A “variable annuity” is an annuity in which the amounts that are accumulated in the cash surrender value (variable deferred annuity) and the amounts that are paid as annuity income benefits (in the case of a variable annuity income) are not guaranteed by the insurance company.24
An annuity historically provided payments of a fixed amount over a specified period of time or through the lifetime of one or more individuals. Since there was been inflation over several decades, the insurance industry became very aware of the need for protecting the purchasing power of annuity benefits. The concept was that the insurers should provide benefits that varied as the changes in the investment performance of the insurers varied, which would then coincide (approximately) with the purchasing power of the dollar. From this was created the variable annuity.
In order to accomplish providing benefits that are relatively stable and “in tune” with the fluctuating economy, it must, simply put, provide more dollars when prices rise and conversely, fewer dollars when prices decline. Theorists initially attempted to accomplish this dilemma by adjusting benefits to coincide with a price index, such as the Consumer Price index published by the Bureau of Labor Statistics. The problem with this approach was that there was no vehicle that allowed the value of the assets backing the annuity to be automatically adjusted (or even manually adjusted) to changes in the dollar value in the assets backing the annuities.
A more practical solution was to allow annuity benefits to adjust to changes in the market value of the assets (usually common stocks) in which the assets are invested. This theory was that over a long period of time, the market value of a representative group of common stocks will conform rather accurately to changes in the consumer price level. Therefore, since the insurer’s liabilities to its annuitants are expressed in terms of the market value of the assets designated to offset these liabilities, funds available to pay annuity benefits will be available in the proper amount and in the proper proportions at all time.
The variable annuity has both its supporters and its detractors,. Supporters believe that the annuitant needs protection against inflation, and they firmly believe that a common stock investment program administered by a life insurance company is the best approach developed so far. Critics of the variable annuity question whether continuing inflation is inevitable and granted that if it is, whether investments in common stock provides an effective hedge against rising prices.
According to a recent Life Insurance and Marketing & Research (LIMRA) Deferred Annuity Buyer Study, 81% of annuity buyers and their spouses own life insurance, compared with 62% of the general adult population. However, only 15% of the 29.4 million economic households owning individual permanent life insurance own an individual annuity (leaving 85% of life insurance owners available for annuity discussion!). And in the same vein, the number of companies that offer variable annuities has grown from 48 companies soon after introduction of the product, to approximately 665 companies offering nearly 400 products.25
TYPE OF ANNUITY - FIXED OR VARIABLE
Recent surveys demonstrate a demonstrable shift from fixed annuities to variable annuities. Current owners of non-qualified annuities are more likely to own variable annuities (65%) than fixed annuities (35%). By 1999, owners of non-qualified annuity contracts were just as likely to own variable contracts (51%) as they were fixed contracts (49%). This survey showing a movement towards variable annuities was evident at all phases of the survey, as only 28% of annuity owners in 1992 had variable contracts.
TYPES OF ANNUITIES OWNED
1997 1998 1999 2001
(percentage)
Fixed Annuities 54 46 49 35
Variable Annuities 46 54 51 65
Statistics reveal that annuity owners with household incomes of $75,000 a year or higher, are more likely to own variable non-qualified annuities, 79% of them own variable annuities, compared to only 61% of annuity owners with incomes between $20,000 and $74,999, and those with incomes under $20,000, 32% own variable contracts. 70% of males own variable annuities, versus 60% females.
In respect to age, annuity owners under the age of 64 are more likely to own variable annuities (80% compared to 55% of those age 64 or older). This should not be a surprise as older persons are more conservative in their financial matters and would therefore be expected to own fixed annuities.
The annuity started as a tax-deferred, simple payout product, but now is an investment “vehicle,” offering tax deferment plus several various payout options, plans that allow for systematic withdrawals, dollar cost averaging and other options.26
The primary benefits of variable annuities are:
» death benefit; » Tax-free transfers;
» living benefits; » performance;
» tax deferral; » probate avoidance;
» liquidity; » potential for a guaranteed lifetime income.
The benefits, as discussed in detail in this text, are legitimate benefits and should be emphasized by an agent.
Premiums deposited in a variable annuity go into a separate account where they are invested in a variety of securities, similar to investing in a mutual fund. Because variable annuity premiums are used to buy securities, they are subject to fluctuating market conditions, resulting in a variable rate of return that depends upon the performance of those securities. There are no guarantees about the value of the annuity at any given time since the value depends upon the separate account performance. Not even the principal amount invested by the annuity owner is guaranteed, which means it could be diminished or lost entirely.
Having said that (above paragraph), some insurance companies have began offering new types of guaranteed minimum benefits under deferred variable annuities.
