Variable annuities (VAs) have dominated the bank investment programs for several years, and the customer demand for these products continues to grow. At the same time, the complexity of the products increases. The regulators continue to focus on problems arising from complaints, from examinations and from sweeps.

The popularity of VAs is largely demographically driven and is intensified by people realizing the uncertainty of their income in retirement years resulting generally from saving too little. While annuitization features were the big VA story in the early years, the shift to guarantees and riders that address every need characterize the products today. As these benefits and riders expand, the bank broker-dealers must expand their Written Supervisory Procedures, Supervisory System and their Sales Guidelines to ensure compliance with rules and regulations, fair dealing and good sales practices.

The VA sales process generally includes the following steps: gathering Customer Information, Determining Suitability, Delivery of the Prospectus, Making Required Disclosures, Presenting VA Benefits and Options, Presenting Required Forms, and Submitting the Application.

Sales Guidelines are a summary form of Written Supervisory Procedures, the Supervisory System, internally generated standards, and the NASD Rules. They are the "Doss & Don’ts" for the sales force and they can be used against the broker and the firm in the event that litigation and/or arbitration occur. So it pays to spend some time in creating them with a careful eye to accuracy and clear expression. The Variable Annuity Guidelines for your institution should include, but not be limited to, elements of all the following topics.

Standard Setting

The institution must determine age, income and other criteria and document these in its WSPs. Statements should be very clear and concise, and any exceptions to the standards must be approved, signed and dated by a supervising principal prior to submitting the VA application, and retained in the customer account file and other locations as the firm requires. An example of some restrictions might be expressed as:

1. ABC Investment Services will not sell VAs to persons 70 years old upon their next birthday unless they meet the Selling to Seniors policy criteria
2. ABC Investment Services will not sell VAs to persons having annual income less than $40,000
3. ABC Investment Services will not sell VAs to persons having liquid net worth less than $100,000
4. ABC Investment Services will not sell VAs to persons cash liquidity to cover less than six months expenses
5. ABC Investment Services will not sell VAs to persons for which the VA would exceed 40% of the entire investment portfolio of that person
6. ABC Investment Services will not sell VAs to a married person without the acknowledgement of the spouse
7. ABC Investment Services will not sell VAs in any exchange mechanism unless the benefits of the new contract are clearly demonstrated to be of greater benefit that those of the being exchanged and that the value of the new benefits is justified by the cost
8. ABC Investment Services sell VAs in any exchange mechanism if the old contract has been issued for fewer than two years

Suitability

VAs are securities, are offered by prospectus, and are subject to NASD Rule 2310 regarding suitability. The broker must gather sufficient information to establish the documented proof that he/she has reasonable grounds for believing that the recommendation to purchase the VA is suitable and appropriate to the client’s needs, resources and objectives.

Suitability is determined by analyzing the customer information gathered in the interview process. Customer information must minimally include age, date of birth, marital status, number and age of dependents, annual income, net worth, liquid net worth, investment objective, investment experience, sources of funds, existing investments, existing insurance, time horizon, and risk tolerance. Because a VA is a tax advantaged product, the need for tax deferral must be established by discovering tax status, tax deferred plans, and other tax advantaged investments owned. An investor may want tax advantaged instruments but does not need more tax shelter; and in this case, the other advantages of a VA may offset that factor.

The documentation must be dated and will include notes, account forms and applications. The investment sub-accounts, taken together as the asset allocation, must be consistent with the objectives, risk tolerance and financial capability and need of the applicant.

The broker must determine the customer needs the benefits being purchased in the VA and that the cost of the benefits is justified. The broker must determine that the VA benefits outweigh other alternative insurance and securities products.

In the event that the institution permits selling VAs to a tax-deferred such as an IRA, the broker must clearly demonstrate and document all of the above information and compare the costs in such a way that proves the benefit of purchasing the VA.

Delivery of the Prospectus

Delivery of the prospectus is required not later than when the broker completes the sales process, and is prepared to files the application. However, it is best if the broker uses the prospectus to point out the various aspects of the variable described in the prospectus during the sales session. The customer will then be familiar with what is a complicated disclosure document. The carrier will also deliver a prospectus to the client via mail.

Making the Disclosures

VAs are extremely complex and difficult to explain thoroughly. The customers will interrupt and have more questions about one feature or benefit than about others. There is always the tendency to talk more about the benefits than the risks, and this must be avoided. The presentation must be balanced and complete. The broker must very clearly describe the product as a Variable Annuity.

