Annuities are hybrid financial products. They are insurance products, and, as such, are regulated by state insurance departments. Some annuities are also considered to be securities, subject to regulation by federal and state securities agencies. Furthermore, some rules are applied by Federal regulatory bodies, while others are established and administered by states. Thus, the rules governing the sale and marketing of annuities are a matter of jurisdiction, and the rules are not entirely consistent from one jurisdiction to another. This can make compliance with relevant rules complicated and difficult. Adding to the difficulty is the fact that the standard of care required of those who recommend annuities is not uniform.
At the present time, there are actually two standards of care in the financial services industry: suitability and the fiduciary standard.
Suitability can be defined as “the quality of having the properties that are right for a specific purpose or situation.” That is a general definition, but the term suitability has a more specific meaning when applied to recommendations of insurance, investment, and annuity products, a meaning which is evolving constantly. Until recently, there was little, if any, precision as to when the sale or recommendation of an annuity would be considered suitable. Virtually no jurisdictions offered rules with any intentional definitions — that is, specifications of the necessary and sufficient conditions that must apply for the transaction in question to be qualified as suitable — or providing concrete examples. Many state statutes were simply self-recursive; they simply defined a suitable transaction as one that is suitable.
These suitability standards generally apply, at the present time, both to: (a) insurance agents recommending insurance and annuity products that are not securities and to; (b) registered representatives recommending insurance, annuity, and/or investment products that are securities so long as the advice that they render, in the course of making those securities recommendations, is solely incidental to their activities as securities salespersons (in many regulations, the term used is “brokers”).
The other standard of care that may apply when an annuity is recommended is the fiduciary standard. This is a much higher standard and applies to investment advisers under the Investment Advisers Act of 1940. Section 202(a)(11) of that Act generally defines an investment adviser as any person or firm that: (1) for compensation; (2) is engaged in the business of; (3) providing advice, making recommendations, issuing reports, or furnishing analyses on securities, either directly or through publications. It does not generally apply to registered representatives to whom the broker exclusion of Section 202(a)(11)(C) of the Act applies. That section excludes from the Act’s definition of investment advisor registered representatives offering advice in connection with the recommendation of a security provided that two conditions are satisfied:
1. no special compensation is received (for the advice); and
2. the advice is solely incidental to the broker’s brokerage activities.
Rules dealing with annuities that are securities
Variable annuities, as annuity contracts, are subject to regulation by state insurance departments — and, indirectly, by the NAIC — and, as securities, are subject to regulation by state securities departments and Federal securities regulators. Over the years, rulings by the NASD and FINRA have sought to provide guidance as to when a variable annuity is suitable.
FINRA Rule 2090
The FINRA Rule 2090 Know Your Customer rule, announced in FINRA’s Regulatory Notice 11–02 in January, 2011, is modeled after NYSE Rule 405(1). It requires FINRA members to use reasonable diligence and to know the essential facts concerning their customers. The Rule explains that essential facts are: “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer and (d) comply with applicable laws, regulations, and rules.”
The know-your-customer obligation arises at the beginning of the customer-broker relationship and does not depend on whether the broker has made a recommendation.
FINRA Rule 2111
FINRA Rule 2111 is both a “know your customer” and suitability rule. Announced in regulatory notice 11–02, and effective on October 7, 2011, it requires that registered representatives and the firms for which they work have a reasonable basis to believe that a recommended transaction or investment strategy involving a security is suitable for the customer, based upon “the information obtained through the reasonable diligence of the [FINRA] member or associated person to ascertain the customer’s investment profile.” It is significant that this rule, unlike previous rulings, applies both to recommendations of product and of investment strategy.
The Rule declares that investment profile “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.” The factors identified in that list are very similar to those identified in SATMR. This is a common condition in regulatory language. Often, the authors of an NAIC rule will adopt the language of rules previously issued by other regulatory authorities such as FINRA.