One particular benefit is known as the guaranteed minimum account (or accumulation) value benefit which states that the account or cash value will, if necessary, be increased to equal a specified percentage of the premiums invested after a specified period of time.
As an example, the guarantee may be that on the last day of the (pick one) year, the cash value will be worth at least 115% (or 100% or 90%, depending upon the choice of the owner) of the purchase payments (considerations), less withdrawals. At the end of the guarantee period, the annuity owner has options, including continuing with the annuity with the enhanced value, or surrendering, or annuitizing.
This benefit is usually optional, for which there is a separate fee charged to cover the cost to the insurer of providing the guarantee. The price ranges from .75 percent to 1.5 percent of the account value each year.
While some insurance companies have introduced minimum guarantees and minimum withdrawal guarantees for their variable annuity contracts, they have driven up the price and additionally, reinsurance companies are not usually interested in reinsuring these contracts. The result has been that some of the insurers that had offered minimum guarantees no longer offer such guarantees. Some insurers have drastically reduced the level of these guarantees. It should be pointed out that an insurance company cannot unilaterally alter existing variable annuities and insurance departments are not anxious to allow insurers to eliminate this consumer-friendly feature.
In the traditional variable deferred annuity contract, the amount of the cash value that is available to provide annuity income payments will depend upon the investment performance of the subaccounts or investment options to which the premiums and cash values have been allocated during the accumulation or deferral state. So that the owner can counter against poor investment performance resulting in insufficient cash value that is needed to provide the necessary income benefits at retirement, some insurers offer a guaranteed minimum income benefit.
Variable annuity death benefit guarantees provide that the death benefit of the variable annuity will never fall below a stated level regardless of the performance of the fund. This benefit guarantees that annuity income payments on the annuity starting date will be based on the larger of the actual annuity value, or a “payout base.” The payout calculation depends upon the contract, but could, for example, be premiums credited with a specified interest rate (such as 4%), the maximum anniversary value before annuitization, or some other combination.
The annuity purchase rates are, by necessity, conservative, because the insurance company takes considerable risk in making such a guarantee. This benefit usually has a separate fee which can range from 0.15 percent to 0.50 percent of the account value each year—typical fee is 0.25% to 0.30 % per year.
Minimum death benefit guarantees presently in use generally include the following:
Interestingly, in “annuity parlance,” the term “tail risk” refers to the minimum death benefit guarantee and minimum living benefit guarantee. “Left tail risk” pertains to underperformance of the underlying assets and the risk that the actual returns will be below that needed to provide the benefits guaranteed under a minimum living benefit. “Right tail risk” pertains to issues of better-than-expected performance.
The guaranteed minimum withdrawal benefit (GMWB) allows the owner of a variable annuity to make period partial withdrawals of a stipulated percentage of the premiums/consideration over a specified period of time, such as 5% may be of the premium/consideration may be withdrawn paid for 20 years—or some plans allow the remainder of the owner’s life. The effect of the GMWB is that the owner is guaranteed the ability to recover at least the premiums that are paid for the annuity, even if the market goes to you-know-where in a handbasket. The GMWB will specify a benefit base that approximates the premiums premiums/consideration paid for the annuity, less any partial withdrawals of the annuity.
Some annuities will increase the benefit base by specified percentages (such as 5% a year) if withdrawals are not taken until after a specified period of time (such as 5 years). Sometimes the annuity provides for a “step-up” provision which allows for increases the benefit base to the current contract value. The change for the GMWB runs between 0.30% and 0.60%.
This is the newest and most popular form of living benefit which guarantees the systematic withdrawal of a certain percentage of premiums annually (such as 7%) until the original investment has been completely recovered, regardless of market performance. Sixty-nine percent of all new, non-group sales in 2004 were contracts that offered this type of feature. The latest version to hit the street provides for lifetime guaranteed minimum withdrawals.
The measuring stick of determining investment performance of the underlying funds to the annuity owner is accomplished through the use of “unit values.” Each investment fund has a separate unit value and any change in the unit value over time reflects the investment performance of the fund. For any actuarial computation or study, it is necessary to convert unit values to dollars—in any event, it would be meaningless to tell an annuity owner that they own X number of units unless the owner knew or was informed as to the value of the unit.
Variable annuities are usually issued on a deferred basis and during the accumulation period, the deposits are used to purchase the accumulation units. At that time each unit is (arbitrarily) assigned a value—usually $10—at the beginning of the annuity, and the initial premiums purchase accumulation units at that price. Each month thereafter, the units are revalued to reflect the change in the common stock that makes up the company’s variable annuity portfolio.
At any valuation date, the value of the accumulation unit is determined by dividing the market value of the common stock (underlying the units) by the aggregate number of units.