A VA is NOT a mutual fund; it is not a fixed annuity; it is NOT an insurance policy; it is NOT a lot of things. It IS a Variable Annuity with multiple investment options, tax deferral, tax treatment features, annuitization options, death benefits options, and living benefit options and riders. And each of these benefits has costs associated with it that are periodic charges against the contract.

Carrier credit ratings must be explained in an evenhanded manner, and the broker must explain that ratings assigned by rating agencies are important only in evaluating the carriers ability to pay the death benefits. These ratings have nothing to do with performance, and this must be discussed.

In addition to all of the disclosures enumerated in the above paragraph, a full and balanced regarding liquidity is essential. It must be made clear that once a VA is purchased, getting out of it is not like selling shares of stocks, mutual funds or bonds. There are penalties and tax considerations. The VA is not suitable for a person having short-term goals and objectives, and it would be inappropriate to suggest that a rapid rise in market values might offset the withdrawal penalties. VAs are expensive investment vehicles, and diminishing that fact in a sales presentation is inappropriate.

If a prospect is risk averse or does not have the financial strength to prudently be exposed to fluctuating market values, these factors must be explained in an evenhanded presentation.

If an exchange is contemplated, the broker must clearly demonstrate to the customer that the benefits of the new contract clearly outweigh the penalties of getting out of the old contract. The broker must also clearly explain the penalties of additional surrender charges. To ensure this disclosure is properly examined and evaluated by both the broker and the customer, the broker must execute the completed carrier 1035 Exchange Transfer Questionnaire.

Presenting the VA Benefits, Options and Riders

The shift in emphasis from annuitization to guarantees presents a real challenge for both the broker and the seller. The broker-dealer will have determined what guarantees, riders and options will be offered. Any that are not offered must not be discussed with the customer, and the broker must ensure that any carrier representative does not discuss these with the brokers or its customers.

Just as with the disclosures, the broker must present them in a fair and balanced manner, and make certain they are in accord with the suitability determination. A customer that wants/needs a guaranteed income stream is somewhat different from a customer that wants an income stream that keeps pace with inflation.

If the broker-dealer’s bank parent has a 1-year economic and market forecast that 10-year maturity interest rates will be in the range of 4.5-5.5% for the next decade, that the S&P growth will approximate 8%, and that inflation over the next ten years will average 6%, the broker selling the VA must consider that in the context of the anticipated fees and charges for the benefits, guarantees and options that will be incurred during the same period. This is the cost/benefit analysis the broker must document.

If, for example, we assume that a very efficient VA will have M&E charges of approximately 1.50%, that the internal expenses of the investment options average .80%, that two guarantee options cost .50% each, the total costs would be approximately 2.8% annually. If the fixed-income and equity investments are evenly allocated in a $100,00 VA contract, the average projected nominal return using the forecast would be approximately 6.5% annually, less the expenses of 2.8%. This projected net, nominal investment return is approximately 3.7%. It would be misrepresentation to emphasize the beginning rate on the VA without also representing the impact of costs.

Sales of VAs to Seniors

Selling to seniors has become a major topic in compliance circles. There are several reasons that regulators have focused on this segment, and most bank broker-dealer programs today have detailed sales guidelines, special tracking programs, and special supervisory review requirements. The National Association of Insurance Commissioners (NAIC) has been successful with its promotion of its model act promulgating state laws that address selling to seniors.

Seniors who will be 70 years old in 2007 were born in 1937. They likely graduated from high school in 1955 and did not have any education in securities or insurance. They were from families that had vivid memories of the Depression, World War II, the Korean conflict, and the personal family economic hardships that were associated with these milestones. It was also a time when many industrial and manufacturing business were formed throughout the Midwest. Assets on the personal balance sheets were largely, personal residences, cars, personal belongings and cash in the bank. Retirement was provided for by the defined benefit plans sponsored by employers and by social security.

In the 1980’s the tax code was revised to provide for tax deductions for contributions to personal retirement plans, and retirement plans shifted to defined contribution plans that were self-directed versus being invested by the employer. The shift toward self-reliance continues today. Although this shift in dependency is entering its third decade, fully-informed financial decision making has lagged. This demonstrated by several studies that indicate nearly 80% of persons who establish a self-directed account do not alter the asset allocation after inception. They understand that taking advantage of timely changes in the asset allocation can significantly improve investment returns, but they do not have the knowledge and/or confidence to make the decisions. However, when offered the opportunity to have financial experts make those decisions on their behalf, they are willing to pay the fees. That puts advisors in a very important and responsible place in the investment decision making process.

