Investment Advisers and Equity Indexed Annuities

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					Annuity Products, Sales Practices,
           and Risks

FIRMA National Training Conference
        Washington, D.C.
          April 12, 2006

                         Your Speaker*
                   Thomas J. Pauloski, J.D.
            Director – Wealth Management Group
            Bernstein Global Wealth Management
                       Chicago, Illinois
                    Phone: (312) 696-7847
                     Fax: (312) 696-7979

*The views expressed by the speaker at this session and in these materials are those of the speaker, not
of Bernstein Global Wealth Management or its affiliates, and should not be construed as tax, legal, or
investment advice.


•   Regulatory Overview
•   Product Overview
•   Typical Product Charges
•   Tax Overview
•   Optional Product Features
•   Sales Practices
•   Potential Risk Management Issues
•   Appendix: NASD® Notice 99-35
Regulatory Overview

NASD® Notices and Alerts

• Notice 96-86 (December 1996): Suitability in
  variable life insurance and annuity sales
• Notice 99-35 (May 1999): Best practices in
  deferred variable annuity sales – see Appendix
• Notice 00-44 (July 2000): Best practices in
  variable life insurance sales
• Regulatory and Compliance Alert 14.2 (Summer
  2000) at 12: Advertising of bonus credit variable

NASD® Notices and Alerts (cont.)

• Investor Alert (May 27, 2003): Variable
  annuities – beyond the hard sell
• Investor Alert (June 30, 2005): Equity-indexed
  annuities – a complex choice
• Notice 05-50 (August 2005): Supervising sales
  of unregistered equity-indexed annuities
• Investor Alert (March 2, 2006): Should you
  exchange your variable annuity?

NASD® Proposed Rule 2821

• Concerns about deferred variable annuities
  – Complex features, riders, and fees
  – Sales to elderly customers for whom long-term,
    illiquid products were not suitable
  – Failure of representatives to understand and explain
    product features
  – Advocating exchange without first ensuring that
    exchange was beneficial
  – Failure of member firms adequately to train and
    supervise representatives

NASD® Proposed Rule 2821 (cont.)

• Four main requirements
  – Suitability
  – Principal review and approval
  – Written supervisory procedures
  – Training of representatives
• Text of rule available at

National Banks and Annuities

• National banks may sell annuities, NationsBank
  v. Variable Annuity Life Ins. Co., 513 U.S. 251
• Consumer protection regulations (12 C.F.R. pt.
  14) address national banks and their “covered
  – Anti-coercion
  – Required disclosures
  – Physical separation of banking and insurance
  – Adherence to state licensing standards
Product Overview


• Annuity is series of periodic payments
   – Note: “Withdrawal” generally is not annuity
• Annuity contract is legal arrangement pursuant to
  which contractholder agrees to pay one or more
  premiums in exchange for right to receive annuity
• Annuitant is individual whose life governs duration of
  annuity payments
• No requirement that annuitant be in good health

Function of Annuities

• Basic function: Systematic liquidation of investment fund
• Protects against possibility of outliving one’s income (in
  contrast to life insurance, which guards against
  premature death)
• Underwriting based upon same fundamental principles
  as life insurance
   – “Law of large numbers”
   – Premiums computed based upon mortality tables

Perceived Advantages of Annuities

•   No annual investment limit
•   No financial underwriting limitations
•   Fund builds on tax-deferred basis
•   Nonprobate asset
•   Provides secure source of income
•   Some protection against creditors’ claims
•   Simple

Classification of Annuities

• Number of lives covered
   – Single-life
   – Joint-and-survivor: Payments cease at last death
   – Joint-life: Payments cease at first death
• Method of premium payment
   – Single-premium
   – Periodic payments
   – Flexible payments

Classification of Annuities (cont.)

• When annuity payments commence
   – Immediate
       • Payout vehicle
       • Purchased with single-premium
   – Deferred (until annuity start date)
       • Functions first as accumulation vehicle
       • May be purchased with single, periodic, or flexible premiums
• Investment performance
   – Fixed
   – Variable
   – Equity-indexed (hybrid)

Classification of Annuities (cont.)

