As the Baby Boomers increasingly move from saving and accumulating assets in preparation for retirement, to planning for income for life (and living!), they face some difficult choices. Interest rates are historically low, the yield curve remains flat, the real interest rates on CD's are minimal, and the equity markets are hitting all-time highs. Science has helped us live longer, but science has not found the answer to paying for that longevity. The financial risks of "living too long"are all too real. Banks, brokers and their customers are increasingly turning to Variable Annuities to solve their retirement income needs.

Bank-owned agencies and broker-dealers that sell Variable Annuities (VAs) have expressed concern that that VAs have been targeted for criticism by financial writers and by unwarranted scrutiny by regulators. Sales of VAs have expanded rapidly over the past decade and may have exceeded $21 billion in 2006. VAs now account for a majority of bank broker-dealer and insurance industry profits. VAs are definitely good for brokers and insurance companies, and they can be great choices for long-term, fully informed investors who clearly understand their features, benefits and costs.

Because of the perceived attack on a product that is obviously popular with investors planning for retirement, it was initially the intent to point out how wrong the regulators and financial writers have been in their criticisms. The regulators' responses, however, have resulted from examinations that stemmed from complaints. It seems more appropriate to address the regulators' comments and concerns and to help banks and broker-dealers ensure that their people, products and processes address these matters.

The regulators, led by the U. S. Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD), have concerns about the growth of VAs and if they are being sold correctly. In July, 2005 the NASD formalized their position by issuing proposed NASD Rule 2821 which would have created recommendation requirements, including a suitability obligation, principal review and approval requirements, and supervisory and training requirements. After strong opposition by insurance carriers, the proposed rule was withdrawn.

At the heart of the matter is the complexity of the VA: the VA is difficult to fully explain; and, it is at least equally difficult for the average investor to understand. The NASD and SEC continue to believe there is inadequate determination of suitability based on investment objectives and liquidity needs.

Is it that the regulators are unduly worried about empty "what-ifs"? Or that they have nothing else to do? Hardly the case! They generally become involved with issues like these when the volume of investor complaints increases and the regulatory sweeps and examinations confirm a reason to take broader, industry-wide action. In the case of VAs, the SEC and NASD have made it clear they are listening, looking and trying to get ahead of problematic issues associated with VAs.

The pooled investment concepts essential to understanding mutual funds are, in the words of one SEC Commissioner "...complicated by the concepts of tax deferral, ordinary versus capital gains treatment, mortality expense, death benefits, living benefits [guaranteed and non-guaranteed values], surrender charges, early withdrawal penalties and various payout options...."

Some financial writers have characterized bank-sellers of VAs as being overly aggressive, under informed, and driven by the need to generate ever-increasing commission revenues. Bank broker-dealers, however, spend significant time and money on their product selection processes, product training, supervision and sales tracking in order to ensure their customers are dealt with fairly on a fully informed basis. Regardless, it is a fact that bank broker-dealers are in a defensive position.

It is time for the banks to play offense, and by that I mean get busy and make sure you really have a great, well-managed program that is properly documented and supervised. If we take the above-quoted SEC commissioner's complicated concepts list as an outline for what the well-informed customer needs to know, we will probably get pretty close to being compliant.

Need for Tax Deferral

During the customer interview process, the registered representative should probe to be certain the prospective buyer of a VA has first contributed to the maximum extent possible to other tax-advantaged options such as an IRA, 401(k), and contributed as much as allowed into a Roth IRA. If it is then determined the customer still wants and needs more shelter, proceed to explaining the similarities and differences between VAs and other less complex investment options. And document every step. Ask all the questions, explain every element, write it down ("WID") and keep it in the customer file.

Let's cover it from the top. VAs are tax-deferred investments. That is tax-deferred, not tax-exempt. The payments are from after-tax income. The increase in contract value in the accumulation phase comes from capital gains, interest and dividends. This tax-deferred accumulation is called the "inside build-up,"and it is not taxed until distributed. When payouts are made, the accumulation is distributed first, before the principal investment. The distributions from VAs are taxed at ordinary income tax rates. Mutual fund distributions, however, receive different tax treatment. Mutual fund payouts result from realized capital gains, dividends and interest (just like VAs), but they are taxed annually at the tax rate currently charged on capital gains, dividends and interest. Capital gains and dividends are currently treated very favorably compared to the tax rates on ordinary income.

While on the subject of taxes, let's take a look at inheritance taxes. The VA is distributed to the beneficiary and tax as ordinary income on the full value as of the time of death. The value of the VA at death is an estate tax liability. Mutual funds are inherited by the heir(s) on a stepped-up basis, meaning the heirs assume a new cost basis that is the price as of the time of death of the owner.

