The Defensive Sale

What happens if you make an unsuitable variable-annuity sale, or simply fail to dot all your i's and cross all your t's in implementing the sale? That depends, of course. But Jane Riley, compliance officer for The Leaders Group, a broker/dealer in Littleton, Colo., offers a case study:

In 2003, an elderly man in his 60s — a client of The Leaders Group — rolled his 401(k) money into a VA. He and his wife were happy with the investment at that time. The rep filled out a suitability form, but the clients only dealt with the rep via phone and mail. They never returned the delivery receipt. Now the clients want out of the contract since the value has dropped, and they are claiming they didn't understand the VA features and restrictions.

Set aside for a moment the question of whether the rep adequately explained the investment to the couple, or whether they actually understood the product. What's the best-case scenario in this dispute? The clients will get out of the contract with 100 percent of their contributions, plus statutory interest, and the rep will be charged back the amount of the commissions paid, says Riley. Worst case — the rep may be penalized in arbitration or another venue, she says.

The good news is that changes are afoot in the VA-sales universe, and industry compliance officials and attorneys say these changes will not only protect clients from unsuitable VA sales, but protect reps in potential arbitration proceedings and errors-and-omissions (E&O) claims. A few months ago the NASD published its final version of Proposed Rule 2821 — Suitability and Supervision in the Sale of Variable Annuities. The proposed rule would require reps to thoroughly document efforts to determine that the investment was, in fact, suitable for the client, would require a registered principal to review all VA sales within two days after they were sent to the insurance company and would require all clients purchasing variable annuities to sign paperwork (the Annuity Disclosure Form), indicating they fully understand the investment and agree that it meets their objectives. The proposed rule would also require that reps receive specific training in variable-annuity products. (See table for more specifics on the contents of the rule.)

While regulators have not adopted the rule yet, b/d firms — and particularly their legal and compliance departments — already consider it to be “the law of the land.” That's because they're pretty sure that Rule 2821 will be adopted in the first quarter of 2007. So they've been getting ahead of regulators and implementing parts of that rule voluntarily.

For instance, Jason Roll, a rep with MassMutual in Denver, says he has been following the precepts of Rule 2821 for months. “My b/d put the provisions of Rule 2821 in place about a year ago,” he says. It took some time to adjust to doing the extra paperwork, but now he'll be ready when the rule is finally implemented, he says.

The New Law of the Land

The main driver behind the NASD's rule proposal are the numerous complaints and claims from clients and their families that variable annuities were misrepresented and improperly sold to them by reps. Over the years, the insurance companies and b/d compliance departments have taken steps to reduce this problem, but they have been reluctant to force clients to take accountability for their purchases, fearing that it would scare clients away. This allowed less-than-scrupulous reps to sell VAs to the wrong people for the wrong reasons. The reps were looking for the commission pop — commissions on VAs are often as high as 5 percent — and the clients thought they were buying CDs on steroids. By holding clients at least somewhat accountable, requiring the reps to do more work and get more training, and giving the b/d more encouragement to scrutinize the sales, the regulators hope that abusive sales will decline.

The insurance companies and b/ds loudly contested the rule when it was first published in July 2005 — close to 97 percent of those offering comment letters on the proposal were opposed to the initiative. But they have come around to the new rule because many of their concerns were addressed in amendments to the original, insurance experts and compliance officers say. Initially, the rule required extensive point-of-sale disclosure about the features of variable annuities, as well as a general product comparison between VAs and other investments to determine that the VA was the most suitable investment out there. It also required that in his review of the sale, the registered principal consider very specific age, net-worth and VA-purchase history guidelines. Each of these elements has been dropped.

In fact, Judith Hasenauer, an attorney and partner in the law firm of Blazzard Grodd & Hasenauer in Pompano Beach, Fla., and Riley of The Leaders Group, see the rule — and particularly the client-signed document — as a potential boon for reps who sell variable annuities ethically. Having a piece of paper that shows the client knew he was purchasing the VA for X, Y and Z reasons, and that he understood the unique benefits and limitations of a VA, can head off many future problems and claims from individuals who sour on the investments even though they were suitable, they say.

Stephen Lovell, a member of the National Member Relations Committee of the Financial Planning Association and principal with Forsythe Heritage in Walnut Creek, Calif., agrees and says he doesn't expect any resistance from clients. “When your client already trusts you and you disclose the required information about commissions, surrender charges and so forth, and then ask them to sign something, 90 percent of them ‘just do it.’”

A legal department representative from Financial Advisors' (FA) Legal in Las Vegas, who preferred not to be named, believes that getting the client to sign off on the specifics of the VA sale could even help advisors weed out bad clients. He's a big believer in taking control of the client-rep relationship — insisting on full disclosure of assets, goals and concerns, and requiring the client to sign documents indicating he understands whatever product he's selling and its suitability, and that he accepts the sale. As he put it, “If a client won't provide full disclosure and sign forms indicating agreement with the product choices, suitability, costs and other details, this is not a client you should keep. Fire clients who are ‘non-compliant.’”

Rule 2821 requires pretty extensive analysis of the financial options when you are considering recommending a replacement for the annuity — not usually the case in the past. This additional set of disclosure and suitability requirements might seem time-consuming, but the results could surprise reps. As the surrender-charge period ends on an existing VA, replacement with a newer product may be in your client's best interests, and without the requirements of the rule, that's something you might never know.

Sometimes replacing the annuity with another annuity is even worth it, says Lovell. A “new surrender period can be more than compensated by [improved] product guarantees if the client has a long-term goal,” he says. Riley agrees. Indeed, the products have changed significantly over the past few years, offering improved features and guarantees. “We've seen dramatic reductions in the duration of the surrender-charge period — dropping from an average of seven years to about three years. And the product guarantees are so much better with newer VAs,” says Riley. These reduced surrender-charge periods, combined with overall better products, means “replacement of one VA with another is not an unreasonable consideration in some situations.”

Ultimately, the biggest burden is going to fall on the rep who is not selling honestly and ethically, because he will have a reduced cadre of clients to sell the products to. The proposed rule adds an additional layer or two of paperwork to the already heavy load. But that additional paperwork burden is actually not that onerous say some compliance officers and reps. Reps will have to print out a couple of extra forms before the client meeting, provide full disclosure (takes another 10 minutes at the meeting and earns client trust) and add the signed papers to the stack that they are already required to complete — not that big of a deal.