• Disposition of proceeds
   – Duration of annuity payment period
       •   Lump sum
       •   Fixed period
       •   For life (or joint lives)
       •   For life (or joint lives) with minimum term certain
   – If stream of payments is selected
       • Fixed amount
       • Variable payments based on investment performance
   – Existence (or nonexistence) of refund feature (e.g., minimum
     payout if annuitant dies shortly after contract is purchased)

Types of Annuity Contracts

•   Flexible-premium deferred annuity
•   Single-premium deferred annuity
•   Single-premium immediate annuity
•   Variable annuity
•   Equity-indexed annuity

Flexible-Premium Deferred Annuity

• Provides for accumulation of funds, with annuity
  payments deferred until some future date
• No set contribution amount or required payment
• May include front-end load or surrender charge or both
• Interest is credited at not less than guaranteed rate

Single-Premium Deferred Annuity

• Generally, no front-end loads, with provision for graded
  surrender charges
• Interest is credited at not less than guaranteed rate
• Often includes bail-out provisions, whereby
  contractholder can withdraw funds without surrender
  charge if interest rate falls below set rate

Single-Premium Immediate Annuity

• Annuity payments commence immediately after insurer
  has received single (usually large) premium payment
• Often used to pay
   – Life insurance death benefit proceeds
   – Structured settlements

Variable Annuity

• Benefits vary with investment performance of assets
  held pursuant to contract
• Assets are held in carrier’s separate account, which is
  not subject to claims of carrier’s general creditors
• Contractholder bears investment risk
• Traditionally, no guaranteed interest is credited
• Annuity payments may be:
   – Fixed
   – Variable (based upon “accumulation unit” values)

Variable Annuity (cont.)

• Death benefit payable if annuitant dies during
  accumulation period
• When annuity contract is described as “variable”
   – Seller of the contract must have both life and securities licenses
   – If contract is not “private placement”
       • Contract form must be registered under Securities Act of 1933
       • Carrier must file and issue prospectus
       • Carrier’s separate account must be registered under Investment
         Advisers Act of 1940

Variable Annuity (cont.)

• Optional features
   –   Stepped-up death benefit
   –   Guaranteed minimum income benefit
   –   Long-term care insurance rider
   –   Bonus credit

Equity-Indexed Annuity

• Hybrid product that includes certain features of fixed and
  variable annuities
• Contract is credited with return based on equity index
  (e.g., S&P 500), usually with guaranteed minimum
• Common methods of “paying” for guarantee
   – Credit limited to percentage (e.g., 80%) of increase in index
   – Credit subject to upper limit or cap (e.g., 7% maximum credit)
   – Increase in index reduced by administrative fee or spread (e.g.,
     credit equals increase in index minus 3% administrative fee)

Equity-Indexed Annuity (cont.)

• Points in time at which increase in index is measured
  may differ from contract to contract
• Credits generally do not include
   – Dividends paid with respect to stocks comprising index
   – Income from reinvestment of dividends
• Generally, equity-indexed annuities are not registered
  with SEC, but instead are regulated by state insurance

Typical Product Charges

Initial Loads

• Initial premium payment may be reduced by either or
  both of
   – Sales load
   – Premium tax
• Many products are now structured so that these charges,
  in effect, are deferred

Ongoing Charges

• Additional charges may apply after contract purchase,
   – Mortality and expense (M&E) risk charge
   – Administrative fee
   – Investment management fees for variable subaccounts
   – Fees for transfers among variable subaccounts
   – Surrender charge (imposed only upon surrender of contract
     within specified time frame)
   – Fees for optional contract features (e.g., guaranteed minimum
     income benefit)
• Total charges often amount to 250 to 350 bppa

Tax Overview

Basic Income Taxation of Annuity Products

• Build-up of cash value generally is not currently taxed
• Transfer of funds from one investment subaccount to
  another generally is not subject to current tax
• Withdrawals (other than annuity payments) and loans
  are treated first as taxable distributions of ordinary
• Portion of each annuity payment received generally is
  treated as nontaxable return of “investment in the
   – Balance of payment is taxable as ordinary income

