Court Decision Threatens To Impose New Duties on VA Issuers

Issuers of financial products like mutual funds and VAs are likewise required to disclose all charges to investors, such as fund-level management fees, and administrative and other charges. We assume that companies fighting for investor dollars will be restrained from imposing excess charges that would put them at a competitive disadvantage. And, indeed, we have seen many investment companies market their investment products as charging lower fees.

The court in the Pacific Life case has suggested in its order certifying a class, and again recently in an order affirming that ruling, that it doubts variable annuities are a good deal for the investor. In part, the court bases its position on the misconception that the M&E charge is intended to pay only for the guaranteed minimum death benefit — the “M” in “M&E.” As VA prospectuses (including Pacific Life’s) routinely state, the M&E charge pays for not only the death benefit and guaranteed annuitization rates, but also for all costs of administering and distributing the product, including commissions, as well as provides for profit to the issuer.

Recent economic research suggests that the “all-in” cost of a VA is comparable to that of other products typically sold by financial advisers, including mutual fund products. The M&E charge for variable annuities is offset by lower fund-level management fees and cost-free movement of investments among funds. This makes sense because, in a market as competitive as that for VAs, issuers would not be able to pass on excessive charges to investors and expect to remain in business.

Requiring VA issuers to disclose the “actuarial value” of benefits would create a whole new series of problems for issuers, regulators, and investors–which may be why the SEC and NASD have never required such disclosure. The Pacific Life court deemed the “actuarial value” of the death benefit to be equivalent to the assumed cost to the issuer of the death benefit used by the pricing actuary in pricing the variable annuity. However, the pricing actuary prices the VA for all investors expected to purchase the product over a long time frame, using computer models that simulate possible future investment results. In this regard, pricing a VA is a little like making sausage; the actuary must fit in all the necessary ingredients, but the end product must result in a competitive charge for what is being sold. Because no issuer sells a guaranteed minimum death benefit all by itself, no freely operating market ever tests whether the actuary’s estimate of the “value” of the death benefit is accurate.

No one disputes that the death benefit is more valuable to some investors than others–as much as 10 times more valuable, according to experts hired by class action plaintiff lawyers. The issuer, who typically never has direct contact with the purchaser, has no means to determine the value of the death benefit for a specific purchaser. If the representative selling the VA purports to tell the investor the estimated “value” of the death benefit without conducting a particularized actuarial study, that estimate is likely to be wrong. Nor is a typical consumer equipped to evaluate claims as to the actuarial value of an insurance benefit.

As a practical matter, requiring issuers to provide such estimates would provide a purchaser the option to challenge the sale later, individually or on behalf of a class, if the investment does not perform as well as desired.

Both Congress and the SEC have been understandably reluctant to impose new duties on issuers without careful study of its impact on investors. The SEC has always required VA issuers to disclose what they charge investors, and what they charge for, but has never required them to disclose the cost to the issuer (or value to the investor) of the guaranteed minimum death benefit. Perhaps the SEC does not wish to see issuers competing on the basis of “actuarial value,” since it might entice investors but would be difficult or impossible to verify.

In any event, the SEC has so far said nothing about the Pacific Life decision, and its silence may encourage other federal judges to usurp the SEC’s role by regulating national securities markets on a district-by-district basis. Variable annuity issuers are left wondering how to respond.