NASD has become increasingly concerned about some members’ unsuitable recommendations and inadequate supervision of transactions in deferred variable annuities…[C]ertain firms continue to engage in unacceptable sales and supervision practices regarding these products. For instance, variable annuity sales have been the subject of more than 80 NASD disciplinary actions in the past two years. These disciplinary actions involved a wide array of misconduct regarding the sales of variable annuity products, including excessive switching, misleading marketing, failure to disclose material facts, unsuitable sales, inadequate training and supervision of salespeople and deficient written supervisory procedures.”
NASD NTM 04-45. A broker and brokerage house must have reasonable grounds for believing that a variable annuity is suitable for the particular individual customer. NASD NTM 96-86.BACKGROUND Basically, annuities create the right to receive an amount of money per period for a specified amount of time. Annuities are classified in a number of different ways. They can either be immediate or deferred. Immediate annuities begin paying out income as soon as you buy them. Deferred annuities are retirement-savings vehicles under which payments begin at some specified future date. Annuities can either be fixed or variable. A fixed annuity guarantees fixed payments to the annuitant either for life or for a specified period of time. Variable annuitiesprovide payments to the annuitant in varying amounts depending on the success of the investment policy of the insurance company. With variable annuities, your return depends on the performance of stocks, bonds and/or other investments. The subject of this blog is deferred variable annuities. This kind of annuity is a combination between an insurance contract and an investment in which gains grow tax-deferred. The two main aspects of a deferred variable annuity are tax-deferral and the death benefit. TAX DEFERRAL Variable annuities provide the benefit of tax deferral, which means the earnings that accumulate in an annuity are not taxed until withdrawn. Be careful, as this benefit is misleading. The potential for tax-deferred growth is almost always offset by (1) higher fees and surrender charges and (2) higher taxes. HIGHER FEES AND SURRENDER CHARGES OFFSET DEFERRED TAX BENEFIT The fees imposed on variable annuities are considerably higher than those imposed on mutual funds and other alternative investments. An investor must hold a variable annuity for a long period of time–ten to twenty years–before the tax benefit will outweigh the exorbitant fees. According the NASD NTM 04-45, variable annuities subject investors to the following fees or charges.
- Surrender Charges: paid by investor when he or she withdraws money from the annuity before a specified period.
- Management Fees: assessed against the sub-accounts.
- Mortality and Expense Risk Charge: charged by the insurance company for the insurance risk it takes under the contract.
- Administrative Fees: charged for record keeping and other administrative expenses.
- Underlying Fund Expenses: relating to investment options.
- Charges for Special Features and Riders: e.g., provisions for stepped-up death benefit or a guaranteed minimum income benefit.
The added expenses associated with variable annuities cannot be justified unless the annuity is held for an extended period of time. It follows that variable annuities should not be sold to individuals who are retired or close to retirement.HIGHER TAX RATE OFFSETS DEFERRED TAX BENEFIT Capital gains typically qualify for a lower tax rate than income. Such is the case with gains accumulated in mutual funds, stocks and investments other than variable annuities. Gains earned in a variable annuity, however, do not qualify for the lower capital gains tax treatment. The variable annuity converts capital gains into ordinary income for tax purposes. A deferred variable annuity is thus a double edged sword: your gains grow tax deferred, but you lose the lower capital gains tax treatment. The investor will usually have to hold the annuity for years before reaching the break-even point when the benefit of deferral catches up with the detriment of converting capital gains to ordinary income. Registered representatives rarely disclose the following: (1) that withdrawals from the variable annuity will be taxed as ordinary income, even if they are capital gains; (2) that capital gains are taxed at a lower rate than ordinary income; (3) that withdrawals from mutual funds have the potential for Long term capital gains tax treatment. EARLY WITHDRAWAL Deferred variable annuities are designed as retirement savings vehicles. With variable annuities you are not supposed to withdraw the money until you retire. You are supposed to open a variable annuity well ahead of retirement age, watch the annuity accumulate gains, and then begin withdrawing the money twenty or thirty years later when you retire. The government does not want you to run out of money before you reach retirement age. So, there is a 10% federal tax penalty if you withdraw money before age 59 and 1/2. In addition, the annuity company charges the investor “surrender charges” when he or she withdraws money from a variable annuity before a specified period. Surrender charges usually start at around 7% of your investment and decline to zero over the next eight years or so. Therefore, if your investment is short-term, you should not be in a variable annuity. If you have an immediate need for retirement income and living expenses, you should not be in a variable annuity. If you require frequent withdrawals, you should not be in a variable annuity. It is always improper for a broker or financial planner to recommend variable annuities to an elderly individual. Most retired individuals currently invested in variable annuities will not live long enough to see the benefits outweigh the costs. This is because they opened the variable annuity too late in their life. Variable annuities lack liquidity. The surrender charge and early withdraw penalties guarantee that the elderly investor will be locked