Basic Income Taxation of Annuity Products
• Distributions prior to age 59½ generally are subject to
  penalty of 10 percent penalty of taxable amount
   – Exceptions for disability and substantially equal payments for life
• Inside build-up in contracts owned by “nonnatural
  persons” is not tax-deferred
• No gain or loss generally is recognized when exchanging
  one annuity contract for another
• Beneficiary of death benefit (if any) generally is subject
  to tax on gain at ordinary rates
   – Distinguish death benefit proceeds under life insurance contract,
     which generally are not subject to tax

Basic Gift and Estate Taxation of Annuity
• Lifetime transfer of contract for less than full and
  adequate consideration is subject to gift tax
• Value of death benefit proceeds payable to beneficiary at
  annuitant’s death generally is includable in annuitant’s
  gross estate to extent that annuitant (or his or her
  employer) purchased contract

Optional Product Features

Stepped-Up Death Benefit

• In standard variable annuity contract, death benefit
  equals account value at annuitant’s death prior to
• Stepped-up death benefit option guarantees that death
  benefit will equal or exceed one or more of
   – Premiums paid minus withdrawals
   – Account value as of specified date or dates (e.g., each contract
     anniversary date), at contractholder’s election
   – Multiple of death benefit that otherwise would apply
• Cost of this feature may range from 10 to 35 bppa

Guaranteed Minimum Income Benefit

• In most variable annuity contracts, annuity payments will
   – Vary based on account value; or
   – Terminate if account value falls to zero
• Guaranteed minimum income benefit will guarantee
  specified minimum annuity payment (e.g., 7% of
  guaranteed benefit amount), even if investment losses
  cause account value to fall below level that otherwise
  would be required to support that minimum payment
• Cost of this feature may range from 40 to 75 bppa
  (current), 90 to 150 bppa (guaranteed)

Long-Term Care Insurance Rider

• Annuity contracts may bundle other insurance or
  insurance-related products with traditional annuity
• For example, some annuity contracts include optional
  long-term care insurance, which would pay for home
  health care or nursing home care if annuitant becomes
  seriously ill
• Such coverage may be better or cheaper if purchased
  outside of annuity wrapper

Bonus Credit

• Credit to contract or account value, typically based on
  percentage of premium paid (e.g., 1% to 5% of initial
• Risks include
   –   Higher contract charges (e.g., surrender charge, M&E)
   –   Longer surrender period
   –   Bonus may apply only to initial or first-year premium
   –   Contractholder may forfeit bonus in certain situations (e.g.,
       withdrawal, payment of death benefit)

Sales Practices

Section 1035 Exchange

• Tax laws allow certain insurance policies and annuity
  contracts to be surrendered and replaced with new
  annuity contract without imposition of income tax on
  surrender proceeds
• Generally used to allow contractholder to obtain more
  favorable annuity contract on tax-advantaged basis
• Risks include
   –   Whether exchange qualifies as nontaxable
   –   Imposition of surrender charge on existing policy or contract
   –   Exchange may trigger new, longer surrender period
   –   Possibility of higher contract charges under new arrangement

Annuity Arbitrage

• Sale technique involving pairing of single-premium
  immediate annuity with life insurance policy
   – Often involves exchange of one or more existing insurance
     policies and/or annuity contracts
   – Annuity payments from new contract are used to pay insurance
     premiums on new policy
• Economic benefit derives from differences in medical
   – Annuitant perceived by carrier issuing annuity contract to have
     certain health risks
   – At same time, insured (same individual as annuitant) perceived
     by carrier issuing insurance policy to be in excellent health

Annuity Arbitrage (cont.)

• One reason for popularity: Insurance producer earns
  two commissions
   – One on new annuity contract
   – Second on new life insurance policy
• Potential risks similar to those described for Section
  1035 exchange
• Broader issue: Will carriers ultimately fail due to flaws in
  underwriting policies and procedures?

