Can Annuities Pass Muster?

Having won some big market-conduct settlements over life insurance sales practices, class-action attorneys now are targeting annuities sold in tax-qualified plans.

Allegations that insurers inappropriately marketed life insurance policies led to multibillion-dollar settlements in the past decade. Now, class-action attorneys are setting their sights on a new target: variable annuities.

The suits target annuities sold within such tax-qualified plans as individual retirement accounts, Keoghs, 403(b)s, 401(k)s and 457s. Because they are a type of insurance product, annuities offer tax deferral. Critics say placing them inside a tax-deferred vehicle is redundant, unnecessary and costly to consumers, because of fees that are higher in variable annuities than alternatives such as mutual funds.

"We view the deferred-annuities cases as addressing a legal, financial and moral wrong that is equivalent to the industry's misconduct in the 'vanishing premiums' cases," said Michael C. Spencer, a partner in the New York law firm Milberg Weiss Bershad Hynes & Lerach. "The annuities cases have great prospects despite the fact that some novel legal issues are raised in them." The novel legal issues concern jurisdiction of cases involving securities.

The life insurance industry defends the use of annuities in tax-qualified retirement plans, pointing to a section of the tax code that allows for their use. Investors might want to include annuities in a tax-qualified retirement plan because of other benefits they offer, such as the right to annuitize, or convert the contract into a guaranteed stream of monthly payments for life.

Taking Insurers to Court

Milberg Weiss, the firm leading much of the annuities litigation, was instrumental in negotiating settlements against many of the largest life insurers in the alleged improper selling of life insurance. The firm's biggest prize came from Prudential Insurance Company of America, the hardest-hit company in the litigation, which has set aside more than $2.6 billion for its settlement and has paid out more than $1 billion.

Milberg Weiss' role in the annuities litigation involves suits against five insurers: Nationwide Financial Services, Columbus, Ohio;American United Life Insurance Co., Indianapolis; American Express Financial Corp., Minneapolis; SunAmerica Inc., Los Angeles; and Hartford Life Insurance Co., Simsbury, Conn.

A case against American Express that settled in January will provide $215 million of benefits to more than 2 million class participants, according to the company. The suit was filed in Minnesota state court on behalf of Richard and Elizabeth Thoresen of Portland, Ore. The settlement was reached before the judge ruled on class-action certification, said the Thoresens' attorney, Ronald A. Uitz, a Washington, D.C., lawyer who is partnering with Milberg Weiss on the case. Notice will go out this summer to 2.7 million people who are eligible for a piece of the settlement. Under the settlement, American Express admits no wrongdoing, and the settlement is intended to cover all of American Express' exposure, Uitz said. The parties were still negotiating the details of the settlement in May, he said.

A case against Hartford Life is scheduled for trial Aug. 25. The suit was brought on behalf of about 14,000 municipal employees in San Diego County, Calif., and a companion case was brought on behalf of about 10,000 municipal workers in Los Angeles. the employees are enrolled in 457 plans, which are qualified plans for municipal workers.

The San Diego case has been certified as a class action, but the Los Angeles case has not progressed that far, said James Lance, a partner in the law firm of Post Kirby Noonan & Sweat in San Diego, which represents the plaintiffs. "The gist of the cases is that Hartford is charging fees that are not properly disclosed and are exorbitant for the services it is providing," he said. "Our position is that millions of dollars in damages have been caused to policyholders in San Diego alone."

Hartford's minimum death benefit has been singled out. Lance said that from the time the plan originated in 1982 until 1995, Hartford charged an annual fee of 85 basis points (0.85%) on assets for the death benefit, which guarantees that beneficiaries will receive at least as much as the contract holder invested in the contract. The law firm's experts have determined that the death benefit is not worth nearly the amount charged, Lance said. Hartford reduced those fees after 1995, he said.

Tax-Deferral Redundancy

Milberg Weiss includes commentary on the subject on its Web site, www.mwbbl.com. "Scrupulous companies do not recommend deferred annuities for funding qualified plans because the main benefit and primary selling point of a deferred annuity is tax deferral of earnings, which is a benefit automatically provided by a tax-qualified retirement Account--regardless of what investment is used to fund the account," Milberg Weiss wrote. According to the law firm, in unscrupulous selling, no disclosure is made that the tax-deferred accrual feature is provided by the tax-qualified retirement plan and that the annuity's tax deferral is unnecessary.

"The impact of annuity insurance fees over time can deplete up to one-third of an investor's account by retirement age," wrote Milberg Weiss. When consumers "discover the deception," they are often trapped by high surrender fees.