up in the variable annuity for a number of years. DEATH BENEFIT Deferred Variable Annuities come with a death benefit that ensures your heirs get back at least as much as you invested if you die while your investments are down. During the sales pitch, a broker or financial planner will emphasize the “protection” that the death benefit gives the customer’s heirs, while deemphasizing potential drawbacks. The broker may gloss over the fact that withdrawals reduce the death benefit dollar for dollar. Often times an investor will already have more than enough life insurance, and the broker will mislead the investor into thinking he or she still needs the death benefit. Your heirs will owe income taxes if they inherit an annuity. Annuities, unlike most other investments, don’t get a favorable tax treatment known as a “step up” in basis when you die. The so-called “step-up in basis” eliminates or drastically reduces the taxes heirs must pay when they sell. The step-up can eliminate taxes on stocks, bonds, mutual funds and real estate that are inherited. While most other investments get favorable tax treatment, withdrawals from an annuity are taxed at regular income-tax rates. In addition, due to its insurance feature, variable annuities cost more than comparable mutual fund investments. An article from MSN Money explains:
The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost. Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio. If the underlying investments returned 8% a year, after 30 years:Your variable annuity would be worth $362,177. Your mutual funds would be worth $431,874 — a difference of nearly $70,000, or 14 years worth of contributions.The gap just widens if you consider the tax implications. In both scenarios, you won’t have to pay tax on your original contributions when you withdraw the money. But the mutual fund gains would in most cases qualify for capital gains tax rates, which currently range from 5% to 15%, while the annuity’s payments would be taxed at income tax rates — currently 10% to 35%.
Most annuity purchases are actually the reinvestment of proceeds from the sale of other annuities. This practice is referred to as “annuity switching.” It is analogous to mutual fund flipping and is highly suspect. The switch pays the broker significant commissions and involves the reestablishment of maximum surrender charges, while providing the investor with little benefit over their existing annuity.
Surrender charges are paid by an investor when he or she withdraws money from a variable annuity before a specified period. Annuity switching may prolong the surrender charge period. With respect to the old annuity, you may be at the end of the surrender charge period. Once the surrender charge period is over, you do not have to pay any further charge for withdrawals. This favorable position is lost by the annuity switch. Now you have to start over again. The new annuity imposes a new surrender charge period that lasts another seven to fifteen years.
A customer’s premium payments to purchase a variable annuity are allocated to underlying investment portfolios termed sub-accounts. Some of these underlying investments may expose the investor to an inappropriately high level of risk. Pursuant to NASD NTM 99-35, a registered principal is required to confirm the suitability of the sub-account allocations and subsequent changes to those allocations.
VARIABLE ANNUITIES WITHIN AN IRA
It is almost never appropriate to place a variable annuity in an IRA or 401(k). The main benefit of a deferred variable annuity is tax deferral. An IRA or 401(k) already has tax deferral. So it makes no sense to place a variable annuity inside an IRA. The only reason it is done is to increase the broker’s commission.
Moreover, when you place a variable annuity inside an IRA, the minimum required distributions can trigger unnecessary surrender charges. When you turn 70 and 1/2 years old, the law requires you to begin withdrawing money from your IRA. Each year you must take a minimum required distribution. When you withdraw from the IRA, you are also withdrawing from the annuity held in the IRA. When money is withdrawn from an annuity, surrender charges are imposed by the annuity company. Therefore, due to the minimum required distribution, you will have to pay surrender charges on the withdrawals of money from the annuity.
Registered representatives, under the pressure to increase their commissions, recommend variable annuities because they generate a 6% to 7% commission, whereas most other types of securities generate only a 1% to 3% commission. Registered representatives often fail to adequately disclose their incentive for selling the variable annuity, namely that they receive a significantly higher commission than they would have, had they invested their clients money in stocks, bonds and mutual funds. “The duty of fair disclosure applies to the broker’s commissions and other compensation where the nondisclosure may be material to the customer’s decision to purchase the security the broker has recommended.” NASD Enforcement v. Josephthal & Co., Inc., 2001 WL 1886873 (May 15, 2001).
The purpose of this blog has been to warn investors against variable annuities by providing them with important information which their brokers failed to disclose. If you are confronted with a sales pitch, ask yourself the following:
- Did the broker explain that an annuity purchase locks the investors in for the length of the annuity?
- Did the broker disclose that surrender charges would be imposed for early withdrawals?
- Did the broker disclose the high commissions and substantial ongoing fees that are earned over the length of an annuity?
- Did the broker explain that commissions were much higher when amounts subsequently invested were used to purchase additional annuities instead of used simply to increase the investment in the first annuity?
- Did the broker explain that the life insurance benefit would be minimal in comparison to the high commissions and ongoing fees?
- Did the broker explain that the high commissions and ongoing fees would ordinarily offset any tax advantage of the annuity?