Investing in a variable annuity in a tax-deferred retirement plan has long been the target of industry critics, but this month a New York law firm did more than just harp on the practice. It filed a lawsuit against it.
Wolf Haldenstein Adler Freeman & Herz filed a class-action lawsuit in the U.S. District Court for the Southern District of New York against American Skandia Life Assurance and its affiliates. The lawsuit alleges that Skandia, which Prudential Insurance of Newark, N.J., has just acquired (see AMN January), made material misleading statements and omissions in the prospectuses of variable annuities sold into tax-deferred retirement accounts.
Alleged misstatements made by Skandia cited in the lawsuit include that tax-deferred variable annuities were appropriate and suitable investments for tax-deferred retirement accounts.
Alleged omissions in the lawsuit include failure to disclose that tax-deferred variable annuities sold to defendants in the case are never suitable investments for tax-deferred retirement accounts because earnings on any investment placed in such an annuity already are tax-deferred. The suit also alleges that purchase of a deferred annuity in a tax-deferred retirement account represents a "useless approach, which simply increases carrying costs."
Double, Triple, or More'
In a complaint filed with the court, it is alleged that Skandia charged "double, triple, or more, the normal commission rate for regular investment products (like mutual funds or individual securities) for variable annuities."
"Moreover," the complaint continues, "because of the subtraction of annual management and carrying fees, calculated as a percent of total assets in the account, purchasers are deprived of up to one-third of their total account value (compared to a regular investment) over the years, and are not informed that the circumstances are remote under which the insurance features for which they are paying fees would have any value."
One of the attorneys for the plaintiffs in the case, Fred Isquith, added: "The fees alone for these investments are very substantial. Even if we just reversed the fees, it would be a very substantial sum of money."
Skandia's response to the lawsuit was a terse statement: "Although we have not yet been formally served with the complaint referenced in press reports, American Skandia understands that the purported class-action lawsuit is similar to numerous claims filed over the past several years against many variable annuity issuers. American Skandia believes the claims to be without merit and intends to defend the case vigorously."
While buying a tax-deferred annuity within a tax-deferred retirement account may smack of wasteful redundancy, the practice does have some benefits, according to industry experts and financial planners.
"If the only advantage of an insurance product for an investor is that the value accumulated in the product is accumulated on a tax-deferred basis, then you could make the argument that you're not gaining much by taking that product and putting it into an already tax-deferred program," said Robert W. MacDonald, chairman of Allianz Life Insurance of Minneapolis.
"But I believe that those products can offer other benefits that are valuable and effective when offered within a retirement or pension plan," MacDonald said.
One such benefit is an option to turn the annuity into a stream of lifetime income. "Annuities are the only product that allows someone to choose the option of receiving income that will last as long as they live," said Mike DeGeorge, general counsel for the National Association for Variable Annuities (NAVA) in Reston, Va.
Myriad of Other Benefits
Another boon offered by variable annuities is the death benefit. That feature protects the pot of money going to an investor's beneficiaries regardless of market conditions. The basic benefit promises to pay a beneficiary the value of the premiums paid by an annuity's owner or the value of an account - whichever is greater. Enhanced death benefits offer even more protection by locking in investment gains periodically and guaranteeing an annual interest rate on premiums paid.
"Think of how many people with qualified retirement plans have seen the value of their accounts drop 30%, 40%, 50% in the last three years," DeGeorge said. "If those people had their money invested in products other than variable annuities, that loss isn't going to be made up if those people die. A mutual fund is not going to make up the difference, but the death benefit of a variable annuity will."
So-called "living benefits," too, can be an enticement for investors with a VA in a retirement account, DeGeorge asserted. Those benefits can not only protect an investor's principal, but also guarantee the value of his or her account at a future point in time.
Aside from insurance benefits, variable annuities within a retirement plan offered to employees of smaller companies have an advantage unavailable to them in other kinds of plans.
"The smaller a company is, the more appropriate group annuities are for it," said Jeff Hall, president of Beacon Benefit Analysts in Quincy, Mass. Hall explained that a typical 401(k) plan for a company with revenues of less than $1 million or 100 employees carries expense charges of about 2%. Expenses for a group annuity plus its wrap fee also amount to about 2%. "The benefit of a group annuity is you don't get stuck with one fund family so you can get better diversification of your assets," he said.
That diversity of choice is less attractive to larger companies, he continued, because they can get a better break on their plan's expenses. While a company with $1 million in assets may be paying 2% in expenses, one with more than $1 million will be paying around 1.25%. "That difference every year really eats into your returns," he said. "It can have a dramatic impact on performance for the five or 10 years that the 401(k) is stuck in the annuity."
Although DeGeorge discounted the prospect that a court would bar insurance companies from selling variable annuities into tax-deferred retirement accounts, such an action would have a significant impact on the industry.
According to NAVA, in 2001 $551 billion of $887 billion in VA assets, or 62%, were in qualified plans. And for that year, $62 billion of $113 billion in VA sales, or 55%, were sold into qualified plans.
But DeGeorge said that it would be a "very remote" possibility that a court would junk a practice with more than 50 years of history behind it.