Variable Annuities

For many Americans, variable annuities are a key part of an investment and retirement plan, even though they probably should not be. However, many investors and retirees do not understand the nuances of variable annuities, creating the perfect opportunity for a broker to take advantage of them and their trust. Knowledgeable securities law attorney Steve A. Buchwalter has helped many people throughout the Los Angeles area and elsewhere in Southern California who have been burned by their brokers. He has substantial experience in finance and knows what it takes to hold a negligent broker responsible for his or her carelessness or wrongdoing.

In general, a variable annuity represents a contract or agreement between an investor and the insurance company. According to the agreement, the insurance company agrees to provide you with periodic payments, starting either at the time the agreement is executed or on a date specified in the contract. A variable annuity can be purchased over a series of payments or in a lump sum amount. The annuity typically comes with a variety of investment options, and the total amount or value of your annuity will be tied to the success of the investment you select (usually called sub-accounts). Common examples of investments for variable annuities include bond funds, money market instruments, stock funds, or a variety of these three. When a variable annuity is purchased, the investor can allocate the amount of the purchase price between sub-accounts within the annuity, changing the amount of investment made in each option included within the annuity.

Overall, variable annuities are intended to provide long-term benefits to the holder and to help the holder accomplish his or her retirement goals. There are usually penalties for the early withdrawal of variable annuity funds, making them a poor choice to achieve short or intermediate term goals.

Variable annuities are some of the highest paying investments when it comes to commissions earned by a stockbroker, typically earning the broker anywhere from 7-10% (or more) of the purchase price as a commission.

While the same can be true on some high-commission mutual funds, most mutual funds have “breakpoints.” A breakpoint is when the amount of the investment hits a certain mark. For instance, lower commissions are triggered when the investor invests $50,000, $100,000, $250,000, $500,000 with the commissions almost disappearing (to less than 1%) when the investment is $1,000,000 or more.

In order to get around breakpoints and their lower commissions, some brokers sell variable annuities, which have no breakpoints. In other words, the broker gets his same 7% (to 10%) commission no matter how much the investor invests. While a broker would receive than 1% ($10,000) in a typical mutual fund sale of over $1,000,000, he would get his full commission of 7-10% ($70,000 - $100,000) if that same investment was in an annuity. Selling annuities has become so lucrative to stockbrokers that many abuses have arisen.

How can the insurance company afford to pay such a high commission on a product? The answer is fees, fees, and more fees charged to the investor.

Variable annuities have expenses (over and above commissions) that could easily exceed 3% per year, all of which is charged to the investor. In other words, if your sub-account investments generate a return of 8%, 3%, or over a third of your return goes to the annuity company as fees. If your investments return 1%, you lose 2% of your principal as the fees do not go down. They have management expenses, mortality expenses, etc. Compare these expenses to those of a mutual fund (which might charge 0.5 to 1.5% per year) and you see where the profit comes from - you. The insurance company makes a guaranteed return of 1.5 - 2.5% on every dollar you pay every year.

To sell these high-commission packages, brokers will sometimes misrepresent the benefits, or give the customer a one-sided view of the benefits. Some common examples are:

Touting the Benefits of Tax Deferral While Ignoring the Corresponding Detriments

While it is true that earnings in a variable annuity accumulate tax-free, there are many other (cheaper) investments that also accumulate tax-free. Further, with an annuity, you (or your heirs) end up paying higher taxes at the end.

Annuities are not the only investments that accumulate tax-free. If you buy stocks, those also accumulate tax-free, as you do not pay taxes until you sell them. If you don't want to pay taxes, don't sell them. Some mutual funds, such as S & P index funds, also accumulate tax-free. Further, with an index fund, securities are only sold (the event that is taxed) when the index changes (which is not that often), and only then, a small amount is sold. The same can be said of real estate or almost any other equity investment.

Further, real estate, securities, and mutual funds held over a year are taxed at the much lower capital gains rate, while annuity income is taxed at the taxpayer's regular income tax rate, which is usually substantially higher.

Touting the Benefits of Avoiding Probate While Ignoring the Corresponding Detriments

While it is true that an annuity avoids probate (as each annuity has a designated beneficiary), your heirs will not have a stepped-up tax basis, as they would with most other investments.

A stepped-up tax basis occurs when you buy something, at say $50. As time goes by, that $50 investment grows to be worth $200. Your tax basis on the investment is $50, as that is what you paid for it. If you sold it, the investment would also have a $150 gain which is taxable.

With an annuity, your heirs would avoid probate, but their basis on the investment would be the same as yours - $50. When they sell the investment, they will be taxed (at their normal tax rate) on the $150 gain.

