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Annuity Angst

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The Securities and Exchange Commission is keeping an eye on a number of troublesome practices affecting variable insurance products–specifically “unbundled” variable annuity contracts, the sharp rise in fund substitutions, and market timers’ use of funds within annuities as short-term trading vehicles.

Paul Roye, director of the Division of Investment Management at the SEC, told attendees at the National Association for Variable Annuities (NAVA) regulatory affairs conference in Washington this week that the fast changing variable insurance products industry is keeping the commission on its toes. One of the emerging trends the SEC is trying to keep pace with, he said, is the unbundling of variable products, which allows investors to pick and choose additional death benefits and other features that fit their specific needs–but usually at an extra cost. While this practice offers investors the benefit of customizing their annuity, Roye says it raises disclosure issues and further complicates an already complex product.

Mike DeGeorge, NAVA’s VP and acting general counsel, says selecting benefits makes the process “more complicated for the investor in working with the broker/dealer or financial planner in determining which features really are best suited for that investor’s needs.” And it becomes imperative that the advisors selling the product understand the benefits, he says.

But a recent survey that queried the top 20 broker/dealers on the conditions and environment surrounding distribution of unbundled variable annuities revealed B/Ds are having trouble keeping up with an annuity contract’s moving parts. “The sheer volume of information that a producer is asked to assimilate to sell these products is getting to be quite a challenge,” says Jim Doyle, VP of professional services at Pivot/Info-One, the Easton, Connecticut-based financial services consulting firm that conducted the survey. “[Broker/dealers] generally responded that product design has run ahead of product support.”

Despite the steep learning curve involved in selling unbundled products, “there is tremendous value to be derived from them,” Doyle says, because they often result in “a better match to consumer need” and “the ability in an unbundled format to add new benefits to existing contracts enhances the retention of those contracts long-term.”

Broker/dealers say they’d be better equipped to sell unbundled annuities if wholesalers were better educated on the products themselves, Doyle says. Broker/dealers responded that “wholesalers are very focused on activity and not very deep on product knowledge and they tend to focus on ‘my feature versus their feature,’ as opposed to the basics of, ‘why an annuity versus another type of financial instrument.’”

Over the past year, the SEC has also seen an increase in substitution applications, Roye says. With substitutions, the insurance company wishes to substitute a new fund or new investment option for a preexisting one, explains NAVA’s DeGeorge. There are valid reasons why an insurance company would want to substitute a new fund for an old one, he says. For instance, “some funds never grow in size and there are problems in administering small, non-growth funds. And there may be another fund that’s a clone of a popular mutual fund that the insurance company believes is more attractive.”

Roye said he believes “consolidation of the fund industry and the desire of variable product issuers to streamline their investment options” are driving substitution applications. And while the SEC recognizes substitutions may be appropriate, the commission has found some substitutions raise regulatory red flags, and are not in the investor’s best interest.

Market timers have also started using variable accounts as short-term trading vehicles, a disruptive practice that has traditionally plagued mutual funds and even individual stocks. Roye said market timers are attracted to the tax-deferred status of variable products, “so the problem is particularly pressing for many funds underlying variable products.”

NAVA’s DeGeorge says the market timing practice, which creates administrative and management issues for the funds in variable annuity contracts, really started taking hold about a year ago. “I would suspect [the market timing in variable accounts started] because of the unstable market,” DeGeorge says. “When the market was booming, it wasn’t hard to earn a 25% or 30% return and there was less impetus for people to try to time the market.”


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