Training programs must include clear information and examples to drive home these differentiating tax characteristics (and all of the other concepts that follow) repeatedly. The bank program managers and supervisors must develop checklists evidencing these explanations to the prospective VA investors, and acknowledgments must be dated and signed by both the customer and the registered representative. WID.

Mortality & Expense Charges

Mortality and Expense (M&E) charge in a VA is something that the average person is unfamiliar with because M&E charges are not found in non-insurance products. Most investors are "insurance ignorant,"and this increases the burden on the agent selling the insurance product. Simply, it is the cost the insurance carrier assumes for insurance risks assumed in the VA contract. M&E pays for the insurance and for some other expenses, often including sales and marketing expenses. M&E is an annual charge based on the total value of the VA and is typically 1.25%.

Death Benefits

Death Benefits associated with a VA provide the beneficiary of the VA contract with an amount that is the greater of all the market value of the account or some guaranteed minimum amount. The guaranteed minimum would typically be the amount paid into the VA contract less the amount withdrawn. In some contracts, and for an additional annual fee, the insurer provides for a "stepped-up"benefit that reflects the increased value due to increased underlying investment values, less the withdrawals.

Guarantees

It should surprise nobody that that customers like guarantees. They want certainty in an investment world that is inherently uncertain. The Living Benefits riders are now offered with most of the VAs sold by the major carriers. Guarantees of lifetime income, account values, minimum withdrawals are just a few of the riders offered, and each comes with an annual fee. Regulators continue to be concerned that that the many rider options offered are so numerous and complex that they not adequately explained by agents, and that customers hear the word "guarantee"and remember little else.

A VA seller needs to be very careful in the selection of the guarantees it will offer. It must be able to demonstrate that the various riders sold to each customer match the needs determinations developed in the suitability process. The cost of these riders is an annual fee, and when combined with all the other charges of the VA and the internal fees of the investment buckets, the combined expense can offset the annual increases in the markets.

More and more carriers are adding guarantees, and it is estimated that approximately 75% of the VA carriers now offer at least one guarantee rider. These carriers offer an increasing array of guarantees because they are easily sold and because they are profitable. Again, regulators are focusing on sales techniques, adequate disclosures, needs determination and the suitability issues. Document, document, document.

Exchanges

Tax-Free "1035"Exchanges are being examined carefully. The tax law allows the tax-free exchange of an existing VA contract for a new VA contract, and some reports indicate that nearly half of current VA production is generated by exchanges. The documentation in the customer file must clearly indicate the exchange was suitable, appropriate and overwhelmingly beneficial to the customer. Be prepared to justify the age restrictions in the Written Supervisory Procedures (WSPs) and any exceptions made to the same. And be prepared to demonstrate that the WSPs are carefully adhered to, tested periodically, and supervised continuously.

Tax-free does not mean penalty free. If the old annuity is still in its surrender period, the issuer has the option under the contract to levy a surrender charge. Some issuers waive the surrender charge if the exchange is into one of their VAs. This raises a couple of issues: the exchange must be demonstrated to be beneficial to the customers in terms of additional features and benefits that translate to economic benefit; and, the new VA must be objectively the choice a fully informed investor would make. Would the person considering doing a tax-free exchange objectively make the choice to go into the same carrier's new VA product? Or is that choice being presented because the surrender charge is being waived on the old VA contract? Again, carefully document the rationale, emphasize the proof of benefit of the exchange to the customer, and be prepared to defend it.

Aside from the exchange value, the rationale must address the new surrender charge period. Suitability must be readdressed in term s age, need for income, extended lack of liquidity, etc. A person at age 60 who bought a VA with an 8-year surrender period is now age 66 and two years remain for surrender charges. If this person exchanges into a new VA having an 8-year surrender period, s/he will be 74 years old before the surrender period expires. Does this person have sufficient liquid assets to accommodate this extension? Explain it, document it, and have a written rationale.

Withdrawals

VA contracts contain penalties for withdrawing money before a certain period after purchase. These surrender periods can extent to 10 years, although many banks have been insisting on surrender periods as short as five years. They are stated as a percentage of the amount withdrawn early. Many bank-sold VA contracts provide for a 10% penalty-free annual withdrawal. Again, the documentation of liquidity needs is the bank's shield against unsuitable recommendations, questionable sales practices, etc.

Payout Options

Most obvious is the fact that the VA buyer intends to receive future payouts. The payments may start immediately in the case of an immediate annuity. Payments can be fixed or may vary according to the performance of the sub-accounts. Payments can be for a fixed number of years, or over the VA holder's lifetime (or the combined lifetimes of both spouses). And, once the VA contract holder starts taking payments, money cannot be withdrawn. Every element of the payout phase options has many possible iterations that include life expectancy, current health condition, future cash flow needs and expectations, etc. Each is essential to fully understanding the VA contract being considered. The seller needs to spend all the time necessary to ascertain the payout phase options are fully explained and understood.

