Investigators Find Abuses In Annuities
By JOSEPH B. TREASTER
The New York Times
January 30, 2004
Opening a new chapter in the investigations of improper fund trading, federal and state regulators have found evidence of trading abuses that hurt investors in variable annuities, a popular product sold by the life insurance industry, several officials working on the investigations said yesterday.
The Securities and Exchange Commission, NASD and the New York attorney general are investigating trading in variable annuities that is suspected of having been done in ways that favored big investors, typically wealthy individuals or hedge funds, at the expense of small investors. Officials at the S.E.C. and the state attorney general's office said that they expected some companies to be charged with violations within weeks.
The regulators would not reveal the names of any of the insurance companies under investigation. Representatives of insurance industry trade groups said they were not aware of trading abuses in variable annuities. Some of the biggest sellers of variable annuities are the Hartford; Equitable Life, a unit of AXA; and MetLife.
Variable annuities, a tax-deferred combination of mutual funds and insurance, are marketed as retirement savings and are often bought by older Americans of modest means. Over the last decade, they have become the insurance industry's fastest-selling product, with investments totaling more than $900 billion at the end of 2003.
The officials said that they were investigating whether insurance companies and brokerage firms violated variable annuity contracts and fiduciary responsibilities to small investors by allowing market-timed trading similar to that found in the mutual fund industry.
"This is pitiful," said David Brown, the head of the investment protection bureau of the state attorney general's office, who has been overseeing the state's mutual funds investigations. "These are people in conservative investments, saving for retirement. But the insurance companies are letting these big investors trade in and out of the funds and that takes money away from the little guy. They're letting the wolves in to feed on the herd. It's just gross."
Industry executives said that companies had been providing information on variable annuity investments to regulators for several months but that they were unaware of improper trading practices.
"We don't know of any violations or to what extent violations have been found among our members," said Michael P. DeGeorge, general counsel of the National Association for Variable Annuities. "To date, there's been no finding of widespread abuse within the variable annuity industry."
Jack Dolan, a spokesman for the American Council of Life Insurers, said, "There's always been the possibility that people would attempt to misuse the variable product and if there is anything illegal under way we certainly would want it prosecuted."
These allegations come in the wake of extensive investigations into improper trading in the mutual fund industry that have resulted in hundreds of millions of dollars in fines and restitution. But many investment experts had believed that variable annuities were unlikely vehicles for market manipulation.
This latest investigation began last fall, and scores of insurance companies and brokerage firms around the country have been ordered to produce documents detailing transactions involving the insurance investments. One federal investigator said that "volumes and volumes of documents and information" have been pouring into regulators' offices.
In the most sweeping of the investigations, the S.E.C. has demanded e-mail messages and other documents on transactions and trading procedures from 40 insurance companies and brokerage firms that deal in variable annuities. These companies, one regulator said, account for 92 percent of the sales in variable annuities.
"We're actively investigating," said Lori A. Richards, the director of the S.E.C. office of compliance, inspections and investigations.
The most persistent abuse discovered so far, the investigators say, has been in market timing, as it was in many mutual fund cases. Here's what investigators say they believe has been happening in variable annuities:
Large investors, some by special agreement with the insurers and brokerage firms, bought and sold shares in variable annuities quickly, based on market-moving information, rather than holding investments for the long term, as intended. Such rapid trading is not illegal, but the majority of variable annuities discourage or formally limit the practice.
For large investors, this kind of trading could produce large profits in tax-deferred accounts. The incentive for insurers and brokers to permit frequent trading, the investigators say, was to attract and retain funds from big investors. The companies earn fees based on investor assets; as the assets grow, so does the companies' fee income.
But market timing also creates extra transaction costs that are borne by all investors in a fund. Perhaps even more significant, the big investors take profits that would otherwise be shared by all members of the fund as values increased over time.
Mr. Brown of the New York attorney general's office said the harm to small investors caused by frequent trading in variable annuities could be more devastating than the abuses in mutual funds.
"I think this is going to turn out to be worse for the little investors than the mutual fund problems," he said. "The reason is that the variable annuities' funds generally consist of smaller pools of money than do those of mutual funds. And profits from the large trades therefore have a proportionally larger impact on other investors in the pool."
Variable annuities involve investments in groups of funds, similar to mutual funds, and have an insurance component so that when an investor dies, heirs receive at least the amount of money invested. Variable annuities generally carry higher fees for investors than mutual funds, but money can be shifted from one fund to another and profits are not immediately taxed. The tax deferral aspect is similar to that of 401(k) plans and other individual retirement programs, but there are no restrictions on the size of annual investments.
Until recently, many variable annuities permitted almost unlimited movement of money among funds. Regulators say that in the last two or three years companies have increasingly imposed limits on trading. But investigators are looking into the possibility that some companies limited trading for most investors but made special arrangements with some large investors.
NASD, the regulatory arm of the brokerage industry, is investigating about a dozen insurance companies and brokerage firms. In New York, Attorney General Eliot Spitzer's office is also investigating at least a dozen insurance companies in New York and several other states. New York officials say they are closely coordinating their efforts with the S.E.C. investigation. Mr. Spitzer has jurisdiction to investigate out-of-state insurers that do business in New York.
James S. Shorris, an enforcement official at NASD, said that while investigators had "definitely found evidence" of improper trading in the insurance investments, they were uncertain of the full extent of the abuses. S.E.C. officials also said they were still assessing the scale. But one New York investigator said the improper trading appeared to be "very widespread."
While there had been recent reports about misdeeds in the variable annuities business, investigations had largely been confined to sales practices, not trading practices.
Yesterday, NASD announced that it had fined the Prudential Equity Group and Prudential Investment Management Services, units of Prudential Financial, $2 million and ordered the firms to pay their customers $9.5 million in restitution for repeatedly circumventing a New York state insurance regulation intended to prevent misrepresentations.