Regulators Question 1035 Exchange Sales

SEC and NASD clamp down on VA exchanges considered inappropriate for clients

The Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) are clamping down on "1035" exchanges of variable annuity contracts. These exchanges occur when brokers convince VA contract holders to switch to a new policy so the broker can earn an upfront commission on the sale. But these switches rarely benefit the policyholders, and usually end up costing them money.

Paul Roye, director of the SEC's Division of Investment Management, said at a recent gathering of investment professionals that the SEC and NASD are "aggressively examining the firms and registered reps that sell variable products for [1035 exchanges] and other types of improper sales practices, and enforcement proceedings should be expected where they are found." Roye cited recent NASD complaints against Waddell & Reed and its president and national sales manager for recommending 6,700 variable annuity exchanges to customers without assessing the suitability of the transactions. According to the complaint, Roye said, "the firm pressured clients to replace variable annuity contracts with similar annuities in order to advance the firm's commercial interests and in direct contravention of the best interests of its clients. These 'switching' transactions are alleged to have generated $37 million in commissions and cost customers nearly $10 million in surrender fees."

A senior official at one independent broker/dealers says he expects regulators to ask insurance companies offering VA contracts, "What percentage of your sales are 1035 exchanges?" He says this information can be derived from data in insurers' annual reports. The thing to look for, he says, is net new asset growth versus sales. This CEO says regulators are especially keen on looking for instances where a client has signed a VA contract allowing its surrender after, say, seven years. Then a salesperson convinces the client to change over to a new contract before the period is up and earns a commission on the new sale.

"The investor is tied up for seven years again, but what we should be doing is to ask if it is appropriate to tie up the investor," says Mark Goldberg, president of Royal Alliance Associates Inc. "If all you are doing is tying up the client for seven years to earn a commission, that's not right." Goldberg says Royal plans to change its policy on policy exchanges and has "dismissed some people--big producers" because he was unhappy with their sales practices. "We are going to slow it down," Goldberg says.

Another problem with "switching" contracts, says Tom Carstens, a partner with Lenox Advisers in New York, is that the client can end up with a contract that has a different mortality table offering a lower payout. For instance, Carsten says if a client accumulated $1 million by age 65 in the New York Manulife annuity contract, which uses a 1983 mortality table, the ultimate return to the client would be $12,000 more than if the client had used the New Jersey contract with a 2000 mortality table. "So buyer beware: if the investments are better in the annuity, you also have to pay attention to what the underlying mortality is," Carstens says. "The reason [Lenox is] heavily promoting annuities [now] as a retirement vehicle, is to lock in that old mortality table."

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