At the inception of the variable annuity fund, an initial unit value is assigned at the close of the business day and at each valuation date at the close of the business day.
Specifically, the unit value at any particular day is the value of the unit the previous day multiplied by a net investment factor. The factor on the valuation date is
EXAMPLE: Calculation of the Net Investment Factor and the Accumulation Unit Value
Total value of the fund $1,000
Accumulation unit value 1.2500
Investment income $5
Capital gains $5
Expenses —$2
Total $8
Net investment factor 0.008
New accumulation unit value 1.2600
Dividends are allocated periodically in most plans, to the participants and are applied to the purchase of additional accumulation units. Alternatively, they may be reinvested without allocation and allowed to increase the value of each accumulation unit.
The appreciation or depreciation of the funds are always designated as the value of the units, not the number of units. Technically, both realized and unrealized gains and losses are determined for each participant by the increase or decrease of the accumulation units. A portion of each payment is deducted for expenses and the remainder is invested in accumulation units at their current market value.
During the liquidation—annuitization—period, the higher the market price of the stock and the greater the dividends, the greater the income will be to the annuitant. However, during the accumulation period it is to the advantage of the annuitant for the stock prices to be relatively low as that way they will be able to acquire a larger number of accumulation units for each premium payment.
Some variable annuity contracts use only one unit rather than two, some discount for mortality before as well as after retirement, and by limiting variations in the unit value to investment experience only.
Basically, fixed annuities only have one “charge,” a surrender charge. Variable annuities have two types of charges based on the assets, plus an annual contract fee. There may also be other fees associated with optional benefits, and other benefits may not have the additional fee. Fixed annuities actually have similar charges, but they are reflected in the interest rates that are credited to the annuity.
The annual contract fee is usually imposed to cover some of the administrative expenses, such as the reports that are provided to the annuity owner. The annual contract fee is normally a flat dollar amount, somewhere between $30 and $50. Often this fee is waived if the cash value of the contract exceeds a stipulated amount (such as $50,000).
There is a charge that is based on assets for investment management expenses relating to the portfolios of assets on which the annuity is based, such amount varying by a number of factors, including the nature of the subaccount investments. As an example, the expenses of managing an international equity fund would be substantially more than managing a money market investment option. Also, the investment management expenses involved where there are actively managed investment options would be more than if the options were indexed more passively.
Investment management expenses for variable annuities average 0.974 according to recent studies.
The mortality and expense charge (M&E charge) is designed to compensate the life insurance company for the risks it assumed in connection with the variable annuity, plus some administrative expenses. The function of the M&E charge compensates the insurer for the three different guarantees within a variable annuity.
Item (3) may seem odd that an insurance company would charge for these expenses, but it should be remembered that an insurer’s obligations under a variable annuity contract can last over several decades and the insurer is guaranteeing that it will not increase the fees and expenses it imposes under the contract regardless of how much the company’s cost of doing business during that period may increase.
The amount of the M&E charge differs by company, but it usually is between 0.75 percent and 1.50 percent of the value of the variable account investments within the contract.
The death benefit payable under a variable annuity has changed considerably in the last 10 years. Originally, the death benefit was equal to the greater of the accumulation units, often reduced by certain surrender charges, and the premiums paid. Since then there have been many variations introduced, most of which are designed to protect against the loss of retirement savings in case of death during the time the stock market has declined.
Some variable annuities provide that the death benefit will be recalculated each year to the accumulated value at that time, but not less than paid premiums less prior withdrawals (the “ratchet” approach). Another type, often called the “rollup” approach, provide that the death benefit will always be an amount at least equal to the premiums paid plus interest at a specified rate.
Of more recent vintage are variable annuities that have death benefits equal to a specified percentage of the gain in the contract—such as, a death benefit that is equal to 30 percent of the excess of the account value over the premiums paid. Some variable benefits combine the death benefits into one provision, others offer a choice of death benefits when the contract is written.
A typical feature is that the amount of the death benefit is reduced for older owners or annuitants. Some annuities have caps and limits on the benefit.
The availability of the death benefit is one reason that variable deferred annuities are popular investments in IRAs and pension plans. A survey conducted for the National Association for Variable Annuities, showed that variable annuity beneficiaries received death benefits that exceeded the value of the annuities by nearly $3 BILLION.
Investment return is a very important variable in determining annuity payments.
F The calculation of benefits from a variable annuity is based upon an assumed investment return (AIR).
The AIR is the investment return on the initial payment which is an assumption made when computing the amount of the variable annuity payment. Later payments will increase or decrease depending upon the relationship of the AIR and the actual investment returns. If, for instance, the separate account earnings are more than a the AIR, the payment amount will increase, if earnings are less than the AIR, payments will decrease.