"To add insult to injury, these surrender fees are used to pay off the sales commission to the agent who improperly recommended the contract in the first place," Milberg Weiss wrote.

The American Council of Life Insurers (ACLI) argues that the tax-deferral redundancy should not be an issue since the annuity fees do not pay for the tax deferral of the product. Instead, they pay for the death benefit, the right to annuitize and a guarantee that fees will never increase, said Laurie D. Lewis, senior counsel at the life industry's trade association, which is based in Washington, D.C.

These annuity fees, known in the industry as the mortality and expense charge, also might pay for the costs of issuing and administering the product, Lewis said.

Mortality and expense charges average about 115 basis points. Variable annuities also charge for the management of each fund, or subaccount, offered in the contract. This can bring total expenses up to 250 basis points or more in many contracts--almost twice the cost of most no-load mutual funds.

Public Support

The U.S. government sanctions variable annuities as an acceptable investment inside qualified plans. "A specific section of the tax code covers annuities as part of a qualified plan, so there's no question in our mind that they were anticipated and expected by Congress," Lewis said.

The U.S. Department of Labor also recognizes a place for variable annuities within qualified plans. Last year, it asked the ACLI, bankers and the mutual-fund industry to develop a form to be used to disclose product fees to 401(k) plan participants, said Ann Combs, vice president and chief counsel for pension and retirement at ACLI. "The Labor Department was very pleased with the form;' she said. "Clearly, it believes annuities can be part of a pension plan."

Combs said the form contains an area for mutual funds to disclose their loads and 12(b)-1 fees. The latter are charged by some mutual funds as an annual percentage of assets to pay for distribution costs, including advertising.

"It's important that people understand what they're paying for," Combs said. "We welcome this disclosure, because it helps our case and to illustrate what we offer."

Combs pointed to a recent event to support the validity of variable annuities inside qualified plans. Early this spring, the U.S. Chamber of Commerce chose SunAmerica, a defendant in one of Milberg Weiss' lawsuits, to provide a variable annuity for the 3 million small-business members eligible for its 401(k) plan. Fidelity Investments, Boston, previously had the contract, but decided not to renew it. The chamber considered proposals from 50 companies before choosing SunAmerica, Combs said.

"Certainly, the business-savvy chamber should know what it's doing, and they went with a variable annuity," said ACLI spokesman Jack Dolan.

Disclosure and Suitability

Last year, the National Association of Securities Dealers, a regulatory agency overseeing the securities industry, issued a notice that both sides of the debate embrace as supporting their positions. The NASD in May 1999 issued Notice 99-35 to its members, reminding them of their responsibilities regarding the sales of variable annuities.

The notice states: "When a registered representative recommends the purchase of a variable annuity for any tax-qualified retirement account...the registered representative should disclose to the customer that the tax-deferred accrual feature is provided by the tax-qualified retirement plan and that the tax-deferred accrual feature of the variable annuity is unnecessary. The registered representative should recommend a variable annuity only when its other benefits, such as lifetime income payments, family protection through the death benefit and guaranteed fees, support the recommendation."

The notice requires that a representative "make reasonable efforts" to obtain information concerning the customer's financial and tax status, investment objectives and other factors that bear on suitability of the product. It states that a member "should conduct an especially comprehensive suitability analysis prior to approving the sale of a variable annuity with surrender charges to a customer in a tax-qualified account subject to plan minimum distribution requirements." Minimum distributions are required to begin at age 70 1/2.

NASD Notice Sparks Debate

While Lewis sees the NASD notice as evidence of governmental acceptance--and as a guideline for sales representatives to explain the benefits of annuities--plaintiffs' attorneys see it as ammunition for their cases. "It's highly supportive of our position," said Spencer of Milberg Weiss. "The type of insurance companies we've sued has basically never honored the guidelines set forth in the notice."

The insurance code and NASD code of conduct include "rules of fair dealing," Uitz said. "That's why insurers cannot argue it's a 'buyer beware' situation in the sale of annuities" inside qualified plans.

"The target marketing of qualified-plan investors is clearly unconscionable, yet that's what insurers are engaged in," Uitz said. "If there were a [legitimate] market, it would be reached by full and fair disclosure of the redundancy by converting insurance charges from basis points into dollars and by truthful labeling of sales loads."

