Annuity Products Sales Practices and Risks FIRMA National

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Annuity Products, Sales Practices, and Risks FIRMA National Training Conference Washington, D. C. April

Annuity Products, Sales Practices, and Risks FIRMA National Training Conference Washington, D. C. April 12, 2006 1

Your Speaker* Thomas J. Pauloski, J. D. Director – Wealth Management Group Bernstein Global

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 E-mail: thomas. pauloski@bernstein. com *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. 2

Roadmap • • Regulatory Overview Product Overview Typical Product Charges Tax Overview Optional Product

Roadmap • • Regulatory Overview Product Overview Typical Product Charges Tax Overview Optional Product Features Sales Practices Potential Risk Management Issues Appendix: NASD® Notice 99 -35 3

Regulatory Overview 4

Regulatory Overview 4

NASD® Notices and Alerts • Notice 96 -86 (December 1996): Suitability in variable life

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 annuities 5

NASD® Notices and Alerts (cont. ) • Investor Alert (May 27, 2003): Variable annuities

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? 6

NASD® Proposed Rule 2821 • Concerns about deferred variable annuities – Complex features, riders,

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 explain product features – Advocating exchange without first ensuring that exchange was beneficial – Failure of member firms adequately to train and supervise representatives 7

NASD® Proposed Rule 2821 (cont. ) • Four main requirements – Suitability – Principal

NASD® Proposed Rule 2821 (cont. ) • Four main requirements – Suitability – Principal review and approval – Written supervisory procedures – Training of representatives • Text of rule available at www. nasd. com 8

National Banks and Annuities • National banks may sell annuities, Nations. Bank v. Variable

National Banks and Annuities • National banks may sell annuities, Nations. Bank v. Variable Annuity Life Ins. Co. , 513 U. S. 251 (1995) • Consumer protection regulations (12 C. F. R. pt. 14) address national banks and their “covered persons” – Anti-coercion – Required disclosures – Physical separation of banking and insurance activities – Adherence to state licensing standards 9

Product Overview 10

Product Overview 10

Annuities • Annuity is series of periodic payments – Note: “Withdrawal” generally is not

Annuities • 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 11

Function of Annuities • Basic function: Systematic liquidation of investment fund • Protects against

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 12

Perceived Advantages of Annuities • • No annual investment limit No financial underwriting limitations

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 13

Classification of Annuities • Number of lives covered – Single-life – Joint-and-survivor: Payments cease

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 14

Classification of Annuities (cont. ) • When annuity payments commence – Immediate • Payout

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) 15

Classification of Annuities (cont. ) • Disposition of proceeds – Duration of annuity payment

Classification of Annuities (cont. ) • Disposition of proceeds – Duration of annuity payment period • • Lump sum Fixed period 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) 16

Types of Annuity Contracts • • • Flexible-premium deferred annuity Single-premium immediate annuity Variable

Types of Annuity Contracts • • • Flexible-premium deferred annuity Single-premium immediate annuity Variable annuity Equity-indexed annuity 17

Flexible-Premium Deferred Annuity • Provides for accumulation of funds, with annuity payments deferred until

Flexible-Premium Deferred Annuity • Provides for accumulation of funds, with annuity payments deferred until some future date • No set contribution amount or required payment frequency • May include front-end load or surrender charge or both • Interest is credited at not less than guaranteed rate 18

Single-Premium Deferred Annuity • Generally, no front-end loads, with provision for graded surrender charges

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 19

Single-Premium Immediate Annuity • Annuity payments commence immediately after insurer has received single (usually

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 20

Variable Annuity • Benefits vary with investment performance of assets held pursuant to contract

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) 21

Variable Annuity (cont. ) • Death benefit payable if annuitant dies during accumulation period

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 22

Variable Annuity (cont. ) • Optional features – – Stepped-up death benefit Guaranteed minimum

Variable Annuity (cont. ) • Optional features – – Stepped-up death benefit Guaranteed minimum income benefit Long-term care insurance rider Bonus credit 23

Equity-Indexed Annuity • Hybrid product that includes certain features of fixed and variable annuities

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) 24

Equity-Indexed Annuity (cont. ) • Points in time at which increase in index is

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 department 25

Typical Product Charges 26

Typical Product Charges 26

Initial Loads • Initial premium payment may be reduced by either or both of

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 27

Ongoing Charges • Additional charges may apply after contract purchase, including – – –