As an example, if an annuitant receives $100 a year with an AIR of 3 percent, and the actual return for the first year is 10 percent, then the payment at the beginning of the second year will be $106.80. [$100 X (1.1 ÷ 1.03)]
In actual practice, annuity payments are calculated by annuity unit value. This is used to determine the amount of variable annuity payments. Simply put, the amount of the annuity payment is determined by multiplying the number of units by the annuity unit value. The annuity unit value is calculated in the same fashion and consistent with the accumulation unit value as discussed above, except that the change in the unit value is the excess of the actual rate or return divided by the assumed rate of return, instead of divided by the previous rate of return.
As an example:
Annuity unit value 1.2500
Net investment factor 0.0080
AIR adjustment (@ 4%) 1.0033
New unit value 1.2559
When a contract owner pays a premium, that premium is divided by the unit value as determined at the close of business that day, as follows:
First, the value of each unit is equal to the value of all of the securities in the separate account divided by the number of outstanding units. If the fund is valued at $400,000 on June 1st and there are 200,000 units outstanding, then the unit value is $2.00.
Next, the number of units that was purchased is equal to the premium paid divided by the unit value on that day. If the contract owner paid a $100 premium on June 1st, he would acquire 50 units ($100 divided by $2.00 per unit, equals 50 units.)
The next step would be to determine the value of the contract which is the total units owned multiplied by the unit value at the end of the business day of the valuation. If the contract owner now owns 835 units (which includes the 50 units just purchased) on June 1st, then the value of the contract on that day is 835 units times $2 per unit, which is now $1,670.
This process is repeated at any time that the contract holder wants a valuation of his contract. The prime numbers are the fund value, the number of outstanding units, the unit value and the number of units owned by the contract holder. The fund’s values fluctuate with the market which will be reflected by the value of the contract. Therefore, every day there are changes in the number of outstanding units as premiums are paid and distributions are made.
Unit value changes are usually measured in small increments and in those situations where the cash value of the policy is distributed among several subaccounts, the total value of the contract is determined by adding the subaccount values.
Mutual funds and variable contracts are explicably intertwined and as explained in detail later, mutual funds are the primary investment vehicle for variable contracts. Mutual funds have been around for more than 50 years, as evidenced by the fact that in 1940 the Investment Company Act was written to regulated “open-end investment companies,”—mutual funds. They became popular in the early 1980s because of the successful marketing of mutual fund managers who convinced many consumers that they were, indeed, “user friendly.” The result was gratifying for mutual funds as many persons who were just “savers” poured their savings into mutual funds in order to take advantage of the higher interest rates.
When the interest rates declines in the later 1980s, those who had invested in fixed-interest financial instruments (read “life insurance”) chose to move their assets to mutual funds, with the end result that mutual funds grew rapidly, to where there are now over 4,000 different mutual funds, up from about 200 only 10 years ago.
With additional competition, insurers wanted to make better products, so they expanded the account options, to the point that today, variable contracts can offer ten or more separate accounts within one contract. To make them even more attractive, the flexibility was increased by allowing contract owners to transfer their assets between the various funds—at little or no extra cost.
Recognizing that not everyone is familiar with investment terminology and practices, the variable contract providers/insurers provide customer support. Programs such as “asset allocation,” “dollar cost averaging” and “diversification programs” help consumers make investment choices available with variable products.
An agent who markets variable products must not only be licensed by the state Department of Insurance, but must also hold a Series 6 or 7 registration with the SEC. LIMRA has reported that the numbers of those agents who hold the SEC registration have decreased and that there are some that are “dually-licensed” that do not market variable products. In the same vein, Securities firms that have added variable products to their portfolios have noticed reluctance to market variable products by their representatives.
The reason for the lack of interest on both insurance and securities representatives is attributed to the lack of understanding of each other’s products. This is entirely understandable; as insurance agents often have difficulty is working with the investment risk and the seemingly-multitude of regulatory and compliance issues. Conversely, the securities dealers who are familiar with the investment part of variable contracts have a difficult time in understanding the risk protection part of the product.
Separate accounts are simply separate accounts into which deferred annuity accumulations are invested. These accounts are separate from the company’s general accounts, hence their name, and are maintained only for the purpose of a mechanism so that contract owners may participate directly in the investment performance of the account. Since the returns vary according to investment performance, they provide a variable return. The annuity owner’s return, plus or minus, in the separate fund is related to the performance of the assets that make up the fund.
F The separate account is a means of transferring the investment risk from the company to the annuity owner.
Since the accounts are separate from the general account of the insurer, the separate accounts are protected from the claims of creditors. Therefore, even if the company is bankrupt, the assets underlying the annuity owner’s cash value are protected from creditors. However, while obvious, it must be pointed out that the assets can also be “lost” by changes in the conditions of the market.
