Variable annuities are contracts between the investor and an insurance company where an investor deposits money in an annuity (either in a lump sum or on a regular basis), and in return the investor gets periodic payments, either immediately or in the future.  See http://www.sec.gov/investor/pubs/varannty.htm.  The value of the annuity varies, depending on the performance of the investments within the annuity.  Many annuities give investors many different options for these underlying investments.

Variable annuities have several benefits.  Typically, the most appealing benefit is that the earnings grow tax-deferred, meaning that you won’t pay any taxes on any gains until you take money out of the annuity (similar to a traditional IRA).  Another benefit is that many annuities have a death benefit built in, which will pay a certain amount (depending on the contract) to a beneficiary.  Lastly, these annuities can create a stream of periodic payments for the investor over a set period of time.

Unfortunately, variable annuities have been a frequent tool to deceive and defraud investors.  Variable annuities in IRAs are especially inappropriate and unsuitable for most clients.  Annuities are one of the highest commission products that financial advisors can sell.  Importantly, there are no breakpoints (reduced sales discounts for large purchases) with annuities.  The investors’ funds are typically tied up for years with high surrender charges.  The annuities have extraordinarily high fees.  There are big upfront sales charges and back-end surrender charges, which linger around 7% if the funds are withdrawn too soon.  In addition, there are mortality and expense charges to cover the risk the insurance company takes on to pay the investor lifetime income.  There are also administrative and annual records maintenance fees.  The average annuity has an expense ratio of 2.35% annually, according to Morningstar. The average mutual fund, on the other hand, charges just 1.44% annually.

The unsuitable and egregious nature of stockbroker’s buying variable annuities for clients has been well documented by FINRA Enforcement and NASAA (the North American Securities Administrators Association).  For example, the following disclosures about variable annuities by Lawrence Kosciulek, assistant director of advertising/investment-companies regulation with NASD Regulation are illuminating:

The message is clear.  As securities, variable products are subject to the 1938 NASD Suitability Rule, and before recommending them you must make a reasonable effort to determine whether they’re suitable for the client.  And reasonable in this context means a greater effort than is required for other securities products.  Variable annuities are subject to a higher level of suitability scrutiny than 100 shares of GM because they’re more complex.

According to NASAA, variable annuities have made their top ten list of investment “scams” for many years.  NASAA disclosed its 2006 forecast of the 13 most common ways “investors are likely to be trapped in 2006.”  NASAA states:

Variable Annuities. Variable annuities are tax-deferred investments that typically place mutual funds inside of an insurance wrapper for tax deferred potential investment growth.  While these products are legitimate investments, regulators are concerned about their popularity in the sales community.  Commissions to those who sell variable annuities are very high, which provides incentive for sellers to engage in inappropriate sales.  Variable annuities are only suitable for a very small percentage of the investing public and generally are not appropriate for most seniors.  The steep penalties for early withdrawals also make variable annuities unsuitable for short-term investors.  Be especially wary of any broker who wants to sell you a variable annuity to hold inside a 401(k) or IRA.  You are already getting tax-deferred growth in an IRA or a 401(k), and the variable annuity simply adds a layer of cost with no additional tax benefit (emphasis added).

FINRA (and its predecessor, the NASD) has discussed the pitfalls of variable annuities for over ten years now.  NASD Notice to Members 99-35 discusses the lack of liquidity of variable annuities due to their surrender charges for early withdrawals, and warns registered representatives about the unsuitability of these products for many investors.  NASD Notice to Members 04-45 warned that variable annuities are complex investments and should not be sold to unsophisticated customers and cataloged numerous disciplinary actions involving variable annuity sales abuses.  Other Notices to Members, including 96-86, 00-44, and 07-43, alerted members and associated persons to be careful when recommending variable annuities to customers.

Another deceptive practice that has been used by advisors is annuity switching or churning.  This occurs when an advisor recommends that an investor close out an existing annuity to open up a subsequent annuity, only a few years after the first annuity was opened.  Annuity exchanges can be properly done with a 1035 Exchange (named after the IRS Code Section that allows this), in which an annuity can be exchanged for another without incurring tax consequences.  If an advisor does not use a 1035 Exchange, and the investors subsequently incurs tax penalties, then there may be some wrongdoing.  Moreover, a 1035 Exchange does not affect whether an investor still has to pay any early surrender or withdrawal charges to the insurance company.

Israels & Neuman PLC is a securities law firm with offices in Denver, Colorado and the Seattle area.  We represent investors in FINRA arbitration proceedings in all 50 states and have represented numerous investors who lost money in variable annuities.  Our attorneys have represented over one thousand investors against many brokerage firms in the past, including LPL Financial, Merrill Lynch, Morgan Stanley, Smith Barney, Stifel Nicolaus & Company, UBS Financial Services, Oppenheimer, Charles Schwab, Wells Fargo Advisors, Ameriprise Financial Services, Raymond James Financial Services, ProEquities, Securities America, National Securities Corp., and many others.

HAVE YOU LOST MONEY IN A  VARIABLE ANNUITY THAT HAS BEEN INAPPROPRIATELY RECOMMENDED TO YOU?

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                Aaron Israels: (720) 599-3505

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