Uitz also maintained that the annuity commission structure puts producers' interests at odds with clients. In the past five years, commissions paid on variable annuities have risen, and the spread between those paid on annuities and mutual funds has widened, he said. One of the incentives for selling variable annuities is that there are no break points on the commissions. "In the mutual-fund world, the more you invest, the lower the percentage you pay in commissions," he said. "For the large-value rollover IRAs, the commissions on a mutual-fund sale might be one-tenth that on a variable-annuity sale."

The regulatory agencies themselves were reluctant to say specifically what, if anything, they have been doing about the issue. Amy Hyland, an NASD press officer, said Notice 99-35 was "a reminder of the very thing brokers were supposed to know" and that it therefore applies to conduct before it was issued.

SEC Joins the Fray 

The Wall Street Journal in November reported that the Securities and Exchange Commission, in its annual reviews of insurance companies, was focusing "on whether companies adequately disclose why annuities aren't necessarily appropriate for qualified plans." Paul E. Roye, director of the commission's investment-management division, told the newspaper, "There's a heavy burden that has to be overcome to justify that product in a tax-deferred plan."

SEC spokeswoman Joanne Bamberger said the Office of Compliance Inspections and Examinations routinely looks at suitability. "To the extent it looks at suitability in compliance reviews, yes, that would be something we'd look at within qualified plans," she said. (See "SEC Wary of Booming Variable-Annuity Sales," page 109.)

Spencer said deferred annuities had grown "phenomenally" in the last decade and now were coming under regulatory scrutiny. "As usual, it takes time for regulators and other watchdogs to catch up to the latest abusive innovations that arise when companies are willing to sacrifice correct conduct for profits," he said. "We applaud the NASD for issuing the notice and following up on it. There are indications that they are continuing investigations."

As for what insurers do with the mortality and expense fees they charge, there is no easy answer. Each company makes it own underwriting decisions based on what is likely to happen in the future, said ACLI's Lewis. "It's possible the M&E charge will provide insurers with a profit, but it's also possible it will cause a loss," she said. "How much things will cost is likely to change. Companies don't know how many people will claim a death benefit or how many will annuitize. You have to set the charge on a level based on your assumptions, but it's not an exact science."

Value of a Death Benefit

Death benefits in some variable annuities promise the highest anniversary account value. Others promise at least the amount invested, less withdrawals, plus 6% per year compounded annually.

Moshe Arye Milevsky and Steven E. Posner recently undertook a project to estimate the value of a death benefit. Milevsky, a professor of finance at York University, Toronto, is a mathematician, statistician and physicist and holds a doctoral degree in finance. Posner is with Goldman Sachs & Co., New York.

In their April 4 report, The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, they reach the conclusion that a simple return-of-premium death benefit is worth from 1 to 10 basis points a year, depending on gender, purchase age and asset volatility. In contrast, the median mortality and expense charge for return-of-premium variable annuities is 115 basis points, according to the report.

"It's all about fees and individual circumstances," Milevsky said. "If the M&E is low enough, then I would put a client in a qualified plan since the death benefit and guaranteed annuitization rates do have some value--about 5 basis points," he said. "But if the fees are 125 basis points each and every year and you are selling it to a 45-year-old in a low tax bracket who is only guaranteed to get their premium back, only at death, then it doesn't belong anywhere, let alone a qualified plan. No, correct that: It belongs in a garbage dump."

Milevsky said TIAA-CREF, the New York-based nonprofit pension-fund company, sells a variable annuity with a mortality and expense charge of 7 basis points. "We'll see more of that kind in six months," he said. "That's a fair value for a death benefit anywhere." But the highest mortality and expense charges currently range up to 170 basis points.

Milevsky also was critical of surrender charges, which can last five to seven years or more. "The surrender charge is like a shadow M&E," he said. "A state regulator recently called me to lament that once he realized what he had bought, he also realized he couldn't even leave."

While Milevsky and Posner use "modern option pricing theory" to arrive at their conclusions--including many pages of calculus equations--Lance, the attorney in San Diego, uncovered some real-life evidence that sheds light on the issue. Lance said his law firm asked Hartford Life during the discovery process how much in death benefits the company had paid in the 17 years the San Diego and Los Angeles plans had existed. He said Hartford claimed it had paid a single death benefit totaling only $119 in San Diego and no death benefits in Los Angeles. Lance said the mortality and expense charge from 1982 to 1995 was 125 basis points. Since 1995, Hartford Life reduced its mortality and expense charge and other contract expenses, he said.

