Lawsuits allege fraudulent annuity sales

April 20, 2004

Class action lawsuits filed against four companies that sold tax-deferred annuities allege that they misrepresented the way variable annuities (VAs) can fund IRAs, 401(k) plans, and other types of retirement programs. This violates consumer antifraud laws.

Nationwide Financial Services, American United Life Insurance, American Express Financial Corp., and SunAmerica Inc. were named in the lawsuits filed by class action specialists Milberg Weiss Bershad Hynes & Lerach of New York.

On May 12, 1999 a California judge sustained two of the nine charges in the SunAmerica complaint, which means the company will be sued for "false or misleading advertising" and "unlawful, unfair, or fraudulent business acts and practices." An amended complaint will be filed against American Express.

The lawsuits allege that the companies used deceptive methods to market and sell tax-deferred annuities to fund retirement plans, when in fact anyqualified retirement plan is tax-deferred. A qualified plan allows you to pay taxes on the amounts you receive at retirement rather than during the accumulation period. Thus, a tax-deferred variable annuity may not be an appropriate choice for these and other retirement accounts because policyholders are charged "exorbitant deferred annuity insurance fees" for a double deferral they cannot use, according to the lawsuits.

Many investors are attracted by the insurance feature of annuities, which include a lifetime payout option and a guaranteed death benefit. The complaints filed against these companies, however, say that 1), the purchase rates offered are usually not favorable to current market rates when you decide to retire and 2), the companies failed to disclose that proceeds of an annuity are subject to federal and state income taxes (unlike life insurance proceeds that are income-tax free).

Plaintiffs in the case say they would not have put an annuity into their retirement accounts had they known about the tax deferral and the high fees.

Selling tax-deferred annuites to retirement plans is fairly common. Nearly 55 percent of the sales of VAs were to such plans in 1997, according to the Life Insurance Marketing Research Association. Additionally, VAs are recognized by the IRS as legitimate funding vehicles for tax-qualified retirement plans.

Though the companies involved in the litigation will not comment, American United Life (AUL) "strongly denies any deception in the sale of annuities or other AUL products," and Nationwide adds, "We will defend ourselves vigorously."

Where do variable annuities belong?

A variable annuity is a fairly simple concept: It is a tax-deferred investment product wrapped in life insurance, so it guarantees that your capital is safe. VAs have "subacounts" that are invested in a variety of products, which can include mutual funds, stocks, bonds, certificates of deposit, and so on. Your investment grows tax-deferred, and there's no limit on how much you can put in.

But such products carry high fees and charges.

According to Morningstar, the average annual expense charged by a VA is 2.08 percent, not including loads and surrender charges, and gains are taxed as ordinary income (as high as 39.6 percent, depending upon your tax bracket when you begin receiving payments from your annuity).

The average mutual fund, on the other hand, charges about 1.3 percent and capital gains (the tax rate on capital gains was lowered to 20 percent in 1997) apply to the profits on a mutual fund. However, retirement mutual funds indexed exclusively to market rates could theoretically be wiped out by a market crash. While this is an unlikely but possible scenario, it makes the insurance features of VAs attractive to some.

Experts often recommend that you buy a variable annuity only after you have "maxed out" your IRA, 401(k), and so on.

The National Association for Variable Annuities (NAVA) stresses the importance of two key components of variable annuities: the guaranteed death benefit, which does not hinge on market trends, and the option for income payouts over your lifetime.

According to Mark J. Mackey, president and CEO of NAVA, "Only variable annuities offer a unique combination of benefits that most retirement-focused Americans want and need: lifetime income payments, beneficiary protection in the form of a death benefit, guaranteed insurance fees, and investment options and strategies that help protect against the eroding effects of inflation. The cost of these benefits is a small price to pay for the protection that is provided."

There are potentially hundreds of thousands of people who could be affected by this class action lawsuit that seeks to change the way tax-deferred annuities are sold. And with VA sales approaching a whopping $100 billion last year, clearly there's a lot at stake here.

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