September 12, 2013 Comments (0) Blog, Securities Fraud

Overview of Variable Annuity Securities Fraud Cases

The following is intended to provide a brief primer on variable annuities, some of their many pitfalls, and the improper sales of such investments that often result in litigation.

i. Variable Annuity – Defined

A variable annuity is an insurance contract in which, at the end of the accumulation stage, the insurance company guarantees a minimum payment. The remaining income payments can vary depending on the performance of the managed portfolio.

The portfolio generally invests in equity securities and its performance determines the amount of this total payment.  Just as with any investment in securities, the underlying subaccounts can go up or down depending on the performance of the investments.  As such, one common misconception of variable annuities is that they are somehow safer than say, mutual funds.  The safety of a variable annuity depends entirely on how the subaccounts are invested.

According to a recent Investment News report, the following firms are the top participating issuers of annuities:  MetLife, Prudential Financial, Jackson National, TIAA-CREF, Lincoln Financial Group, SunAmerica/VALIC, Nationwide, AXA Equitable, Ameriprise Financial, AEGON/Transamerica, Allianze Life, Pacific Life, Sun Life Financial, Protective, and New York Life.

The variable annuity providers contract with financial advisors throughout the country to sell their products.  The annuity provider then pays a commission to the financial advisor for selling their product to the financial advisor’s customer.

ii. Variable vs. fixed


But there are a couple of twists that make a fixed annuity slightly different. On the plus side, unlike with a bank CD, the interest you earn in a fixed annuity isn’t taxed until you withdraw the money from the annuity.

In addition, insurers typically charge an early withdrawal penalty for withdrawals made within the first seven to 10 years that you own the annuity. These early withdrawal penalties can start as high as 10 percent and then usually decline by a percentage point annually until they disappear after seven to 10 years.

A variable annuity, by contrast, works more like a mutual fund. You invest in one or more “subaccounts.”

Often, these variable annuity subaccounts are modeled after or even go by the same name as retail mutual funds. There are some important differences, though, between a mutual fund and a variable annuity. For one thing, a variable annuity has an extra set of fees — usually known as insurance costs or M&E (mortality and expense) charges — that give them higher annual operating expenses than mutual funds. Frequently, the combination of the investment management fees to run the underlying investment portfolio plus the insurance charges drive a variable annuity’s annual costs above 2 percent a year.  These costs can make variable annuities one of the more costly investments sold by financial advisors.

The primary difference, though, between a fixed and variable annuity deals with risk.  With a fixed annuity, the annuity provider is guaranteeing a rate of return and the primary risk is only that the provider is unable to pay that return.  A variable annuity, on the other hand, has the same risk as any other investment, including the risk of a total loss.

iii. Underlying subaccounts

As stated above, the biggest risk of investing in variable annuities (versus fixed annuities) lies in the subaccounts.  The more aggressive the investments in the subaccounts the more exposure the annuity has to risk.

One common mistake with investing in variable annuities is the false sense that you can’t lose money in your annuity so it is ok to more aggressively invest the subaccounts.  This is a false assumption.  Although annuity companies do often offer a nominal guaranteed growth, any meaningful increase in the value of the annuity (either the present value or the death benefit) comes from the value of the underlying investments.  As such, dramatic losses in the subaccounts will substantially impact both the present value and likely the ultimate death benefit of the annuity.

iv. Common Misuse of Variable Annuities

There is a time and place for virtually any investment sold by a brokerage firm.  Annuities have tax benefits that can be attractive, as well as other benefits which are not the subject of this piece.  The problem with variable annuities is that they are often over sold (or sold as too large a percentage of the investor’s particular net worth).

Just as with any other investment, it is never wise to over-concentrate your assets in any particular investment.  Brokers often convince clients that because you can diversify the underlying subaccounts that it is ok to invest a significant percentage of your net worth in a variable annuity.  This ignores the illiquidity of annuities as well as the costs associated with early withdrawals.  If your financial advisor is recommending that you put all of your eggs in one basket, there is likely a reason.

iv. Costs and commissions

And here is the reason.  Most of the problems with annuities revolve around the costs.  Of course, it is exactly these costs that incentivize financial advisors to sell them (and attract bad brokers to over sell them).  The primary costs associated with variable annuities are as follows:

1. Surrender charges – Most insurance companies charge a surrender fee (usually on a five to seven year scale). These fees often start at around 8% in the first year down to 0% in year seven. So, a $100,000 investment could cost you $8,000 (8%) in surrender fees if you take your money out in the first year.

2. Up-front commissions. Annuities are still primarily a commission-based product. They can pay commissions of 5% or more to the agent who sells them to you. That’s $5,000 or more in commissions for each $100,000 invested.

3. Annual fees, administrative charges, mortality expenses, and other charges – There are a variety of charges that the annuity provider charges the customer for administering the annuity contract.  These fees directly impact performance and make it difficult for variable annuity investors to outperform the market regardless of how the subaccounts are invested.  Of course, it is all of these costs that make the investments so profitable for insurance providers and this is why they are willing to pay such a high commission to the financial advisors willing to sell the products.

v. Annuity Switching

Selling an existing variable annuity to buy a new variable annuity is a hot button issue for most securities regulators.  Since demonstrating that a variable annuity purchase is suitable for a client is difficult, demonstrating that selling one annuity to buy another one is a particular red flag.

The factors to be considered by any financial advisor before recommending a variable annuity are as follows: the age of the investor; the investor’s annual income; the investor’s financial situation and needs; their investment experience; their investment objectives; the intended use of variable annuity; the investor’s investment time horizon; their existing assets (liquid and non-liquid); the investor’s risk tolerance, and their tax status.

