A federal judge in Georgia is threatening to disrupt more than 70 years of precedent under federal securities law by threatening to hold a variable annuity issuer liable for fraud for failing to disclose to broker-dealers the estimated “actuarial value” of the death benefit it provides investors. (Cooper vs. Pacific Life Insurance Company.)

The court has certified a class of VA investors, ruling that Pacific Life owed an unprecedented duty to disclose internal pricing information or risk sweeping civil liability. If the judge’s ruling stands, issuers and registered representatives will find themselves in a no-win position, forced either to provide obscure and unhelpful information to investors, or withhold it. Either way, litigation is sure to follow.

Variable annuities are registered investment products that are often sold within a qualified plan, such as an IRA. Class action plaintiff’s lawyers have sued numerous VA issuers in recent years, alleging that the issuer failed to disclose to investors that they did not need to purchase a VA within a qualified plan in order to avoid paying income tax on their investment as it grows, because the qualified plan itself already provides tax deferral.

Plaintiffs argue that issuers are required to make this disclosure by NASD Notice to Members 99-35, which states that a registered representative should recommend a VA for use in a qualified plan only when its benefits other than tax deferral support the recommendation.

In response, issuers have pointed out that the tax treatment of qualified plans is public information which they have no duty to disclose, and that NTM 99-35 applies not to issuers but to representatives making a recommendation. Thus far, no case has resulted in a judgment for plaintiffs, or even in a significant settlement.

The Pacific Life case differs from any prior case because the judge in that case has recognized an entirely new duty of disclosure he says issuers owe, one that even the plaintiffs did not argue for in their court filings. The court observed that Pacific Life imposes “insurance charges” on the VA investor of 140 basis points (1.4 %) — what is commonly known as a “mortality and expense” (“M&E”) charge — but that the “actuarial value” of the guaranteed minimum death benefit to the investor is as little as 5 basis points (.05%).

The court found the disparity between the M&E charge and the actuarial value is a material fact that a reasonable investor would consider in deciding whether to purchase a VA within a qualified plan. The court ruled that the issuer owed a duty to disclose this disparity to broker-dealers selling its product, and its failure to do so could support a claim for securities fraud, because the representative licensed through the broker-dealer would not be able to disclose this information to an investor.

The Pacific Life decision departs from prior securities fraud cases by focusing on the value received by the investor rather than the price paid for the security. The federal securities laws passed in the early 1930s in response to abuses that led to the stock market crash of 1929 emphasize creating transparency in the securities markets, so investors and the market as a whole can set a price for securities based on the performance and results of the underlying company.

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.