Question: Upon reading your column a month or so ago about the hazards of variable annuities, I cut it out of the paper and sent it to my parents (mid-70’s) who, for years, have been big on investing their money in annuities. Unfortunately, they received it too late. Not only did they lose more than 20 percent of their principal in the variable annuities their broker had sold them only two years ago, but they also let their broker talk them into switching all of their “old” variable annuities into new ones. Thinking that there would be no penalties, my folks were devastated to learn that the penalty period had begun again. Is there anything they can do -- short of murdering their broker?
Answer: According to recent sanctions meted out by the National Association of Securities Dealers and investigations by the Securities Exchange Commission (yes, a salesperson must have a securities license to sell variable annuities), a number of brokerage firms were fined and required to pay restitution because their representatives flipped customers from one variable annuity to another without benefit to the customer.
As we pointed out, variable annuities are, in effect, mutual funds packaged in the middle of an insurance contract that is very difficult for even a lawyer to understand. Since deferred variable annuities carry heavy commissions (up to eight percent), the motivation for sales and switching is often nothing more than old-fashioned churning.
Unfortunately, most customers do not even realize they are paying a commission, much less that the commission will be recouped from their investment over a long period of time. Nor do they understand that they will be charged very high annual fees – an average of nearly 2.5 percent of assets in each annuity. These charges and fees are not clearly detailed in what we feel are ridiculously complicated and confusing documents called, of all things, “disclosure” forms. And to make matters even worse, most folks do not understand that if they surrender their annuity within the first seven to 12 years, they will be charged surrender fees to make up for the commission the salesperson earned up front.
Since variable annuities grow (or are supposed to grow) tax deferred, exchanges – called Section 1035 exchanges, when one variable annuity is switched to another, there is no taxable event. But contrary to representations made to customers, an exchange of one annuity for another still triggers surrender charges -- meaning that even less principal will be available for investment.
In one reported situation strikingly similar to that your parents’, an investment advisor convinced a number of his clients to exchange the variable annuities he had sold them for new annuities, telling them that there would be no fees involved in the transfer. According to the NASD, these clients lost more than $165,000 in fees alone while the exchanges generated more than $200,000 in commissions for the advisor. Not too shabby for taking advantage of his elderly clients.
Since commissions are not clearly explained, the purchase of a variable annuity is, in our view, much more dangerous than stock transactions where the commission is clearly shown on the confirmation statements.
Variable annuities are meant for only a very small segment of our population which does not include elderly individuals who do not have the time to watch their principal grow.
Taking the NextStep: Have your parents contact the NASD and SEC to see if the representative who handled their annuities for them, or his company, has been sanctioned. These reports are matters of public record. Have them get their information together and make a formal complaint against the investment advisor and his employer in the manner required by the rules.