When several insurers collapsed in recent years, the subsequent legal battles were publicized and very favorable attention was drawn to this characteristic of variable contracts. They pointed out that even though many, if not most, consumers purchase variable contracts because of the opportunity to directly participate in the invested assets, they are assured that they will not lose their share of those assets, even if the company should become insolvent.
While the protection against creditors is a major plus for variable products, there is no doubt that the greatest reason to purchase a variable contract is the owner’s participation in the investment. Since the asset performance is the responsibility of the owner, there is always the possibility of gains that can far exceed what an insurer can provide because of the restrictions on the investments of an insurer. It is very common for an owner to realize twice the investment return that he would get under a guaranteed rate.
The first variable contracts allowed the policyholder only three investment options in which to invest the funds, such as a stock fund, a bond fund and either a treasury or money-market fund, which were essentially mutual funds run by the insurance company and set aside as a separate account. The policyholder could put all of the funds into one of these choices or distribute the funds amount the options. Initially there usually was a minimum requirement of at least 5 or 10 percent of income funds that had to be allocated to any investment option that was selected.
The resemblance to mutual funds by separate accounts is not coincidental as both are covered under the Investment Company Act of 1940, which says:
A UIT operates like a holding company with the investors as its clients. The UIT managers usually purchase shares of other management company investments and then pass the gains and losses on to their investors, i.e., they do not actively manage their own portfolios and they do not trade securities.
A management company operates as the name implies—it actively manages the accounts. Some insurance companies, or “sister” companies, i.e., companies owned by the same holding company, etc. have their own independent management companies. Usually they offer the companies’ mutual funds as “subaccounts” within one of their own accounts. Within a single separate account, an insurer may offer as many as 6 or more subaccounts. An example could be where an insurer owns a separate account (UIT), which purchases shares in 4 funds in the insurer’s management, (such as an equity fund, a growth fund, a bond fund and a money-market fund). They also offer 2 funds through another independent management company (such as a balanced fund and an international fund). The second management company trades directly with the public. Therefore, the separate account allows purchase of shares in 6 subaccounts.
Some insurance companies have variable contracts that could offer separate accounts through either a UIT(s)—in which case the insurer is just the conduit through which the annuity owner and the mutual fund can operate—or they can deal directly through an open-end investment company(s). Does one system outperform the other? Not necessarily, but clients may have a preference (and it could make a difference in a sale).
To purchase separate accounts (a.k.a. “variable accounts”) for variable annuities, the owner of the contract selects the separate accounts where they want their assets from the contract invested. If the owner does not like where the assets have been placed, usually the contract will allow the owner to transfer funds between the separate accounts once the contract has been issued. If the separate account is a UIT which invests in other mutual funds, these funds are then subaccounts of the separate accounts.
The Securities Act of 1933 was one of the first regulations passed as a result of the 1929 crash of Wall Street, and this Act required issuers of securities to provide sufficient information to investors so that they could make informed decisions on investments. This was to be accomplished by issuers to register their information with the federal government and to make it available to prospective investors via a “prospectus.” This was considered as a rather harsh law but it was appropriate for the times as it outlawed fraud committed in connection with the initial underwriting of securities, and most importantly, it required that a prospectus be delivered to every person who expresses interest in a security.
Congress also determined that in their opinion, one of the reasons for so many banks failing was that commercial bankers were actually engaged in investment banking. Therefore, a banking act of 1933 banned banks from being in the securities business.
A subsequent Act (1934) created the Securities and Exchange Commission (SEC) who was given the task of overseeing the industry. The Act also regulated the conduct of those persons engaged in the secondary trading of securities, but this was amended later by the establishment of a self-regulatory body to help police the industry, with the result that the National Association of Securities Dealers (NASD) was created to regulate over-the-counter trading in a similar fashion to the way the stock exchanges regulate their members.
Therefore, anyone who wants to sell securities—which definitely includes mutual funds and variable contracts—must first be registered with the NASD. Mutual fund and variable contract sales require a Series 6 (Investment Company/Variable Contracts limited Representative) registration, or a Series 7 (General Securities) registration which is required in order to sell all levels of securities.
The 1933 Act (Securities Act of 1933) exempted from registration and prospectus delivery requirements “[a]ny insurance or endowments policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance Commissioner…or any agency or officer performing like functions, of any State of Territory of the United States or the District of Columbia.” Every federal law following this 1933 Act has excluded insurance products and insurance companies, either explicitly or implicitly The 1940 law that regulates investment companies which engages in offering securities that invest primarily in securities excludes an “insurance company” from the definition of investment company.