  Potential Risk
Management Issues

Potential Risk Management Issues

• General suitability of investor
   – Sophistication
   – Net worth and income
   – Complexity of product
       • Features
       • Charges
       • Options and riders
• Investor’s risk tolerance
• Long-term horizon
   – Surrender charge and 10-percent penalty
   – Investor’s age
   – Short-term liquidity needs
Potential Risk Management Issues (cont.)

• Conduct of sale
   – Approved materials, including prospectus
   – Explanation of product features and charges
• Internal procedures
   – Compliance with applicable laws
       • State and federal securities laws
       • State insurance laws
       • NASD® rules
   – Registered principal review of each sale

Potential Risk Management Issues (cont.)

• Contract replacement practices
   – Enhancements available in new contract
   – Charges assessed upon exchange
   – New surrender charge period
• Sales within qualified retirement plans
   – Tax-deferral feature is redundant when annuity is held by
     qualified plan
   – Nontax product features must outweigh product costs
• Financial strength of carrier
• Tax consequences / consultation with tax advisor

NASD® Notice 99-35

NASD® Notice 99-35

• Notice 99-35 provides guidelines for NASD® members
  relating to their supervisory responsibilities with respect
  to variable annuity sales
   – Not mandatory
   – Designed to help members implement appropriate procedures
   – Supervisory requirements may be found in NASD® Rule 3010
       • Includes internal review annually

NASD® Notice 99-35 (cont.)

• Differentiate potential annuity benefits vs. mutual funds
   – Tax-deferral
   – Death benefit
   – Guaranteed income for life
• Securities law registration requirements
   – Variable contract under 1933 Act
   – Carrier’s separate account under 1940 Act
   – Distributor as broker/dealer under 1934 Act

NASD® Notice 99-35 (cont.)

• Guideline categories
   –   Customer information
   –   Product information
   –   Liquidity and earnings accrual
   –   Investment in qualified retirement plans
   –   Replacement of existing contracts

NASD® Notice 99-35 (cont.)

• Customer information guidelines
   – Make reasonable effort to obtain information about customer,
       •   Age
       •   Investment objectives
       •   Risk tolerance
       •   Tax status
   – Discuss all relevant facts with customer, including:
       • Customer’s liquidity needs
       • Product fees and charges

NASD® Notice 99-35 (cont.)

• Customer information guidelines (cont.)
   – Ensure that application and customer information is complete
   – Forward information promptly to registered principal for review
   – Registered principal check for accuracy and consistency

NASD® Notice 99-35 (cont.)

• Product information guidelines
   – Registered representative must thoroughly understand product
   – Customer should be given current prospectus
   – Use only sales materials approved by registered principal

NASD® Notice 99-35 (cont.)

• Liquidity and earnings accrual guidelines
   – Lack of liquidity may make product unsuitable for short-term
   – Inquire whether customer has long-term investment horizon
   – Ensure customer understands surrender charge and penalty for
     early withdrawal
   – Establish procedure when investment will exceed:
      • Stated percentage of customer’s net worth; or
      • Stated dollar amount

NASD® Notice 99-35 (cont.)

• Qualified retirement plan guidelines
   – Disclose to customer that tax-deferral feature is unnecessary
     when purchase is for qualified retirement plan
   – Recommend variable annuity only when nontax benefits (e.g.,
     lifetime income) support purchase
   – Conduct “especially comprehensive suitability analysis” when
     plan is subject to minimum distribution requirements

NASD® Notice 99-35 (cont.)

• Replacement of existing contract guidelines
   – Develop “exchange or replacement analysis document”
      • Complete for all replacements
      • Signed by customer, registered representative, and registered
   – Determine whether replacement product is suitable, considering
      • Product features and enhancements
      • Costs and fees, including surrender charge
      • New surrender charge period

NASD® Notice 99-35 (cont.)

• Replacement of existing contract guidelines (cont.)
   – Monitor registered representatives who have particularly high
     rate of replacements
   – Adopt other measures reasonably designed to ensure that
     replacement sales comply with applicable rules


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