If a financial advisor is recommending an annuity swap, they must also consider the following: any surrender charges and/or bonuses received; the loss of existing benefits (living or death) in giving up the existing annuity; any increased annual contract costs; any increases in the surrender charge period; any product enhancements and improvements obtained; and whether the customer has recently replaced another variable annuity.

In light of all of these considerations and the high costs of these investments, it is difficult for a financial advisor to justify a variable annuity swap or variable annuity switch.

vi. Regulatory Scrutiny

Because of some of the issues discussed above, the sales practices of those who sell variable annuities have been met with a great deal of regulatory scrutiny.  The sheer number of regulatory notices issued by FINRA on variable annuities should tell you that the improper sale of variable annuities is a problem of which FINRA is acutely aware.  Here is but a sampling of some of the FINRA notices that discuss or relate to the sale of variable annuities:

Regulatory Notice 12-55  Suitability – Guidance on FINRA’s Suitability Rule

Regulatory Notice 11-25  Know Your Customer and Suitability

Regulatory Notice 10-05  FINRA Reminds Firms of Their Responsibilities Under FINRA Rule 2330 for Recommended Purchases or Exchanges of Deferred Variable Annuities

Regulatory Notice 09-32  SEC Approves Amendments to NASD Rule 2821 Governing Purchases and Exchanges of Deferred Variable Annuities; Effective Date: February 8, 2010

Regulatory Notice 08-39  FINRA Requests Comments on Proposed New Rules Governing Communications About Variable Insurance Products; Comment Period Expired: September 30, 2008

Regulatory Notice 07-53  SEC Approves New NASD Rule 2821 Governing Deferred Variable Annuity Transactions; Effective Date: May 5, 2008

Regulatory Notice 07-36  FINRA Clarifies Guidance Relating to SEC Regulation S-P under Notice to Members 07-06 (Special Considerations When Supervising Recommendations of Newly Associated Registered Representatives to Replace Mutual Funds and Variable Products)

FINRA has also sanctioned a number of firms for improper sales of variable annuities.  Here are but a few that are listed directly on FINRA’s website:

7/23/09 – FINRA Fines Bank Broker-Dealers $1.65 Million for Supervisory Failures in Variable Annuity, Mutual Fund and UIT Transactions

4/14/09 – FINRA Fines Fifth Third Securities $1.75 Million for 250 Unsuitable Variable Annuities Transactions

1/29/08 – FINRA Fines Banc One for Unsuitable Variable Annuity Sales, Inadequate Supervision of Fixed-to-Variable Annuity Exchanges

11/6/07 – FINRA Publishes Guidance, Text for New Rule Governing Deferred Variable Annuity Transactions

5/8/07 – NASD, State Regulators Issue Joint Statement to Support Insurance Regulators’ Model Annuity Suitability Regulation

2/15/07 – NASD Charges Two Former Prudential Brokers with Facilitating Hedge Fund Manager’s Deceptive Market Timing in Variable Annuities


The SEC has also weighed in.  For the full breakdown on the SEC’s position on variable annuities, visit

vii. Determining whether a Variable Annuity Recommendation is Suitable

FINRA Rule 2111 on Suitability states that a member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.

FINRA Rule 2330 also discusses suitability and specifically applies to variable annuity recommendations and recommendations on how to invest the initial subaccount allocations.  FINRA Rule 2330 states that a variable annuity transaction is suitable in accordance with Rule 2111 and, if there is a reasonable basis to believe that (i) the customer has been informed, in general terms, of various features of deferred variable annuities, such as the potential surrender period and surrender charge; potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of 59½; mortality and expense fees; investment advisory fees; potential charges for and features of riders; the insurance and investment components of deferred variable annuities; and market risk; (ii) the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization, or a death or living benefit; and (iii) the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable (and, in the case of an exchange, the transaction as a whole also is suitable) for the particular customer based on the information required by paragraph (b)(2) of this Rule.

Although suitability is an investor specific inquiry, variable annuities are often considered unsuitable in the following contexts:

1. When the age of the purchaser is above 70.

2. When the client’s original objective was for immediate income.

3. When the assets invested are already tax deferred (i.e IRA funds).

4. When the purchaser has a high net worth (and therefore has little need for insurance)

5. When the annuity is being purchased through an exchange (including a 1035 exchange).

viii. Misrepresenting Key Benefits

One of the most common problems we see in litigating these investments is that financial advisors often misrepresent the key benefits of a variable annuity contract to induce their customer to purchase the investment.

One benefit that we see misrepresented a lot is the “guaranteed minimum income benefit” rider, also called the “living performance guarantee.”  Different providers have different names for this rider, but essentially the feature provides guaranteed income regardless of actual performance.  The rub is that brokers often gloss over or fail to mention that the rider requires that the contract be kept in force for a long time, often ten years or more, before it can be utilized.  Additionally, the investor must annuitize the contract to get the guarantee.  I.e. the investor must transfer the principal to the carrier in exchange for the guaranteed payments.  The insurance company is then betting the client dies before the full value of the funds has been paid out.  The real problem for the investor, though, is that these riders are extremely expensive and rarely does the math work in the favor of the investor.

viii. Litigation options

Financial advisor have two main obligations to their clients.  The first is a duty to perform due diligence on any investment they recommend.  The second is to ensure that any investment recommendation made is appropriate for the client in light of that client’s age, investment experience, investment objectives, and net worth.

If a broker or brokerage firm makes a recommendation that is unsuitable or without performing adequate due diligence they may be responsible for any losses in a FINRA arbitration claim.

ix. Conclusion

If you believe that you were sold a variable annuity improperly, please call the securities attorneys of The White Law Group at 312/238-9650 for a free consultation.


For more information on The White Law Group, visit

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