In their report, Milevsky and Posner wrote that a 50-year-old male who purchased a simple return-of-premium guarantee should be charged no more than 3.5 basis points per year, while a 50-year-old female should pay no more than 2 basis points. If the insurer guarantees a 5% annual increase in the value of the death benefit, the fair premium rises to 20 and 11 basis points, respectively.

Milevsky also said insurers ought to charge a higher mortality and expense fee for portfolios with more volatile investments--since there is a greater chance for a steep decline in value--and a lower fee for more stable investments.

In addition to the death benefit, virtually all variable annuity policies guarantee some sort of living benefit in the form of a guaranteed annuitization rate. According to the report, a typical contract stipulates a certain mortality table and interest rate to be used in the computation of the annuity payments. Milevsky and Posner say the implied interest rates are "usually on the order of 3%," which they consider conservative. "We therefore proceed under the assumption that this benefit is presumed to have little value since it is ignored by pricing actuaries, valuation actuaries, regulators and the reinsurer. Furthermore, only 2% to 3% of variable annuities are ever annuitized."

The ACLI questions some of the assumptions in the Milevsky/Posner study, and it has asked actuaries to examine it. "Of particular import to us is what the professor says about not taking into account the annuitization rate, that actuaries ignore it," Lewis said. "That's not what two major issuers of annuities say. Once you start with an incorrect assumption, you reach an incorrect result."

Milevsky and Posner in their report allow for some latitude in insurer costs. "Of course, by focusing solely on economic value, we abstract from reality somewhat by ignoring any reserving requirements as well as regulatory costs, agent commissions and reasonable profits," they wrote in their conclusion.

Since the publication of the paper, Milevsky said insurers had been calling him to ask about new ways to address their risks. He's also heard from plaintiffs' attorneys in the lawsuits. "So I'm straddling both sides of the fence," he said.

Performance vs. Marketing

Despite their higher fees, some annuity contracts have outperformed some name-brand mutual funds over statistically meaningful periods. That being the case, why shouldn't the issue boil down to merely a matter of good investment choices vs. lousy ones?

"Because what it really comes down to is deception of consumers about the nature of the annuity product being sold," Spencer said. "You can always find good examples and bad examples of anything. Our focus here is not the investment performance of the products but how they're sold and the fees people pay for supposedly certain features of the annuities that are not in fact the reason they're sold to them."

Spencer added it is not the entire industry that is engaged in the kind of marketing practices he alleges.

Whether the core issues about variable annuities inside qualified plans are settled on their merits might depend on the outcome of some of the legal issues. They have to do with the application of the 1998 Securities Litigation Uniform Standards Act, which contains provisions requiring that class actions involving "covered securities" be brought only in federal court under federal law.

"There's a dispute as to whether that applies to deferred variable annuities, which is a large part of our suits, because state consumer-protection laws are far more directly applicable to the marketing abuses that are raised in our cases," he said.

Case Update

Milberg Weiss Bershad Hynes & Lerach and other law firms have filed suits against five insurers, alleging inappropriate sales of variable annuities for tax-qualified retirement plans.

American Express Financial Corp., Minneapolis

Settled in January. Notice will go out this summer to 2.7 million people who are eligible for a piece of a $215 million settlement. Under the settlement, American Express admits no wrongdoing, and the settlement is intended to cover all of American Express' exposure, said Ron Uitz, a Washington, D.C.-based lawyer working with Milberg Weiss. The parties were still negotiating the details of the settlement in May, he said.

American United Life Insurance Co., Indianapolis

The American United case was delayed when the judge to whom it was assigned discovered that his retirement plan includes some assets from the defendant. He recused himself, and another judge has been assigned.

Hartford Life Insurance Co., Simsbury, Conn.

The case against Hartford Life was lodged in a state court in New Britain, Conn.; but Hartford had it moved to a federal court. A motion by Milberg Weiss to send it back to state court was pending before a judge.

Another case against Hartford Life was brought on behalf of about 14,000 municipal employees in San Diego County, Calif. A companion case was brought on behalf of about 10,000 municipal workers in LosAngeles. The employees are enrolled in 457 plans, which are qualified plans for municipal workers. The San Diego case has been certified as a class action, but the Los Angeles case has not progressed that far, said James Lance, a partner in the law firm of Post Kirby Noonan & Sweat in San Diego, which represents the plaintiffs. Lance said many Hartford Life executives have been deposed during the discovery stage in San Diego and experts were giving depositions in May.A trial date is set for Aug. 25.