Ongoing Charges • Additional charges may apply after contract purchase, including – – – 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 28

Tax Overview 29

Tax Overview 29

Basic Income Taxation of Annuity Products • Build-up of cash value generally is not

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 income • Portion of each annuity payment received generally is treated as nontaxable return of “investment in the contract” – Balance of payment is taxable as ordinary income 30

Basic Income Taxation of Annuity Products (cont. ) • Distributions prior to age 59½

Basic Income Taxation of Annuity Products (cont. ) • 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 31

Basic Gift and Estate Taxation of Annuity Products • Lifetime transfer of contract for

Basic Gift and Estate Taxation of Annuity Products • 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 32

Optional Product Features 33

Optional Product Features 33

Stepped-Up Death Benefit • In standard variable annuity contract, death benefit equals account value

Stepped-Up Death Benefit • In standard variable annuity contract, death benefit equals account value at annuitant’s death prior to annuitization • 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 34

Guaranteed Minimum Income Benefit • In most variable annuity contracts, annuity payments will either

Guaranteed Minimum Income Benefit • In most variable annuity contracts, annuity payments will either – 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) 35

Long-Term Care Insurance Rider • Annuity contracts may bundle other insurance or insurance-related products

Long-Term Care Insurance Rider • Annuity contracts may bundle other insurance or insurance-related products with traditional annuity features • 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 36

Bonus Credit • Credit to contract or account value, typically based on percentage of

Bonus Credit • Credit to contract or account value, typically based on percentage of premium paid (e. g. , 1% to 5% of initial premium) • 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) 37

Sales Practices 38

Sales Practices 38

Section 1035 Exchange • Tax laws allow certain insurance policies and annuity contracts to

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 39

Annuity Arbitrage • Sale technique involving pairing of single-premium immediate annuity with life insurance

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 underwriting – 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 40

Annuity Arbitrage (cont. ) • One reason for popularity: Insurance producer earns two commissions

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? 41

Potential Risk Management Issues 42

Potential Risk Management Issues 42

Potential Risk Management Issues • General suitability of investor – Sophistication – Net worth

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 43

Potential Risk Management Issues (cont. ) • Conduct of sale – Approved materials, including

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 44

Potential Risk Management Issues (cont. ) • Contract replacement practices – Enhancements available in

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 45

Appendix: NASD® Notice 99 -35 46

Appendix: NASD® Notice 99 -35 46

NASD® Notice 99 -35 • Notice 99 -35 provides guidelines for NASD® members relating

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 47

NASD® Notice 99 -35 (cont. ) • Differentiate potential annuity benefits vs. mutual funds

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 48

NASD® Notice 99 -35 (cont. ) • Guideline categories – – – Customer information

NASD® Notice 99 -35 (cont. ) • Guideline categories – – – Customer information Product information Liquidity and earnings accrual Investment in qualified retirement plans Replacement of existing contracts 49

NASD® Notice 99 -35 (cont. ) • Customer information guidelines – Make reasonable effort

NASD® Notice 99 -35 (cont. ) • Customer information guidelines – Make reasonable effort to obtain information about customer, including: • • Age Investment objectives Risk tolerance Tax status – Discuss all relevant facts with customer, including: • Customer’s liquidity needs • Product fees and charges 50

NASD® Notice 99 -35 (cont. ) • Customer information guidelines (cont. ) – Ensure

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 51

NASD® Notice 99 -35 (cont. ) • Product information guidelines – Registered representative must

NASD® Notice 99 -35 (cont. ) • Product information guidelines – Registered representative must thoroughly understand product specifications – Customer should be given current prospectus – Use only sales materials approved by registered principal 52

NASD® Notice 99 -35 (cont. ) • Liquidity and earnings accrual guidelines – Lack

NASD® Notice 99 -35 (cont. ) • Liquidity and earnings accrual guidelines – Lack of liquidity make product unsuitable for short-term investor – 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 53

NASD® Notice 99 -35 (cont. ) • Qualified retirement plan guidelines – Disclose to

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 54

NASD® Notice 99 -35 (cont. ) • Replacement of existing contract guidelines – Develop

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 principal – Determine whether replacement product is suitable, considering • Product features and enhancements • Costs and fees, including surrender charge • New surrender charge period 55

NASD® Notice 99 -35 (cont. ) • Replacement of existing contract guidelines (cont. )

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 56