FINRA Rule 2330
The current FINRA suitability rule applicable to deferred variable annuities “to recommended purchases and exchanges of deferred variable annuities and recommended initial subaccount allocations,” is FINRA Rule 2330, modeled after NASD rule 2821. It provides that:
“No member or person associated with a member shall recommend to any customer the purchase or exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe
(A) that the transaction is suitable in accordance with Rule 2111 and, in particular, that there is a reasonable basis to believe that
(i) the customer has been informed, in general terms, of various features of deferred variable annuities, such as the potential surrender period and surrender charge; potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of fifty-nine-and a half; mortality and expense fees; investment advisory fees; potential charges for and features of riders; the insurance and investment components of deferred variable annuities; and market risk;
(ii) the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization, or a death or living benefit; and
(iii) the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable (and, in the case of an exchange, the transaction as a whole also is suitable) for the particular customer based on the information required by paragraph (b)(2) of this Rule; and
(B) in the case of an exchange of a deferred variable annuity, the exchange also is consistent with the suitability determination required by paragraph (b)(1)(A) of this Rule, taking into consideration whether
(i) the customer would incur a surrender charge, be subject to commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), or be subject to increased fees or charges (such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements);
(ii) the customer would benefit from product enhancements and improvements; and
(iii) the customer has had another deferred variable annuity exchange within the preceding thirty-six months.
Like the NAIC’s “Suitability in Annuities Transactions Model Regulation” (SATMR), FINRA Rule 2330 provides guidance as to the factors that should be considered before the recommendation of an annuity. Indeed, the factors that it cites are virtually identical to those cited in SATMR, which took them from the earlier NASD Rule 2821. Section (b)(2) of Rule 2330 states that:
“Prior to recommending the purchase or exchange of a deferred variable annuity, a member or person associated with a member shall make reasonable efforts to obtain, at a minimum, information concerning the customer’s age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the deferred variable annuity, investment time horizon, existing assets (including investment and life insurance holdings), liquidity needs, liquid net worth, risk tolerance, tax status, and such other information used or considered to be reasonable by the member or person associated with the member in making recommendations to customers.”
Notwithstanding the similarity of language in FINRA Rule 2330 and SATMR, the regulatory implications are very different. SATMR applies, in those states that have adopted it, to the sale of all annuities, while the FINRA Rule applies only to the sale of variable contracts. As we shall see, however, Section 989J of Dodd-Frank applies the suitability rules of SATMR, including these suitability factors to the sale of all annuity contracts, and, arguably, to the sale of insurance products other than annuities.
The reader will have noted, by this point, that there are many rules, from different agencies, at different jurisdictional levels, governing the sale of an annuity, and he or she might well be asking, “which ones affect me? Do I have to comply with all of them?” The answer is “if you’re a registered representative selling a variable annuity, you’re subject to all of them.” Why? Because, as an insurance agent selling an annuity, you are subject to state rules governing annuity sales, and, as a registered rep selling a registered product, you’re subject to FINRA Rules, and any additional rules that may be imposed by your State Department of Securities. A more practical answer might be “observe all the rules, even those that may not apply to you right now, just to be safe.”
As the twelve suitability factors cited in SATMR and FINRA Rule 2330 and, as we shall see, incorporated by reference into Section 989J of Dodd-Frank, must be considered by any advisor prior to recommending an annuity, we will now look at each of these factors in more detail.
The 12 suitability factors of SATMR/FINRA Rule 2330 in detail
1. Age. The age of the buyer of an annuity is an extremely important factor in any determination of whether that annuity is suitable. In the case of an immediate annuity payable for life, the age of the annuitant will determine the amount of each annuity payment. If the proposed annuitant is not in good health or if his or her family health history suggests a shorter than average life expectancy, the advisor should question whether a nonunderwritten life annuity is appropriate. For such an applicant, a fully underwritten annuity — where the amount of annuity payments would take into account the annuitant’s health status — might offer a substantially greater benefit than a nonunderwritten contract.
If the contract being proposed is a deferred annuity, the age of the prospective owner and of the prospective annuitant, if different, are relevant factors. Many insurers will not issue a deferred annuity contract if the proposed annuitant is older than a certain age, which, in the authors’ experience, accounts for many contracts where the annuitant and owner are different individuals. This can create problems.
Even where the prospective owner and annuitant are the same individual, the age of that person is relevant to the suitability of a deferred annuity. The NAIC and insurance regulators of many states have issued consumer alerts, warning seniors of deceptive sales practices, and, in many states, special suitability requirements apply when the applicant of a deferred annuity is a senior citizen. That said, no state regulation of which the authors are aware states that an annuity is inappropriate merely because the prospective buyer has reached a certain age.
Where the proposed deferred annuity includes either a guaranteed minimum death benefit or a living benefit rider, the age of the owner and/or annuitant often determines the availability or the terms of that benefit.
