Picture this: An older woman with a limited investment horizon her nest egg in a diversified portfolio, but at his advisor's urging, he agrees to move everything into a variable annuity with whopping upfront fees and penalties for early withdrawal.

If it sounds far-fetched, Chris Biggs says it's anything but.

Biggs, securities commissioner for the state of Kansas, recently encountered this specific scenario, and he regularly hears others like it. In fact, fully one-third of the complaints to Biggs' compliance office related to inappropriate sales of variable annuities. The vast majority of these cases involve brokers working on commission, he says.

Meanwhile, the SEC saw annuity-related complaints rise 43 percent in 2002. True, the absolute number of complaints (686) was small, but this is only because few consumers know the SEC accepts annuity complaints, says Susan Wyderko, the SEC's director of consumer education.

Wyderko views annuities-sales misdeeds as a growing national problem, and she warns that broker/dealers who fail to educate their customers about the products are gambling with their reputations.

The Next Big Thing?

In light of all the other troubles plaguing the securities industry — the research scandals, the mutual fund breakpoints and illegal trading issues, the rising tide of unsuitability claims — this latest development may feel like a piling on, an opportunistic me-too, if you will. After all, a broker might fairly ask, where were all these complaints when things were going well in the markets?

Biggs says the answer is obvious: The complaints were few then because most investors had no reason to scrutinize their investments. Only when returns soured did people take a hard took, and many “were disappointed to find they lost a lot of money when they thought they were guaranteed investments.”

Timing concerns aside, it appears as though the industry is on the cusp of yet another working over from regulators. Some evidence of this fact:

  • Earlier this year, the NASD fined American Express Advisors and Edward Jones for unsuitable sales.

  • Some state regulators, like Biggs, are moving to shore up the state annuities sales regulations.

  • In September, the National Association of Insurance Commissioners adopted new guidelines related to suitability of variable annuities to older investors.

The NAIC has been particularly busy with its proposed annuity rules. After talking with its member companies for the better part of the year, the association adopted new regulations in September aimed at ensuring ethical sales of annuities products. The new rule says that those who sell annuities “must have reasonable grounds for believing the recommendation is suitable for the senior consumer on the basis of the facts disclosed by the senior consumer as to his or her investments.”

The regulation requires “reasonable efforts” to obtain relevant information. Should the consumer refuse to provide such information, recommendations “will be considered reasonable under the circumstances actually known to the insurer or producer at the time of the recommendation.”

Between the Cracks

The insurance industry has long held that variable annuities are foremost an insurance product and therefore should be properly regulated by insurance commissioners. But because there are underlying investments, securities regulators also have a hand in regulation. The upshot, critics say, is that some problems have fallen between the two regulatory groups — especially at the state level.

In Kansas, Biggs is pressing the legislature for changes that would give him jurisdiction over annuity sales. He argues his department already regulates more than nine out of 10 brokers selling annuities, and therefore the change wouldn't add a layer of regulation as industry lobbyists have maintained.

Biggs thinks there are many reasons that annuities are being sold inappropriately. But he suggests the biggest is simply that brokers working on commission are attracted to the best payouts available. He says it is human nature to want to be paid well, and with annuities commissions ranging from 6 to 8 percent (compared to 2 to 6 percent on mutual funds), it's not hard to see why brokers are attracted to them. (The fact that breakpoints don't come into play, as they do with mutual funds, means annuities are all the more appealing to brokers.)

Mark Gelbach, principal with True North Advisors in Dallas, thinks the commission issue is important. Those working on commission are rewarded immediately for the sale of most variable annuities, but then have no financial incentive to do further advising or work with the client.

Commissions don't influence Gelbach's recommendations since his is a fee-only business. And while he thinks variable annuities can be a good investment in a very limited set of circumstances, he's not overly keen on them.

“I usually have a jaundiced eye when it comes to annuities because they are expensive,” he explained.

They also are very technical investments, which makes it hard to explain their pluses and minuses to clients, he says. He estimates that to educate a client adequately takes at least 30 minutes. “We educate them ad nauseum,” he said. Even then, clients don't fully understand because they latch onto phrases like “guaranteed” and “death benefits” while other features may not fully register. “They hear what they want to hear,” Gelbach says.

To wit, the SEC's Wyderko says he knows some who have bought annuities without understanding they have to die before qualifying for a death benefit.

While some may intuitively understand a death benefit, the range of product options and the fine print make annuities a complicated beast for the average customer. In fact, annuities can be so Byzantine that even the seemingly well versed admit to some difficulty.

“As a professional I appreciate the complexity of annuities, and I find them hard to thoroughly explain myself,” said Sally Balch Hurme, AARP interim director of consumer protection. Hurme, who advocates for seniors, said anecdotally the AARP has heard more complaints about the products of late.

The AARP sends its members information on annuities and works with other organizations to help make the complex simple. The SEC is one partner, said Wyderko. It offers information on variable annuities that is not copyrighted, so that any organization can pick up the simplified language and make the document their own. In fact, there have lately been some large brokerages ordering brochures in bulk from the government's Pueblo, Colo., facility.

Wyderko said brokers must do their best to educate consumers not only about the upsides of variable annuities but also the downsides. “I think more needs to be done to education prospective purchasers prior to the purchase,” she says.

Those who fail to do so are leaving themselves exposed to what might prove to be the next big wave of regulatory wrath.