cir. 1964).
91 SEC v. United Benefit Life Ins. Co., 387 U.S. 202, 204-210 (1967).
92 74 Fed. Reg. 3138-3176 (Jan. 16, 2009).
93 17 C.F.R. § 230.151A.
94 17 C.F.R. § 240.12h-7.
95 74 Fed. Reg. 3153 (Jan. 16, 2009).
96 74 Fed. Reg. 3141-3143 (Jan. 16, 2009).
97 74 Fed. Reg. 3150 (Jan. 16, 2009).
98 74 Fed. Reg. 3144 (Jan. 16, 2009).
99 74 Fed. Reg. 3156-3157 (Jan. 16, 2009).
100 74 Fed. Reg. 3155 (Jan. 16, 2009).
101 74 Fed. Reg. 3156-3139 (Jan. 16, 2009).
102 Office of Compliance Inspections and Examinations, United States Securities and Exchange Commission, Joint SEC/NASD Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products (June 9, 2004), http://www.sec.gov/news/studies/secnasdvip.pdf
103 Id.
104 Id.
105 Id.
106 Recent Enforcement Actions Involving the Sale of Variable Annuities, http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p010369.pdf (noting three recent SEC enforcement actions and 22 recent NASD enforcement actions).
107 Daisy Maxey, Battle Looms on Indexed Annuities, Wall St. J., August 7, 2008, at D6.
108 www.finra.org/AboutFINRA/index.htm
109 Id.
110 http://www.finra.org/ArbitrationMediation/Parties/Overview/ArbitrationProcedues/index.htm].
111 Should You Exchange Your Variable Annuity? (last updated March 2, 2006), http:// www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsurance/p006045
112 Id.
113 Id.
114 Robin Carnahan, Office of Secretary of State, Missouri Securities Division, Variable Annuities: A Basic Guide, http://www.sos.mo.gov/securities/pubs/Variable%20Annuities.pdf
115 20 C.S.R. § 400-5.410 (2008).
116 26 U.S.C. § 1035(a)(3).
117 Robin Carnahan, Office of Secretary of State, Missouri Securities Division, Variable Annuities: A Basic Guide,, http://www.sos.mo.gov/securities/pubs/Variable%20Annuities.pdf
118 74 Fed. Reg. 3141 (Jan. 16, 2009).
119 Id.
120 Leslie Scism, Added Value-and Anxiety-For Variable Annuity Owners, Wall St. J., Feb. 2, 2009, at R7.
121 Robin Carnahan, Office of Secretary of State, Missouri Securities Division, Variable Annuities: A Basic Guide,, http://www.sos.mo.gov/securities/pubs/Variable%20Annuities.pdf
122 Id.
123 Id.
124 Id.
125 Leslie Scism, Added Value-and Anxiety-For Variable Annuity Owners, Wall St. J., Feb. 2, 2009, at R7.
126 74 Fed. Reg. 3140 (Jan. 16, 2009).
127 See Scism, note 120.
128 Id.
129 Id.
130 Id.
131 I.R.S. Publication No. 525, at p. 9-10 (Dec. 23, 2008), http://www.irs.gov/pub/irs-pdf/p525.pdf
132 I.R.S. Publication No. 590, at p. 11 (Jan. 30, 2009), http://www.irs.gov/pub/irs-pdf/p590.pdf].