2. Annual income. The annual income of the buyer of an annuity is relevant to the suitability of that contract for several reasons. If the contract is a flexible premium one, contemplating ongoing contributions, the applicant should be able to make those contributions.
3. Financial situation and needs, including the financial resources used for the funding of the annuity. An annuity is a tool designed to meet specific financial needs; therefore, the nature and extent of those needs are relevant to the annuity’s suitability to do the job. Moreover, the source of funds is of particular concern when securities are involved. The agent recommending the annuity must be appropriately licensed, not only for the annuity contract being proposed, but also for securities, if the source of funds for the annuity is securities and if he or she is recommending that those securities be sold to fund the annuity.
It is widely believed that if the source of funds includes securities, that anyone recommending an annuity must necessarily be registered to sell the type of securities involved. Sources such as the Joint Bulletin No. 14-2009 issued by the Arkansas Insurance and Securities departments in September, 2009, are often cited to support this position. However, a close reading of the ruling in question may indicate otherwise. For example, the Arkansas ruling states:
“The recommendation to replace securities such as mutual funds, stocks, bonds and various other investment vehicles defined as securities under the Arkansas Securities Act is the offering of investment advice. It is unlawful to offer investment advice unless one is registered (licensed) with the Arkansas Securities Department as an investment adviser or investment adviser representative.”
This does not say that the proceeds of the sale of securities may never be used to purchase an annuity unless the agent recommending that annuity is securities registered. It says only that the agent may not recommend such liquidation without being registered as an investment advisor, or investment advisor representative. Even a Series 6 or Series 7 registration might not suffice in Arkansas because the regulators in that state have defined a recommendation to replace securities as the rendering of investment advice. In another state, that same recommendation might be considered to fall within the solely incidental exception of Section 202(a)(11)(C) of the Investment Advisers Act of 1940. Generally, however, an advisor recommending a nonvariable annuity, to be funded with the proceeds of securities sales, must be registered to sell the type of securities involved, but need not be securities registered if he or she does not actually recommend the sale of securities to purchase the annuity. But this may not be a reliable safe harbor. Can an advisor whose client purchased the annuity he recommended with funds from securities sales rely upon the defense that “I did not know where the money was coming from”? If he or she is obliged to consider “Financial Situation and Needs, Including the Financial Resources Used for the Funding of the Annuity,” and SATMR imposes that obligation, the answer would appear to be a flat “no,” absent evidence that the client deliberately misled the advisor as to the source of funds.
4. Financial experience. The financial experience of a consumer is important, especially if the financial product being recommended is complicated or appropriate only for sophisticated buyers. A complaint often made by plaintiffs in annuity-related litigations, is “I did not understand what I was buying.” The more complicated the annuity, the more likely this complaint — or, at the least, the more reasonable it may sound to a jury or arbitrator.
5. Financial objectives. As the authors have noted earlier, an annuity is just a tool. Any assessment of its suitability must necessarily consider the job to be done. It is vital that everyone involved in the sale of an annuity — the applicant, the recommending advisor, and the insurance company issuing the annuity — understand what financial objectives that annuity is being purchased to achieve. In the authors’ opinion, it is probably impossible to over-emphasize the importance of this factor or to over-document its consideration. A thorough documentation of why the annuity is, in the opinion of the advisor, the right tool for the job can be invaluable to the defendant in litigation alleging a bad sale. More importantly, it may prevent that litigation by ensuring both that the consumer buys the right product and that he or she understands as much.
6. Intended use of the annuity. This is a variation on the theme addressed by factor No. 5, focusing less on, “is the annuity the right tool for the job?” and more on, “how will that tool be used to do the job?” Consideration of this factor can produce useful, and possibly unexpected, results. For example, if the proposed annuity includes a guaranteed minimum death benefit and the purchaser shows a special interest in this feature, a discussion of life insurance, which is usually a more efficient delivery instrument for death benefits than an annuity, may be in order.
7. Financial time horizon. Time horizon can be a confusing term. It can be used to mean the maximum period during which this investment will be held. It can also be used to mean the number of years before which distributions, or income, are expected to be needed. Both are relevant to a proper determination of suitability, and the authors suggest that the advisor and consumer understand how long the annuity will be held, which is particularly important when surrender charges are considered, and over what period of time distributions — whether in the form of withdrawals or regular annuity payments — will be made.
