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A Fitting Problem

THE QUESTION WHAT NEXT? is an expression of exasperation but also one of hope as if so much has already happened that it can't possibly get worse. With all the scandal that's buffeted the securities industry, it's understandable if reps are muttering these words to themselves, but unfortunately the regulators have a very specific response to their question: insurance products. Having found the securities

THE QUESTION “WHAT NEXT?” is an expression of exasperation but also one of hope — as if so much has already happened that it can't possibly get worse.

With all the scandal that's buffeted the securities industry, it's understandable if reps are muttering these words to themselves, but unfortunately the regulators have a very specific response to their question: insurance products.

Having found the securities industry severely wanting in its policing of research conflicts, market-timing and fee disclosures, the regulators are looking to see if similar abuses exist in the insurance industry.

In some ways, their timing couldn't be worse. If such an investigation had taken place a few years ago, most brokers could have shrugged it off — “What do I care about insurance products?” But with the rise of comprehensive financial planning, more and more registered reps are selling insurance, even though relatively few of them have a good understanding of the products.

A survey of 926 financial advisors by Registered Rep. and Hartford Life found that 80 percent currently sell annuities, 60 percent sell individual life insurance and 45 percent sell other types of insurance, such as disability or casualty.

Further, a report issued last year by the Boston-based Cerulli Associates showed that 40 percent of wirehouse brokers, 54 percent of regionals and 44 percent of independents expect to increase their sales of insurance products this year.

“What someone from Prudential or Metlife is doing is not so different from what someone from Merrill does,” notes Andre Cappon, a consultant with the New York-based CBM Group (and occasional Rep. contributor).

Marked By Spitzer

Recently, New York Attorney General Eliot Spitzer issued subpoenas to several insurance brokers seeking information on the compensation agreements between them and insurance companies, which are often not fully disclosed to the clients. The probe turns on the familiar conflict-of-interest issue, but even those inclined to take the investor's side can see the potential for good-faith errors on the part of brokers.

“It would take a highly ethical person not to fall into that [hidden commissions] trap,” says Bob Hunter of the Consumer Federation of America.

As far as reps are concerned, the most important insurance-product probe is the NASD and SEC examination of the variable annuity market. Variable annuities, which accounted for $124.6 billion in sales last year, are essentially investment products packaged in insurance wrappers. They seek to provide both a death benefit and capital appreciation. But because they are more complex they are easily misunderstood by investors, and often even by reps.

As John Olsen, a financial planner in Kirkwood, Mo., says, “I am a strong critic of the way annuities are sold in this country. But this is not a matter of fraud or chicanery. Many reps simply don't know what they're selling.”

High commissions — typically above 5 percent — help drive the sales of these products, which are often sold jointly through broker/dealers and insurance agencies. “This can create an incentive for an agent to push a client into a variable annuity and, yes, that does happen at times,” says Neal Solomon, a fee-only financial planner in Gloversville, N.Y.

Financial planners describe how insurance companies often offer special sales promotions that supposedly credit clients with extra money from the commission. What happens in reality is that the commissions are recouped through other charges.

At some firms, advisors are limited to proprietary products. “As a result, the specific products available to that advisor may not be the best one on the market for that client,” says Carly Maher, manager of variable annuity products at Commonwealth Financial Network in Waltham, Mass. “As an independent broker/dealer, we maintain an ‘open shelf’ policy.”

Variable Complaints

A number of investors have complained they were not told of these hidden agendas. Many also found the variable annuity product was not suitable for them, but by then it was too late to get out without incurring heavy surrender penalties.

Suitability is a big concern. Typical is the complaint received by the SEC from a 77-year-old woman, diagnosed with a brain tumor, who had entrusted $175,000 (the proceeds from a home sale) to a salesperson, with the understanding that she needed money for her husband's nursing home and also to buy a car. The money was invested in a long-term annuity. After paying the withdrawal penalties and accounting for the market-value decline, she was left with $70,000.

An annuity is almost never the best option until an investor has exhausted other retirement options.

“If the investor had not fully funded his tax-deductible vehicles, such as a 401(k) plan, it may be more appropriate to invest in those before buying a variable annuity,” says Solomon. “There he gets a tax deduction, whereas a variable product offers only tax deferral.”

Perhaps the biggest area of abuse is when reps encourage clients to switch from one variable annuity product to another. The reps use Section 1035 of the revenue code, which allows investors to move between life insurance products without tax implications, as a way to explain the action. Indeed, there may be valid reasons for an investor to jump from one product to another — he may get better benefits or lower fees. But in many cases, compliance officials say, reps encourage the exchange simply to get a commission check with each transaction.

