Ameriprise to Pay $22 Million (Part 2)

Read part one of the article on Ameriprise's $22 million annuities case.

GIVING FLEXIBILITY

Diehl of The Hartford says the key to an annuity is its flexibility.

During the early 1990s, when tax rates were high, people used VAs to defer taxes and maximize wealth accumulation--similar to the way investors use individual retirement accounts (IRAs).

But today, as tax rates have declined and the baby boomers head into retirement, the protection aspect of VAs has taken center stage. "They're great for providing an income stream that cannot be outlived," Diehl said. And with a plethora of options, they can be tailored to the client's objectives.

Diehl reports that in the last five to six years, the ability to tailor an income stream for the rest of an investor's life has become a driving force in the VA industry. "It's good for clients because most clients realize they are going to be retired for much longer than their parents and grandparents. Some are retiring earlier, and medical advances have increased life expectancies."

The instrument's flexibility means people don't even have to annuitize their payouts. Some simply use them as a form of life insurance and pass on 100% of the principal to their heirs. Other new varieties of annuity products allow the client to borrow some of the money from the account balance in case of an emergency--a safety net that wasn't possible with older annuities. But all of these features have significant costs, and advisers stress that clients must understand what they're paying for upfront.

Diehl admits that many annuities with long investment lock-up periods aren't appropriate for the very elderly. But they aren't always wrong for all older clients. "To have compounding and tax deferral and the historical market returns on your side, you need to have at least five years of investment horizon," Diehl says. "If you need money two years from now, recommending any equity-based investment would be risky."

Still, he says, looking at a five- to 10-year time frame could make sense for someone who's 85-years-old, has a family history of longevity and doesn't want to risk his heirs' inheritance.

THE REGULATORY VIEWPOINT

Elisse B. Walter, senior executive vice president of regulatory policy and programs at the NASD, says that her organization isn't against VAs themselves. "Our concern is not whether the product is good or bad, but how it is being sold and whether it is appropriate to the people to whom it is being sold," she says.

The NASD took the step of publishing a guidance in 1999. But not enough advisers followed it, and the tidal wave of lawsuits and arbitrations followed.

In May, the self-regulatory organization submitted to the Securities and Exchange Commission amendments to a rule it first proposed in December 2004. The new proposal, now under review by the SEC, focuses on ensuring that registered reps are certain the VAs are appropriate for clients.

In addition, the National Association of Insurance Commissioners (NAIC) endorsed a model suitability requirement for people ages 65 and over, and an NAIC committee backed extending that to other age groups as well. Also on board is NAVA, whose corporate counsel, Michael DeGeorge, says the group supports efforts by states to adopt the NAIC's model, as well as expanding it to cover all purchasers.

Some of the more notable settlements include Waddell & Reed's agreement in April to pay the NASD a $5 million fine and a coalition of state regulators $2 million to settle charges relating to its campaign of "switching" VAs. The practice allegedly involved brokers advising clients to exchange one VA for another in an effort to generate commissions for themselves, rather than serve the clients' best interests. The result was a rash of unsuitable sales in which clients paid substantial, unnecessary expenses--including fees for early withdrawal.

Under the settlement, the company also agreed to repay up to $11 million to more than 5,000 customers whose annuities were exchanged by the firm.

(Waddell & Reed didn't admit or deny the allegations.) Two years ago, the NASD fined Prudential $2 million and ordered the company to repay $9.5 million to customers for sales of annuities that violated NASD rules and New York State Insurance Department regulations. Earlier this year, Massachusetts Secretary of State William Galvin went on the offensive. He sent subpoenas to 15 financial firms as part of his investigation into whether senior citizens were being targeted for unsuitable VA sales.

YOU CAN STILL DIG YOURSELF A HOLE

Even if you've done your homework and are certain a VA is right for your client, there are still ways to get into trouble.

Pete Michaels, a Boston-based securities law attorney, relates the case of a broker client who advised his customer to put $900,000 into a VA, which had a death benefit that guaranteed all the principal would go to his heirs. During the life of the investment, however, the underlying mutual funds dropped sharply in value. The client brought an arbitration.