Another change in these seniors’ lives is they are moving from accumulating assets for retirement into the phase of needing income from those accumulations for living. For most people in retirement growth becomes less important than income. The reality that they have arrived at retirement with insufficient savings to provide the income they want to enjoy the life style they envisioned has influenced them to be receptive to the promises provided by the guaranteed, living benefits offered by carriers in their Variable Annuities.

Selling to seniors in a responsible way brings with it accountability, the obverse of the responsibility coin. As has been demonstrated in this and the articles that accompany it, VAs are complicated, and many of the guarantees are expensive. Seniors that have not had the experience with some of the VA features are not fully equipped to make cost/benefit decisions without the advice of trained financial experts, and many trained financial advisors do not have the in-depth product or sales training to manage the process.

Selling a VA is not like selling a fixed annuity or a mutual fund. The sales process is complicated by the VAs’ many options, and it takes a lot more time than many sales people are willing to devote to doing the job properly. That is why regulators and compliance professionals have concentrated their efforts on the many aspects of selling to seniors.

In July, 2005 the SEC published NASD proposed Rule 2821 that would have created extensive requirements specifically directed at the business of VAs. It was withdrawn because of insurance industry objections that claimed it was duplicative, but the elements within that proposed Rule are the focus of for the regulators today. Most bank broker-dealers have gone to great lengths to strengthen their Written Supervisory Procedures, suitability requirements, age restrictions, training requirements, supervisory system, principal review documentation, etc., specifically addressing the recommendation of sales and exchanges of VAs. It is highly advisable for every bank broker-dealer to elevate the review of their VAs sales component to ensure Seniors are being dealt with on a fully-informed and fair dealing basis and that they have the documentation to withstand the scrutiny of regulators and potential litigators.

Requirements

The bank broker-dealer’s Selling to Seniors Guidelines should restate the general VA restrictions and supplement them with restrictions specific to seniors. To begin, define "Senior." Some banks define senior as being age 65 or older. Some define senior as being 70 years old on their next birthday. Defining senior as being an age above 70 is likely not defensible.

The general suitability requirements should be supplemented with more detail about present and future living expenses. Any estimate of current or future income must be conservative and rationalized in the written documentation. Discussion about the use of "sole and separate property" and "jointly owned property" for the purchase of a VA must be documented. A very clear understanding of the present and future tax situation must be documented for the purpose of establishing the need for tax deferral and for determining the future need for cash.

The detailed analysis of the need for death benefits must be documented. Documentation of the inquiry about estate planning, wills, trusts, titled accounts, etc., is necessary. Documentation regarding the discussion about the liquidity of VAs and the impact it can have in up and down markets is essential. Because the tax treatment of distributions of VAs is different from mutual funds, fixed annuities and individual securities, the written record should confirm the discussion with the prospective buyer.

I am not going to go into the details of the various and numerous options and riders offered by most VA carriers today except to state that each one of these carries the responsibility of the firm to determine through due diligence it is an appropriate offering, document the need, document the explanation, and document the proof of the benefit versus the cost of each one.

If the documentation is not present, the firm should assume the steps were not taken. If the appropriate disclosure forms and acknowledgments are not signed and dated by both the customer and the registered representative, it should be assumed they were not obtained. And, if either or both of these two conditions are present, it should be assumed that WSPs were not explicit and/or the training was inadequate and/or supervision is inadequate. Not pretty, and not defensible.

The Future

The current crop of seniors will be replaced with another and another and.... And selling to each succeeding generation will have some of the same problems, issues and concerns. The newly released data for 2006 indicates that for the first time in history, we had a negative savings rate. It is true that the definition of "savings" does not include housing and investments, and it would be easy to claim that wealth is a better measure. Just as the price of one share of stock traded on the NYSE sets the valuation of all other shares of the same company, the same is true of housing... only more so. If one solid comparable housing unit sells in your neighborhood, the theoretical valuation of your house is adjusted. The problem with housing is that there is no liquidity, and most advisers consider housing as shelter, not investment. The point is that liquidity is rising in relative importance, and all investment professionals need to take special steps to ensure the liquidity needs of all generations are adequately addressed in the suitability determination.

Summary

Your bank broker-dealer program must develop well-reasoned and documented sales practices for all classifications of customers. Standards must be documented and your personnel must be continuously trained. The rules and regulations are minimums, and each institution must determine if its standards and practices meet or exceed these minimums. Falling short of these minimums is not an option. When dealing with seniors, it is not possible to be too careful: discover, document, explain, review, document... and supervise, discover, document, train, document. Practice makes perfect!

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.