If that same investment was made in a normal investment in stock (or real estate, or almost anything else), upon your death the basis for tax purposes is increased to whatever the investment is worth at the time your heirs inherit the investment. In the case above, the tax basis would be increased to $200, and if your heirs sell upon receipt of the investment, they would owe no tax.

Touting the Guaranteed Death Benefit While Ignoring the Corresponding Detriments

Since annuities are issued by insurance companies, there must be some type of insurance involved. The insurance usually involved is what is called the “guaranteed death benefit.”

The guaranteed death benefit usually means that your heirs are guaranteed at least the amount you invested, minus any amount you withdrew, no matter how much the annuity may be worth. If the annuity is worth more than the guaranteed death benefit, your heirs would get that higher amount. Some annuities periodically adjust the death benefit upwards if the annuity is worth more on a certain date.

To make up the expenses of making such a guarantee, the annuity company will usually charge you 1.5% per year of the total value of the annuity.

It is important to note that the guaranteed death benefit is insurance that only covers losses in the account. Since the value of an annuity usually goes up in the long run (as does the value of the stock market), the losses are often minimal or non-existent. That means that you're paying for insurance that you are not likely to use.

Even if the market is down, you end up buying some of the most expensive insurance one can buy.

Not Emphasizing the Early-Withdrawal Penalties

In order to pay brokers those high commissions that were discussed earlier, annuity companies need to keep you locked in (and paying those management and mortality fees) for a long time. As such, many annuities have large penalties if you withdraw your money earlier than the contract term (usually 7-15 years). Those penalties are in addition to IRS penalties if you withdraw monies before you're 59 1/2 years old (usually 10% in addition to paying your regular tax rate on the monies withdrawn). So in an annuity, if you need your money for an emergency 10 months after you make the deposit, you may be hit with a 15% penalty from the annuity company plus a 10% penalty from the IRS.

Chances are - No. In almost all instances and investment goals, a different type of investment would have been a better choice than an annuity. Unless you fit into one of the three categories below, chances are that you would have benefited from an investment other than an annuity.

1. Someone with an unnecessary or high- fee cash-value life insurance policy who would like to get out but faces a large tax liability because the cash value of the policy is higher than the premiums paid. In that case, the investor can take advantage of the 1035 tax-free exchange to roll the cash value of the policy over into a variable annuity, carry over the cost basis and continue tax-deferred growth with the lower-fee investment options (compared to life insurance) that the annuity provides.


2. An investor who is not comfortable investing in the stock market without some type of guarantee should the market be down when the investor dies.


3. Some complex estate planning strategies that can only be accomplished with a variable annuity.

Unless you fit into one of the three categories discussed above, chances are that an annuity was not right for you.

When a variable annuity is sold, an investor may have a number of claims against the broker. First, depending on the individual’s financial situation, a variable annuity may have been a poor option for achieving his or her financial goals. Also, the investor may be able to bring a claim based on how the broker allocated funds among the sub-accounts. The allocations may not have been appropriate given the investor’s goals, or in light of how much risk the investor wants to take with the annuity. Finally, due to the complexity of variable annuities, it is critical for a broker to explain the material components and risks to an investor before the investor decides to pursue an annuity. Major financial institutions and media outlets like Forbes, The Wall Street Journal, and The New York Times have pointed out the problems that annuities may pose.

Proving liability in a variable annuity case first requires the plaintiff to show what a reasonably prudent broker would have done in a similar situation. Since investors lack the same understanding and knowledge of finance as a broker, the law places brokers in a fiduciary relationship with investors, which requires them to take a heightened level of care in advising clients on matters like variable annuities. After proving that the broker failed to meet this heightened fiduciary duty, the plaintiff must show what his or her account would have probably been worth had the investor not committed negligence or fraud. An investor may be entitled to compensation in an amount equal to the difference between what his or her account is actually worth after the negligence or fraud and what his or her account would have been worth had the broker not committed negligence or fraud.

If you have been the victim of broker fraud or similar misconduct, Los Angeles lawyer Steve A. Buchwalter can help. Experiencing an unexpected and avoidable financial loss as the result of a broker’s wrongdoing can be a stressful and devastating experience. We can make sure that your rights are asserted along every step of the way and that you pursue the compensation you deserve. We also serve people throughout Ventura, Orange, and Santa Barbara Counties, as well as other areas of Southern California. Call us or contact us online to set up a free consultation.

¹ The following would apply to variable and index annuities. It does NOT apply to immediate and fixed annuities.