The first insurers to issue variable annuities took the position that they should be allowed to rely on the exception under the 1933 Act (Section 3(a)(8) exemption), said exemption position was pleaded all the way to the US Supreme Court, where in 1959, it was determined that such contracts were securities.28
The ruling of the Supreme Court stated that the meaning of the term “annuity” in the 1933 Act exemption was a question of federal law and determined that “the concept of insurance involves some investment risk-taking on the part of the (insurance) company…(and) a guarantee that at least some fraction of the benefits will be payable in fixed amounts.” The key factor is that since the entire investment risk is borne by the purchaser instead of the insurer, the variable annuity contracts were deemed securities.
Not all types of fixed annuities can rely upon the exemption as there have been several court decisions within the past 15 years that have held (or suggested) that fixed annuities with certain features could be securities.29
The SEC has also questioned the status of some “innovative” fixed annuities. When the federal securities laws were enacted, fixed annuities simply represented obligations to pay a fixed sum of money periodically during the life of the annuitant and were based on an assumed interest rate. Then when the prevailing interest rates began to increase, several life insurance companies issued deferred annuity contracts that provided for discretionary excess interest to be credited above a minimum guaranteed rate. The SEC voiced concern about how much risk the purchaser would be deemed to assume when the insurer could lower the rate to a guaranteed minimum rate, whether a meaningful mortality risk was assumed under the contracts, and the extent to which the insurer was marketing the contracts as investments to compete with other investment vehicles.
A Supreme Court decision in 1967 and other lower court rulings, indicated that the manner in which an annuity contract is marketed can affect its status under Section 3(a)(8). Basically, to the extent that a contract is not marketed as a safe and secure retirement savings vehicle but more like a professionally managed investment, suggested that a fixed annuity could be a security.30
While these decisions might indicate to some that two identical annuity contracts, if marketed differently could have different status in the eyes of the SEC, most experts agree that this is not entirely logical and has not, so far, been carried to that extreme.
Therefore, whether a fixed annuity contract under the 1933 Act can be a security will depend upon all facts and circumstances, including contract guarantees and the manner in which the insurer promotes the contract. However, in 1986 after the SEC had thoroughly studied the problem with fixed annuity contracts as an investment, they adopted Rule 151 (under the 1933 Act) that states that fixed annuity contracts within this rule are deemed exempt under the 1933 Act exemption. This Rule 151 is a “safe harbor” rule, which is that annuities that are covered by this rule may rely upon the exemption, but annuity contracts that fall outside the scope of the rule are not necessarily precluded from relying on the 1933 Act exemption.
Whether an annuity falls within this exemption is of major concern to the insurance company, however the agents will be directed whether a certain annuity can be marketed as an insurance product, or whether it would be a security. There have been numerous situations where the question of exemption applies to certain annuities with various rulings by the SEC and the courts. It is beyond the scope of this text to detail all of the situations and legal questions and actions, but in order to understand this problem, Rule 151 helps to determine whether an annuity is an investment. In order to fall within Rule 151, an annuity must satisfy two tests:
In addition, there are four parts of the investment risk test, each of which must be satisfied:
Rule 151 does not, in itself, provide guidance in determining whether marketing really does satisfy the test. However, SEC documentation on this rule makes certain things clear, such as undue emphasis should not be place on current rates of interest; the product should be presented as relatively safe and secure retirement vehicle; and other retirement features such as payout options, death benefits, etc., should not be emphasized more or less than the current interest feature.
There have been court rulings and SEC interpretive releases addressed when fixed annuities are entitled to this Section 3(a)(8) exemption, one of the most significant involved Variable Annuity Life Ins Co. where the court held that its annuities were securities not entitled to the exemption because interest rates being credited to amounts held under the contracts could be changed at any time by the insurer at its discretion.31 This ruling has been tested, and so far annuity contracts without any limit on the insurer’s discretion to change current interest rates on money held under the contract apparently would be nonexempt securities. This rule has only been tested in the 7th Circuit, so it is unclear how it would fare in other jurisdictions.
Rule 151 did not originally “safe harbor” any annuity that credited interest on the basis of an external index. However, the final rule does not preclude indexed annuities from falling within the bounds of the rule.
An indexed annuity can fall within the rule provided it meets all the requirements of the investment risk test and it is not marketed primarily as an investment. When addressing the indexed annuity, the release adopting Rule 151 cited the rate of indexed interest must be guaranteed prospectively for the next 12 months or longer. They also asserted that an indexed annuity that adjusted the rate of return actually credited more often than annually actually operate less like a traditional annuity and more like a security and shirt to the purchaser all of the investment risk regarding fluctuations in the rate.