Bonuses

All consumers, regardless of the product, love a bonus. It implies "something free." But not when it involves an annuity. If a bonus is offered, it is credited to the VA account value, but it usually includes a provision that the VA buyer will pay an additional penalty for early withdrawals or account liquidations. Does the bonus actually offset the additional liquidity restriction and penalty? This suitability determination, like all the other above, must be documented and maintained in the customer file. WID.

So the defense, as far as it goes, is made. There are many other elements that could be included here, but these are the ones that continue to draw the regulators' attention because of the ongoing level of complaints that are followed by sweeps and examinations. In summary, the defense for VAs lies in good sales practices carefully supervised. After carefully and diligently explaining the features and benefits of a VA, the determination that the customer needs the benefits offered by a VA must be made in writing. WID. There is nothing a bank can do to prevent "selective memory,"but there is no defense against not doing all that has been clearly put forth by the regulators and compliance practitioners. And yet again, WID!!!

Marketing Plans

The general mission of all bank broker-dealers is to profitably provide solutions to customers' investment problems, issues and concerns. This cannot happen if a sale does not take place. This is not theory or a classroom exercise. And to ensure that resources are efficiently applied and sales opportunities are realized, marketing techniques are becoming very sophisticated.

The answer to "Who should/will buy a VA,"is both valuable information and a compliance concern. The clearly understood difference between "should buy"and "will buy"can differentiate a sound program from a boiler room operation. Marketing professionals of all ilk understand this.

Bank clients are generally older. They are closer to "distribution"versus "accumulation"than the general population. For the most part they have educated their children, paid for their houses, have stronger balance sheets, have more investable assets, and are generally more conservative. Fear of running out of money and the guarantee of not running out of money are powerful motivators in the VA sale. All of these characteristics are reasons that financial advisers target these segments.

Segmentation has become very sophisticated and scientific. It is easy to sort bases according to age, gender, race, education, investment experience, buying patterns, technology use, advisor usage, risk profile, etc. Enter the garden of good and evil.

So where is this going? Your program needs big sales increases this year. Let's say the marketing advisors identify a group of probable buyers as having the following characteristics: over fifty years old, single, working females who are less sophisticated financially, have the propensity to willingly take advice, are not technology users and have investable assets.

There are a lot of these identified in the bank database. VA sales increases to this segment are much stronger than to the general branch referrals. The stock market corrects 10%; the 10-year Treasury moves to 5.76% from 4.76%; inflation pick up; and, the yield curve steepens.

It is fair to assume the targeted segment identified above is likely to be very concerned? Yes, indeed it is! In addition to the markets going against her, the fees accentuate the negative returns. She wants out of the VA and back into cash. The penalties are stiff, and the customer is upset and visiting the bank branch manager stating that, "Had I had any understanding of what this investment could do to my future, I would never have gone near it. I want my money back now, or else!" And, there are six others just like her making the same complaint.

It will look really bad to the bank's chairman when he reads about this in the newspaper as the result of plaintiff counsel being hired and the complaints being filed with the NASD. The first inclination to "make them whole"will be met with the advice of general counsel and the Chief Risk Officer that "You cannot do that because it could be setting a precedent that any/all investment losses will be covered by the bank (shareholders). The OCC and the FDIC will be concerned." There is no winner in this scenario. Reps will be reprimanded or fired, managers will be cited for failure to supervise, fines will be levied, and the bank's reputation will suffer.

The regulators and plaintiff counsel will laser-focus on the fact that the program utilized questionable sales practices and targeted persons that are less sophisticated. One recent research study indicated that some non-bank companies are avoiding persons having a higher degree of investment sophistication and those with technology and analytical occupations. These are not bank broker-dealers, but they will cause the regulators to cast a wide net again and increase the use of sweeps and extra examinations.

In summary, just avoid any marketing plan that can have the unintended consequences of including your bank broker-dealer in the universe of those using questionable tactics. Think long-term. Strengthen training and testing. Use only the most reputable carriers and products. Deal fairly with customers on a fully disclosed basis. Document the rationale for any and all VA sales. WID!!!

Richard D. Starr is BISA Director of Government Affairs, is Chairman of BISA's Legislative, Regulatory & Compliance Committee, and is a regular contributor to Bank Insurance & Securities Magazine. He is also President of Financial Institutions Group, Inc., a full-service financial services consulting firm focusing on bank broker-dealers and insurance agencies. He can be contacted at rstarr@bisanet.org.

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