8. Existing assets, including investment and life insurance holdings. Existing assets are important, not only because they are part of that client’s financial situation (Factor No. 3), but because the nature and extent of those assets will help the advisor to determine the extent to which the financial objectives, identified in factor No. 5, are likely to be met. A review of existing assets can also help the advisor assess the accuracy of the client’s responses to the advisor’s questions regarding the other suitability factors. For example, a client claiming to have extensive financial experience and sophistication and a great desire for tax-favored treatment of his investments, yet who holds only certificates of deposit, may not understand the extent to which the expressed concerns are inconsistent with his prior financial decisions and current holdings.
9. Liquidity needs. The liquidity of an asset refers to how quickly and cheaply it can be converted to cash. While a deferred annuity that imposes surrender charges (as most do) can be surrendered for cash relatively quickly, the cash received might, because of those charges, be significantly less than the annuity’s value just prior to surrender. In a few indexed annuities, surrender charges never expire, and may even apply to death proceeds taken in a lump sum; those annuities may be considered relatively illiquid. That does not necessarily make them unsuitable, as long as the annuity purchaser is comfortable that the illiquidity is still reasonable, given his or her goals. On the other hand, it’s important to note that even those contracts whose charges do expire after a term of years may have a high cost for early liquidity during that surrender charge period, especially in the early years of that period.
10. Liquid net worth. After learning the liquid net worth of the annuity applicant, the advisor can compare that figure with the applicant’s liquidity needs. If it appears that the liquid net worth is not sufficient to meet the liquidity needs during the surrender charge period, the advisor may wish to recommend that some of the funds being considered for investment in the annuity be placed in a highly liquid account to meet that potential shortfall.
11. Risk tolerance. Risk tolerance is an essential factor in the determination of the suitability of an annuity because annuities are risk management instruments. Unfortunately, this simple fact is not widely, or well understood by many financial advisors and, sad to say, regulators. Moreover, the very notion of risk is largely misunderstood and, often, misapplied.
What is risk? Textbooks in finance tell us that there are many different kinds of risk, including market risk, interest rate risk, inflation risk, currency risk, credit risk, liquidity risk, etc. Yet many risk tolerance questionnaires used by financial advisors — and often required by insurers and/or broker/dealers to be completed prior to the sale of an annuity, especially a variable annuity — focus only on one of these: market risk, which is commonly defined in either of two very different ways.
One definition says that market risk is the risk that market pressures may cause the value of an investment to fluctuate. In that sense, market risk means volatility. Another definition, also used widely, says that market risk is the possibility that market pressures will cause the value of an investment to decline. In that sense, market risk equals principal risk. Both involve uncertainty — which, the authors believe, is the central element of risk — as to the future value of one’s capital.
Certainly, that’s an important consideration to any investor; but it’s not all-important. The widespread use of risk tolerance assessment tools, such as a questionnaire, that identifies risk only as the possibility of losing one’s capital, or principal, focuses attention only on the capital preservation and wealth accumulation potential of the product being considered, concerning which tool is employed.
That can be a problem when one is assessing the suitability of an annuity because the risk that is of greatest concern to a prospective annuity purchaser may not be “that I might lose some principal” but, rather, that “I might run out of income.” Moreover, principal risk is never a factor in an immediate annuity, because an immediate annuity is an income stream, and typically has no principal or accessible cash value. It may not be a factor when the product proposed is a fixed deferred annuity, because all fixed deferred annuities guarantee principal, except to the extent that surrender charges or a market value adjustment may erode principal if the contract is surrendered early. Indeed, principal risk may not be a great concern even when the proposed product is a variable deferred annuity if a guaranteed living benefit has been chosen because the income guaranteed with such benefits is often immune to adverse market performance.
The authors do not suggest that market risk should not be a concern in determining the suitability of any proposed investment, including an annuity, but only that many risk tolerance measurement tools focus only on market risk — and, in doing so, marginalize, or ignore completely, the applicant’s tolerance for other risks that may be of far greater concern. We believe that any discussion of risk tolerance should be informed by the applicant’s responses to the other eleven factors in this list, and by the advisor’s understanding of the client’s total picture.
12. Tax status. The tax status of the applicant for an annuity is obviously important because annuities receive special tax treatment. The tax deferral that is enjoyed by a deferred annuity comes with a cost: Namely (a) all ordinary income treatment of all distributions and (b) a ten percent penalty tax on any distribution not qualifying for an exception under Code section 72(q)(2). The benefit of such tax deferral is much greater for applicants in high tax brackets than for applicants in very low brackets, for whom the benefit may be outweighed by its cost.