Therefore, it is possible for indexed annuities to fall within Rule 151. One particular recent court case addressed the major points and is a good example of the thinking of regulatory authorities and the SEC in the area of whether indexed annuities are securities.
In this case32 the issue was whether an equity-indexed annuity where the insurer guaranteed the investor would receive 100% return of premium plus 3 percent interest annually, depending upon the performance of the S&P 500, was a security under the 1933 Act. The court found that the insurer had assumed sufficient investment risk because it was obligated to return premium plus 3 percent annual interest regardless of how poorly the market performed. The only investment uncertainty assumed by the investor was whether she would receive interest beyond 3% per year on her premium payment. Further, the court noted there was no direct relationship between the benefit payments and the performance of the investments that were made with the contract owner’s money.
NOTE: While the designing of annuities is the function of the insurance company and their actuarial and legal departments, whether an indexed annuity—particularly an equity index plan—meets the requirements of the courts and the SEC that exempts the product from being considered as an investment, depends greatly upon how the plan is marketed. Even though a plan has been thoroughly researched and carefully constructed to meet the legal requirements of an exempt product, a careless or intentional misrepresentation of an annuity as an investment product could have a deleterious effect on the overall marketing of such a plan.
F Care must be taken that the annuity is not be described as providing a means of investment in the stock market with downside protection, and the traditional annuity retirement features, such as income options and death benefits, should be emphasized along with the interest-crediting mechanisms.
Variable contracts have special rules as part of the NASD rules and they apply mostly to the construction of the policy and not specifically to agent’s conduct.
Obviously, when the values of a contract can change daily, it is necessary that the value must be determined at a specific time, in this case when the payments have been received—they are considered to have been received when the application has been received. This further emphasizes that all applications and premiums must be submitted to the insurance company’s home office promptly.
A representative may not sell contracts through another broker-dealer unless the other broker-dealer is also a member of the NASD. This also means that an agent cannot sell a product that his broker-dealer is not licensed to sell or does not have a valid sales agreement.
Sales charges may not be excessive and the NASD Rules set forth what is considered as “excessive.”
Section 2300 of the Conduct Rules addresses “suitability” which is the recommending of products for customers only when the product suits the customer’s needs.
The SEC requires that variable annuities cannot be sold without a prospectus similar to that required of new stock issues accompanying any presentation. It is a complete, full disclosure of all of the provisions of the contract and includes expenses, investment options, benefit provisions and the rights of the annuity owner under the contract. It is rather lengthy and in great detail, with the result that most purchasers of variable annuities are not really excited about reading it, but they should, as it contains information that is not available anywhere else. The prospectus provides details on various charges and expenses, such as
Since variable annuity contracts are forms of insurance, states require that agents have a insurance license in order to sell these products. States do vary as to requirements and some require a special separate variable contracts license, while others allow variable contract sales if the financial representative has a valid insurance license and is properly registered with the NASD.
More than 10 companies offer “Extra-credit” annuities, which are variable annuities that credit investors’ payments with an additional payment, generally ranging from 3% to 5%. One of the most frequent usages of this annuity is for Section 1035 exchanges. Unfortunately, some agents have moved annuities by explaining that their current annuity has a surrender charge of 2% (as an example) while the proposed annuity will pay a bonus of 4% (example). This, therefore, covers the surrender charge plus credits an additional 2% to the account.
While this may sound good, one must always remember that insurance companies are not in the business of “giving away” money. While there are differences among the various extra-credit products, it should be kept in mind that most of them come with high charges – known as M+E (mortality and expense, plus administration) charges—plus investment management fees, high surrender charges, and limited standard death benefits.
In reviewing six of the most popular of these contracts, it is interesting to note that all six contracts have surrender charges that are longer and higher than most variable annuities. As an example, the lowest surrender charge in the fourth year is 7%, 6% in the fifth year, and 3.5% in the seventh year — all of which are much higher than the average variable annuity.
Obviously, the higher fees associated with the extra-credit annuities will lessen the benefits of the extra-credit payments over a period of time.
For example, an agent with a substantial company reported that he had a 60 year old client with an annuity valued at $100,000 who inquired about moving the annuity into an extra-credit annuity, therefore receiving a bonus of $4,000, just for exchanging the annuity, almost a “wash” with the $4,100 surrender charge she would have on her present annuity. The agent pointed out that the fees on the extra-credit product were 30 basis points higher than the current product and those fees would reduce her account value by about $25,000 after 20 years - and more than $80,000 after 30 years (assuming a steady 10% growth per year before fees).
In addition, there would be a new surrender charge when the client purchased the replacement annuity. With her current annuity, the client would be free of any surrender charge after three more contract years while the extra credit annuity imposed a 7% sales charge for the first four contract years, 6% in the fifth year, 5% in the sixth year, and 4% in the seventh year.
