Oil and Water: Fiduciaries and Variable Annuities

The financial services industry continues to try to convince investment advisers and other financial fiduciaries to sell variable annuities. Smart RIAs and other financial fiduciaries ignore these pleas, as they realize that variable annuities are liability traps for fiduciaries, blatant violations of the fiduciary duties of loyalty and prudence.

A fiduciary must be loyal to their client, acting solely in the best interests of the client. The methodology used by most variable annuity issuers essentially guarantees a windfall for the variable annuity issuer at the client’s expense. Even a leading variable annuity issuer has admitted to the inherent inequities in the current system. In the January 2004 issue of Financial Planning magazine, John D. Johns, Chairman  and CEO of Protective Life Corporation, addressed the illogical and inequitable nature of the inverse pricing methodology, where fees are based on the accumulated value of the variable annuity rather that the potential cost to the variable annuity issuer in the event a death benefit had to be paid to the variable annuity owner’s heirs.

Another fiduciary liability trap for fiduciaries involves the actual value of the death benefit itself. Dr. Moshe Milevsky conducted the groundbreaking study on this issue. In the January 2007 issue of Research magazine, he re-counted his earlier findings, namely that

if the M&E fee was only meant to cover pure risk – the typical VA policyholder was being grossly overcharged for this so-called protection and peace of mind. We found that the basic return-of-premium GMDB was worth no more than 5 to 10 basis points of assets per  annum. By the term “worth” we meant that it would only cost the insurance company backing the guarantee 5 to 10 basis points to reinsure or hedge their exposure to this risk.

When you consider that most VA issuers charge approximately 2 percent, or 200 basis points, annually for the M&E, or death benefit, fee, the breach of fiduciary duties as to both loyalty and prudence are obvious. Add in another 1 percent cumulative annual charge for the various subaccounts within the VA itself, and possibly another 1percent annual advisory fee for “managing” the VA, and the abusive nature becomes even more obvious.

A study by the Department of Labor concluded that each additional 1 percent of fees or expenses reduce an investor’s end return by approximately 17 percent a year over a 20 year period. (For nitpickers, the actual number is 16.97 percent.) Over a twenty-five year period, that number increases to 20.75 percent. Over a thirty year period, that number increases to 24.35%.

The true impact of escalating fees is even more problematic. Over a fifteen year period, a 3 percent fee would reduce an investor’s end return by approximately 34.46 percent, while a 4 percent fee would reduce an investor’s end return by approximately 43.22%. Over a twenty year period, a 3 percent fee would reduce an investor’s end return by approximately 43.07 percent, while a 4 percent fee would reduce an investor’s end return by approximately 53 percent. Throw in a 7 percent commission to the stockbroker or insurance agent selling these products and you understand why “financial advisers” and insurance companies push VAs so hard.

There is a saying in the financial services industry that variable annuities are sold, not bought. That’s because any investor who had the information set out in this post would run away from the VA salesman. But salesmen do not explain this aspect of VAs. They just preach tax deferral and the notion that the VA owner can never run out of money. Well, IRAs provide tax deferral without all the added fees. And in order to get the lifetime money guarantee, the VA owner has to annuitize the VA, meaning the VA owner loses control over the money.

While their are various survivorship options available, usually single or joint lives, once those options are over, the insurance company, not the VA owner’s heirs, receive any balance left in the VA account. It is for that reason that VAs are so detrimental to estate planning.

So if you are a fiduciary and you decide to recommend and/or invest in VAs, be sure to check your E & O policy, because if you ever face a client claim based on the VAs, it is essentially what we in the South like to refer to as “shooting fish in a barrel,” for the reasons discussed in this article. The various methods used to guarantee a windfall to the VA issuer basically ensure that a fiduciary will be found liable for violations of both the fiduciary duties of loyalty and prudence.

It is hard to honestly argue that a product that may reduce an investor’s end return by 40 to 50 percent is in their best interests. If it is a jury trial…forget it, and hope that the jury does not decide to set an example. With today’s all public arbitration panels, making such a ludicrous argument may result in an award designed to truly punish the VA salesman and warn others.

For more information on variable annuities and the fiduciary duties/liabilities involved, see our white paper,”Variable Annuities: Reading Between the Marketing Lines,” at http://investsense.com/variable-annuities/.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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