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Annuity Exchange Transactions Raise Questions

Advising a customer to surrender a variable annuity to purchase a new product may give rise to state securities regulators obtaining jurisdiction.

Judith A. Hasenauer, 06/07/2011

Have a comment, insight, or burning opinion on this article? Make your feelings known in the comments section at the end of the article.

The Illinois securities regulator issued an order on May 24 that determined that transactions involving the exchange of variable annuities for indexed annuities violated Illinois securities laws. The order resulted from a series of transactions that the Illinois securities regulator determined violated the securities suitability standards and the fiduciary standards applicable to people who are licensed as registered representatives of a broker-dealer or are investment advisors. The order issued by Illinois does not seem to determine that indexed annuities are themselves securities. The enforcement action that gave rise to the order dealt with the sales transactions themselves and did not explore in detail the nature of the financial instruments that were being sold.

There have been attempts in the past by both the Securities and Exchange Commission (SEC) and the Financial Institution Regulatory Authority (FINRA) to determine that indexed annuities are securities that are subject to the registration requirements of federal securities laws and the sale of which requires FINRA registration and compliance with the FINRA rules that apply to the sale of securities.

Courts have determined that the SEC's attempt to regulate indexed annuities were invalid because the process of establishing the rules was invalid. Subsequently, before the SEC could regroup to cure the defects in the rule-making process, Congress stepped in and passed a provision that required indexed annuities to be treated as insurance products that are treated as such under state insurance laws.

It is interesting to note that the Illinois action was directed to the sales process--not toward the nature of the indexed annuities themselves. This is consistent with previous state pronouncements that treated recommendations to exchange a variable annuity for another financial product as a "securities" transaction that subjected the recommending party to state securities laws.

This highlights a problem that has hung around the annuity business since variable annuities first saw the light of day--what is the nature of an annuity? Is it strictly an insurance product or is it a security? In 1959, when the U.S. Supreme Court determined that variable annuities were not exempt from the federal securities laws as were other forms of annuities, the Court said that the reason was that variable annuities were not the type of annuities that Congress had intended to exempt. Therefore, although variable annuities were "insurance" for purposes of state insurance laws, they were also "investment company securities" for purposes of federal law.

Over the years since that Supreme Court ruling, a number of state securities regulators have attempted to exercise various levels of jurisdiction over variable annuities. When variable annuities first became popular in the mid-1960s, the National Association of Insurance Commissioners (NAIC) created model laws and regulations that stated that variable annuities were solely "insurance" products and were subject to the exclusive jurisdiction of state insurance regulators. These models were adopted in one form or another in all of the states so that by the end of the 1960s, variable annuities at the state level were regulated only by state insurance regulators.

As the years have passed and annuities in general and variable annuities in particular have become ever greater factors in financial planning, state laws and interpretations have changed, and the entire issue has become more confused and complicated.

There is little doubt that all life insurance products would meet the definition of "securities" under federal securities laws if they were not specifically exempted. Since they are specifically exempted from registration and regulation under such laws, it is the hybrid products, such as excess interest annuities and indexed annuities, that have caused regulators to attempt to apply the principle set forth by the Supreme Court that those annuities that Congress had not intended to exempt would fail to receive the exemption.

In this arena, an additional factor comes into play. The bulk of current annuities being issued are exchanges involving existing annuities--primarily variable annuities. Even in states where it is clear that annuities are insurance products and not securities, the advice to a customer to surrender a variable annuity to purchase a new product--even one that is not subject to state securities law, may give rise to state securities regulators obtaining jurisdiction over the salesperson who recommends surrender of the variable annuity. Thus, it is the transaction that grants the jurisdiction, not the nature of the product.

Obviously, this attempt to gain jurisdiction over a transaction that involves products that are exempt securities presents a number of sticky problems. It may be clearer under federal securities laws than under state securities laws. This is because variable annuities are securities for federal purposes. The Illinois enforcement order seems to hang itself on both the jurisdiction over the salespeople as registered securities representatives and as registered investment advisors. The rendering of investment advice for compensation subjects the person rendering such advice to jurisdiction under both state and federal laws on the subject.

The Illinois order concluded that there was misconduct in the recommendations that were made and in the implementation of the recommendations. If we are to take such conclusions as true, it is likely that the courts will support the conclusions of the Illinois securities regulator that such actions violate the rules applicable to registered securities representatives and registered investment advisors. We are certainly in no position to determine the validity of these conclusions and have observed situations in the past where regulators have overreached without valid facts to support their conclusions.

Regardless of the outcome in the Illinois case, this situation leads us to the conclusion that we will continue to see actions at various levels of regulation that will involve all types of annuities and urge everyone involved in the annuity business to plan accordingly. We also urge compliance officers and supervisors to make sure that firm's practices address all the suitability issues relating to the disposition of securities such as mutual funds and variable annuities when an exchange of these results in the sale of a fixed annuity.

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