Ameriprise to Pay $22 Million in Annuities Arbitration Case

By Elizabeth Wine

July 1, 2006 - The two workers were part of a larger group of 32 ExxonMobil chemical plant and refinery employees. They were blue-collar and financially unsophisticated, ranging in age from 55 to 67. Some were pipefitters making maybe $45,000 per year, while others were machinist supervisors earning as much as $80,000 with overtime. During three years of meetings that began in 1997, their broker repeatedly told them: "Why are you working? I can make you more money when you're retired than when you're working."

The employees say they turned over their retirement savings to that broker, who put their money in variable annuities and mutual fund B and C shares. But after losing much of their retirement money, the employees brought an arbitration action against the adviser, David McFadden, and his firm, Securities America. In May, an NASD arbitration panel awarded the workers $22 million--one of the largest such awards. The amount included $3.5 million in punitive damages.

The case is indicative of the increasingly treacherous landscape of variable annuities, a hybrid investment contract that marries securities--such as mutual funds--with an insurance wrapper. While they have been growing in popularity and are undoubtedly legal, there is also a dark side for investors and financial advisers alike. Ever since a flood of complaints that VAs were sold inappropriately, especially to senior citizens, they have been high on regulators' watch lists. The NASD alone has brought more than 280 actions in the last five years, with state regulators also on the warpath.

Investors are seeking to recoup losses through arbitration as well. The ExxonMobil workers' award isn't the only one of its kind. Securities lawyers say it may be the start of a new miniwave of similar complaints.

Several lawyers speaking at a securities conference held recently in New York reported working on cases where groups of workers near retirement charged brokers with inappropriately selling them these complex, high-fee instruments.

In fact, VAs can carry hefty commissions, averaging about 5% to 7% on B shares, according to the National Association for Variable Annuities (NAVA). In addition, they often feature confusing contractual language and are laden with hidden fees.

Regulators have particularly been scrutinizing VAs when they're sold to senior citizens. These products lock up money for years--at least five to seven typically--when seniors may need access to their money sooner for medical or other emergencies.

In the multimillion-dollar case involving Securities America, the workers claimed McFadden did several things wrong. He put them into funds offered by whichever fund company had sponsored his seminar, and then he inappropriately took their tax-qualified money and put them into VAs, which are also tax-qualified. Because VAs may be more expensive than ordinary mutual funds, the workers claimed he had cost them money unnecessarily so he could collect a bigger commission. In their legal papers, the workers' lawyer said McFadden sold them an annuity on which he earned as much as 6.5% in upfront commissions. They add that he failed to disclose the higher fees to them.

"There's no benefit to the customer, and they're still saddled with a 2.5% load--that includes the cost of the subaccounts," says the employees' lawyer, Joseph C. Peiffer.

But that was only the start. The workers also claimed the underlying mutual funds were unsuitable for them and that McFadden traded their accounts without their permission or knowledge. Instead of providing the safe, diversified portfolio he promised them, the broker traded many of their accounts between aggressive funds--in several cases, the ProFunds UltraOTC, which is designed to double the return of the Nasdaq-100--and bond funds.

"He was trading hundreds of people's accounts in and out of this stuff, and Securities America had set up no system to monitor this stuff," says Peiffer, of New Orleans-based law firm, Correro Fishman Haygood Phelps Walmsley & Casteix.

But Scott C. Hoyt, general counsel at Securities America, says that the firm "disagrees with the award and intends to appeal." Declining to discuss McFadden's future at the firm, Hoyt says that at press time, the broker was still registered with Securities America, a unit of Ameriprise Financial.

AVOIDING THE PITFALLS

Yet despite the recent regulatory problems, an array of bells and whistles that creates endless varieties of the complicated contracts, frequently high costs, and the numerous fees VAs carry, proponents say they're still extremely valuable tools. When used properly, VAs can help grow savings tax-free, create a client's retirement income stream and help smooth out the bumps in an existing income. They can also be helpful in estate planning. Their popularity continues to grow: Assets in VAs climbed to $1.2 trillion in the fourth quarter of 2005--a 7% increase from the year-earlier period, according to NAVA.

In fact, some experts expect VAs to be more popular than ever. Susan Hirshman, a wealth strategist at JPMorgan Asset Management who specializes in helping advisers with affluent clients, says that knowing how to use VAs is becoming more important. "As more and more people start to retire, they're going to get more popular," Hirshman says.

"People will look to take a huge lump sum and convert it to a monthly paycheck. There will be more scrutiny on it, so it will be that much more important."

John Diehl, a certified financial planner who serves as vice president of the retirement solutions group at The Hartford, notes that outside of annuities, defined benefit plans and Social Security are the only sources of regular income for most retirees--and the future of both appears to be in doubt.

Plus, with a movement towards lower-cost VAs just beginning, there are even more reasons to use these products--for the right client and under the right circumstances. "You make sure the client never runs out of money," says Norman Mindel, a financial adviser with Genworth Financial.

He adds: "It's hubris on our part as advisers to do a 30- to 40-year projection so the client won't run out of money. What happens if we're wrong?"

The average life expectancy in the U.S. is 84 years, on a bell curve.

Just 6% of the population will die at age 84. But the rest will go sooner or later. "I have to assume you're going to live a long time,"

Mindel says. "I want to lay that mortality risk off on someone."

A Monte Carlo risk simulation shows that a person with $1 million saved can only draw out $45,000 a year--adjusted for inflation--and still have a 95%-plus probability of not running out of money before death. That scenario assumes a portfolio with 60% to 70% equities.

If a client has needs of more than $45,000 per year or a risk tolerance too low for such a high equity exposure in retirement, he'll need an alternative plan. Mindel says VAs are the answer. With an annuity, the client has his base costs of $45,000 covered, and he can manage around the extra requirements.

"This is about buying peace of mind," says Mindel. "Every month, you get a check and are not concerned with what the annuity is doing on a month-to-month basis. Clients are not worried about the interest rates or the underlying portfolio."

Mindel admits that this peace of mind does come with a price, and the higher fees can mean the rate of return on annuities is not as competitive as other investments. "But you're laying off the risk, it's not a rate-of-return issue. To me, as long as the client understands that cost, they can make a decision as to whether it has an appeal to them."

Read more about the Ameriprise case and problems with annuities.

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