The agent also showed the client that the extra-credit product did not offer a better standard death benefit than the one she currently had. Besides, the company offering the extra-credit had a lower rating than the existing annuity carrier.
This is not to say that extra-credit products are never appropriate. However, a professional will carefully weigh all of the product’s costs and features when doing any comparison. Since the extra-credit annuities have higher fees than many other variable annuities, these fees will generally offset the bonus payment over a period of time. Further, if the product is being used as a Section 1035 exchange vehicle for contracts still subject to surrender charges, the performance will suffer further as the bonus is partially or fully offset by the surrender charge.
The SEC (Securities & Exchange Commission) has no particular disclosure forms for Variable Annuity exchange transfers, other than generalities to the effect that there should be a rather detailed disclosure of the transaction which would aid the contract owners in determining whether it is in their best interests to exchange.
Be this as it may, the SEC has recently given considerable attention to any exchange offer that involves the “bonus” credit program and it has stated concerns about any higher surrender charges and fees associated with the bonus programs. It has required insurance companies to keep records concerning the exchange activity and how is related to the total number of contract owners that are eligible to exchange, the persistency of the new contracts and number, types, and details of complaints made about such exchanges. These records must be made available to the SEC during examination.
The SEC recently produced an educational brochure, “Variable Annuities – What You Should Know,” available on its Web site for investors, and within that brochure, they address the bonus credit plans and caution investors to carefully “take a hard look at bonus credits” before entering into an exchange.33
Brokers-Dealers who are involved in such exchange situations – including supervisory and suitability requirements – should be aware that the NASD has taken a leaf from the SEC’s book and issued an “Investor Alert” cautioning investors who are considering an exchange and in particular, those with a bonus credit plan, to only make the exchange “when you determine…that it (the exchange) is better for you and not just better for the person who is trying to sell the new contract to you.”34
STUDY QUESTIONS
1. A variable annuity is an annuity in which the amounts that are accumulated in the cash surrender value and the amounts that are paid as annuity income benefits
A. are guaranteed by the insurance company.
B. are not guaranteed by the insurance company
C. must be paid out in a lump sum.
D. are taxed as they accumulate.
2. Premiums deposited into a variable annuity
A. are co-mingled with the insurance company’s assets.
B. are never taxed, at any time.
C. must always be level for the life of the annuity.
D. go into a separate account where they are invested in a variety of securities.
3. Some companies offer a benefit which states that the account will be increased to equal a specified percentage of the premium invested after a specified period of time. This is called
A. a variable life guaranteed minimum income benefit.
B. a minimum death benefit guarantee.
C. a guaranteed minimum account value benefit.
D. a return-of-premium rider.
4. The measuring stick of determining investment performance of the underlying funds to the variable annuity owner is determined by using
A. a percentage of the S&P 500 index.
B. the Consumer Price Index.
C. unit values.
D. comparative analysis with the level premium increased for inflation.
5. The death benefit under a variable annuity has changed over the years and most of the changes have been made to protect against the loss of retirement savings in case of death
A. during the time the stock market has declined.
B. during the time the stock market has increased.
C. caused by accident.
D. during a period of very high inflation.
6. The calculation of benefits from a variable annuity is based upon
A. assumed investment return.
B. 1983 mortality tables adjusted for annuities.
C. what is recommended by Barron’s.
D. the assumptions of the American Actuarial Society.
7. In a variable annuity, the means of transferring the investment risk from the company to the annuity owner is
A. through the stock market.
B. through the calculation of unit values.
C. called the “primary” mutual fund and subaccounts.
D. the separate account.
8. Variable annuity contracts were deemed securities by the Supreme Court and the key factor in this decision was that
A. variable annuity compensation is in the form of commissions.
B. the SEC wanted to increase their oversight power.
C. the entire investment risk is borne by the purchaser instead of the insurer.
D. this would allow banks to enter the annuity market.
9. In addition to the factor above (8), in order for an annuity to fall within Rule 151 (which excludes annuities as investments)
A. the contract must not return more than three percent average growth of the cash value.
B. the annuity must have a fixed return.
C. the annuity must be an immediate annuity only.
D. the contract must not be marketed primarily as an investment.
10. In marketing indexed annuities, care must be taken that traditional annuity retirement features, such as income options and death benefits are emphasized and the annuity
A. should not be described as providing a means of investment in the stock market with
downside protection.
B. is always presented as a type of security regulated by the SEC.
C. cannot be underwritten in any fashion or declined for any reason.
D. must be marketed by licensed security dealers.
CHAPTER THREE:
1B 2D 3C 4C 5A 6A 7D 8C 9D 10A