Because the money invested in the VA was meant to be locked up for many years, the client shouldn't have had to rely on the money. Furthermore, the death benefit meant his heirs would receive the entire amount originally invested upon his death. Complicating the case, the VA, which was tax-advantaged, was in an IRA--also tax-advantaged.

Michaels says that regulators frown on putting a tax-advantaged vehicle into a tax-advantaged account if the vehicle--in this case, the annuity--carries a high price tag. "Their attitude is, You could do better to buy a mutual fund and a term life insurance policy yourself and not have to pay the hefty fees that come with a variable annuity,' " Michaels says. (He admits that having the annuity in the IRA wasn't ideal; it came about because the customer's money was already in the IRA and couldn't be moved out before age 59 1/2 without a hefty tax penalty.)

But Michaels' broker-client prevailed because of the death benefit. Michaels says that if a customer cannot get affordable--or, for that matter, any--life insurance because of age or illness, a VA with a death benefit is a good alternative. In defending a VA situation in an arbitration, you must be able to point to either tax advantages or the death benefit, Michaels says.

Ernest E. Badway, a securities law attorney at Saiber Schlesinger Satz & Goldstein who practices in both New York and New Jersey, currently has a case where his broker client sold a VA in good faith to a "snowbird"--a New Yorker with a retirement home in Florida. It ended in tears.

The adviser, who was in New York, spoke to the client in Florida on the telephone. The application was issued with the client's New York address. In spite of the broker's determination that the VA was appropriate, the client decided otherwise after the underlying investments lost money. The investor called the state of Florida, complained, and the broker got into trouble with both Florida regulators and the NASD. The investigation is pending. An enforcement action is possible.

Badway says that in this case, it's not the address but the client's actual place of residence that was most important in filing securities paperwork. Although the address issue is a minor one, the client is using it as a loophole in an attempt to escape the transaction after the underlying investments declined in value, Badway says.

"What's problematic is customers lose money on variable annuities, and they sometimes have forgetting spells," Badway says. "They'll say, 'Oh yes, we spoke about this' at the time of the sale, but then when the product loses money, all the reasons they agreed were valid fall by the wayside. These customers--people who made a lot of money in their businesses--all of a sudden did not understand."

Badway adds: "This is one of those issues that in the next couple of years we're going to be seeing." Both regulators will bring enforcement actions and customers will bring arbitration and civil actions against firms and brokers, he says.

A WINDFALL FOR LAWYERS

James D. Yellen, a New York-based securities law attorney who has become an arbitrator and mediator after more than a decade as a defense litigator at Morgan Stanley, reports that colleagues in the claimants bar see VAs as a rich source of work. "They're hoping variable annuities will be the next big wave because regulators don't like them. They're hard to understand, and brokers make hefty commissions on them."

But Yellen and several other legal practitioners agree that it'll be tricky to turn claimant victories into windfalls because of the difficulty in calculating damages. If there's a death benefit, the client's heirs will receive the full amount of the contract. Therefore, says Michaels, the Boston lawyer, clients who have seen the value of their accounts fall in tough markets have really only lost the use of the money in their lifetimes.

"There's no real harm, so it's hard to know what to pay them," says Michaels. "Say their contract drops $50,000. If I pay them $50,000 to settle, the market could come back, and the client has made money. Plus, his heirs get the whole amount in the death benefit."

That may not matter, as NASD arbitration panels are likely to side with a sympathetic claimant simply because the stakes are so great and VAs are so complex, Michaels says. And unlike in regular courts of law, even if an adviser can prove he disclosed all the fees and charges, he can still lose before a panel. "If they see 15 weeping coal miners up there, some of whom have lost their homes, you just settle it," Michaels says.

And the ExxonMobil workers were sympathetic. In their arbitration papers, their lawyer, Peiffer, says: "McFadden never told them that it was even a remote possibility that they might have to cut their expenses by more than half or that they would have to sell their homes and move into apartments or that they might have to go back to work stocking vending machines (George Allen Moore) or scheduling oil changes (Dickie White)."

Peiffer adds that the workers "could not readily unretire once they retired. It is very much like jumping out of an airplane: You cannot get back in if you discover your parachute does not work."

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