Many investors do not realize that such switches trigger commissions and surrender charges and that their surrender period could reset. The NASD-SEC survey found that some advisors were switching variable annuities unnecessarily every two or three years. Not surprisingly, regulators are now calling for investment advisory firms to better supervise their representatives and to review emails and even instant messages closely so as to identify “unfounded, false or misleading justifications for switches or replacements.”

When to Switch

How then does a financial planner, with no vested interest, decide that an exchange is appropriate?

“The rule of thumb I use is, overall, the client must clearly be in a better position after the exchange,” says Olsen. “It can't be a case of ‘maybe.’”

He encourages reps to take the “Ben Franklin approach” — by drawing a vertical line down a piece of paper, listing the positives and negatives of switching.

The biggest negative? High surrender charges. On the positive side, reps should consider whether the death benefit in the new contract is significantly better than the old one. Also, if there are new riders available, it may be in the client's interest to switch.

Unfortunately, there may be cases where the switch is in the client's best interest, but the insurance companies still do their best to deter the move. Financial planners cite numerous cases in which the company says, “Oops. We lost the paperwork. You'll have to do it again.”

Finally, reps looking out for their clients need to be aware of the whole issue of market-timing. A recent Cerulli report suggests, “In order to protect clients from VAs with market-timing practices, advisors should examine the net flows in and out of the subaccounts.”

But ultimately, Olsen says, clients must be aware of what they are getting into. “In many cases, they wanted to be in that micro-cap stock fund — until it began losing money.”


Proposed NASD regulations involving variable annuities.


In recommending the purchase of a deferred variable annuity, a registered rep would be required to determine that:

  • The customer has been informed of the unique features of the variable annuity.

  • The customer has a long-term investment objective.

  • The annuity as a whole, and its underlying subaccounts, are suitable for the customer, particularly with regard to risk and liquidity.

The registered representative also would be required to document these determinations.

Disclosure and Prospectus Delivery

The firm or its rep would be required to provide the customer with a current prospectus and a separate, brief, “plain English” risk disclosure document highlighting the main features of the transaction, including:

  • Liquidity issues, such as potential surrender charges and IRS penalties.

  • Sales charges.

  • Fees (including mortality and administrative fees, investment advisory fees and charges for riders or special features).

  • Federal tax treatment.

  • Any applicable state and local government premium taxes.

  • Market risk.

The risk disclosure would be required to inform the customer whether a “free look” period applies to the variable annuity contract, during which the customer could terminate the contract without paying any surrender charges and receive a refund of his purchase payments.

Principal Review

Before a registered representative could effect any transaction in a deferred variable annuity, a registered principal would be required to review and approve the transaction. The registered principal also would be required to consider specific factors (for instance, whether the customer's age or liquidity needs made a long-term investment inappropriate).

Before a registered rep completes a recommended transaction, the registered principal would be required to review and approve, in writing, the suitability analysis document and a separate exchange or replacement of an existing variable annuity.

Supervisory Procedures

The rule proposal would require registered firms to establish and maintain specific, written supervisory procedures reasonably designed to achieve compliance with the rule's standards.


Registered broker/dealers would be required to develop and document specific training policies or programs designed to ensure that registered reps and registered principals comply with the rule's requirements and that they understand the unique features of deferred variable annuities.

Source: Joint SEC/NASD Report of Examination Findings Regarding Broker/Dealer Sales of Variable Insurance Products, June 2004.


A deferred variable annuity is a contract between an investor and an insurance company, under which the company agrees to make periodic payments, beginning at some future date, to the contract owner. Should the contract owner die during the accumulation phase, a death benefit is payable to the beneficiary.

The assets grow tax-deferred, meaning no income taxes are due until distributions are taken.

The investor may purchase the annuity contract in a lump sum (“single premium” annuity) or in installments (“flexible premium” annuity).

The insurance company offers the investor a variety of portfolios, called subaccounts, which are similar to (but priced differently from) mutual funds, and invest in various types of investments, ranging from conservative to aggressive in their investment styles. The investor can pick a portfolio that most closely matches his risk-reward appetite.

Variable annuity contracts may offer various types of death benefits, rebalancing features, dollar cost averaging options, assorted payout structures, and optional riders, such as a guaranteed minimum income benefit, guaranteed minimum partial withdrawal benefit, and long-term-care insurance.

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