Nationwide Financial Services, Columbus, Ohio

Nationwide filed a motion in June 1999 to have its case dismissed, but an Ohio judge denied the motion in March. That case is in the discovery stage, said Michael C. Spencer, a Milberg Weiss partner.

SunAmerica Inc., Los Angeles

A judge in the case against SunAmerica, a subsidiary of American International Group, New York, dismissed seven of nine charges. The two remaining claim "false or misleading advertising" and "unlawful, unfair or fraudulent business acts and practices." Spencer said the case was proceeding as state consumer-protection claims, which do not require class certification. As of May, it was in the discovery phase.

SEC Wary of Booming Variable-Annuity Sales

As the variable-annuity business booms, the U.S. Securities and Exchange Commission is keeping a protective eye on investors.

The agency is particularly concerned about a relatively new feature of variable annuities--bonus credits--which are designed to woo investors with an initial credit. Several companies have substantially increased their sales by offering an immediate 1% to 5% credit on new accounts.

The problem is, the bonuses often are coupled with higher surrender charges, longer surrender-charge periods and higher asset-based charges, which might eventually outweigh the financial benefit of the sales gimmick, said Paul F Roye, director of the SEC's Division of Investment Management.

"Quite simply, we are concerned with the potential for sales-practice abuses because the cost of the bonus may be less visible than the bonus itself," he said.

Roye made his remarks before an audience of insurance executives at the regulatory affairs conference of the National Association for Variable Annuities. Roye also warned that the SEC would require that investors receive "full and fair disclosure" about the securities they buy. He said those who sell securities should make suitable recommendations.

"We understand that you operate in a competitive environment," he said. "However, increasing sales at the expense of those for whom these products are not suited will not be tolerated."

NAVA President and Chief Executive Officer Mark Mackey said the association "fully supports" the SEC in its efforts to educate the public about annuities.

"The SEC has an obligation as a cop on the beat to see what's going on, and it's my understanding that's what they're doing," Roye said. "We certainly support ethical sales practices, and there must be full and fair disclosure."

The bonus credits are just one concern the SEC has about sales of variable annuities. A recent examination of 52 investment and insurance companies that sold variable annuities in 1999 resulted in about 80% of those companies being cited for not adhering to regulations governing sales practices, said Susan Nash, a senior assistant director of the SEC. About 20% of those cited warranted further investigation and possible penalties, she said. Typically, such an examination reveals about 3% to 6% of cases in the financial-services industry that are considered that serious, according to the SEC.

The commission's investigation comes at a time when the variable-annuity business has never been better, Since 1994, assets in variable-annuity subaccounts have grown an average of 36% per year compared with about 25% for total mutual-fund assets, Roye said. Assets at the end of March totaled $847.9 billion, up from $34.7 billion at the end of 1990.

The SEC's examination of variable-annuity sales practices, which has been under way since the end of last year, has moved into a new phase. On June 5, the SEC unveiled an online brochure to help investors understand the benefits, risks and costs of variable annuities, which have become more complex in the past year.

Many of the SEC's concerns are highlighted in the online brochure (www.sec.gov/news/varann.htm). It cautions investors that variable annuities might not be appropriate within tax-qualified plans; that no variable-annuity benefits are free; that tax-free exchanges of annuities under the 1035 section of the tax code could trigger surrender charges; and that exchanging one annuity for another could cause the beginning of a new surrender-charge period.

Roye pointed to the bonus credits to illustrate this point: "Our concerns are heightened in cases when a bonus is paid to an investor transferring funds from one variable annuity to another in a '1035 exchange,' where an investor at or near the end of a surrender-charge period takes on a new surrender-charge period as a result of the exchange."

He speculated about where higher bonuses might lead the industry. Higher bonuses lead to higher charges and longer surrender periods, and the SEC is concerned that they can effectively become "nonredeemable" if withdrawals trigger these expenses plus recapture of the bonus.

"At some point, we may want to draw a line in this area to preserve the redeemability feature of these products," he said.

Roye challenged the industry to design bonus products with investors' interests in mind and to put safeguards in place to prevent inappropriate sales. "I would urge you not to wait for our inspections staff or NASDR [National Association of Security Dealers Regulation] to come knocking on your door with questions about bonus products," he said. "This is an issue that involves nothing less than the integrity and credibility of the industry," he said.

Roye said the SEC was giving "serious consideration" to NAVA's proposals for streamlining variable-annuity prospectuses. Mackey said the proposals would reduce prospectuses to about 10 pages from about 30 and would replace legal language with words the average person could understand.

"This is an area in which the industry and the SEC can agree that less can be more," he said.