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Market timers target annuities

Lawsuits hamper insurer efforts to stop short-term trading

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By Sara Hansard

July 1, 2002 6:01 am ET

Market timers increasingly are targeting insurance companies that offer variable annuities, and they're suing in some cases when insurers try to stop them.

The attraction is understandable: Investors can sell funds in variable-annuity subaccounts, then reinvest them in other subaccounts without paying capital gains taxes.

Income taxes are due on profits only when annuities are redeemed at retirement.

Because market timers move large amounts of money quickly into and out of funds to capture profits, they can wreak havoc on a fund's investment strategies, say representatives of the mutual fund and variable-annuity industries.

Portfolio managers may have to keep higher amounts of cash for higher levels of redemptions, or they may have to sell shares to cover the redemptions, which leads to higher transaction costs.

Striking back

Three lawsuits have been filed over the past year against insurers that took steps to stop investors from market timing. The only previous lawsuit in the industry over market timing was filed in 1993, so last year's actions have drawn the attention of the industry and federal regulators.

The Securities and Exchange Commission supports industry efforts to stop market timing in mutual funds and annuity subaccounts.

"We are sympathetic to funds that try to discourage market timers from using their funds as short-term trading vehicles," Paul Roye, director of the SEC's division of investment management, said last week at a conference of Reston, Va.'s National Association for Variable Annuities.

At the Washington conference, Mr. Roye said several funds that sell to insurers have begun imposing redemption fees for short-term trading, and he expects to see similar proposals for funds in variable annuities.

Janus Capital Management LLC in Denver began selling a new class of funds in May for its Aspen series, which specializes in international investing.

Because arbitrageurs often try to profit from differences between U.S. prices and prices in other markets, Janus imposes a 1% redemption fee on the new class if shares are sold within 60 days of purchase.

"We have been, for the last couple of years, watching the amount of money that's being timed increase, especially lately with the volatility [in the market]," says Dave Agostine, managing director of Janus' institutional services division.

He says Janus has seen trading in new accounts drop by about 95% since it added the redemption fee.

Sarah Friedell, a spokeswoman for Fidelity Investments in Boston, says that last year Fidelity Investments Life Insurance Co. also instituted a 1% redemption fee for trades within 60 days in seven funds in volatile sectors.

On the legal front, the U.S. District Court in Manhattan last fall dismissed a suit brought against The Equitable Life Assurance Society of the United States in New York, by First Lincoln Holdings Inc., a private investment group in Wilmington, Del.

First Lincoln had invested $10 million in an Equitable annuity, based on an oral agreement that it could actively trade on the account, according to court documents.

But the court ruled in Equitable's favor, since the insurer disclosed in its prospectus that the annuity was not designed for market timing and warned that it may restrict transfers.

The second case involving Equitable was filed by American National Bank and Trust Co. of Chicago, as trustee for Emerald Investments LP of North Brook, Ill.

The case - brought against AXA Client Solutions, a unit of Equitable parent AXA Financial Inc. of New York - is being tried in the U.S. District Court in Chicago.

AXA has since been dismissed as a defendant, leaving only Equitable on the hook.

The Chicago court already has held that AXA failed to disclose to Emerald that it had policies against market timing, which it enforced after Emerald began trading on the accounts.

The court, however, also said that agreements Emerald had made to trade actively on some of the accounts weren't covered by contracts on other accounts.

In yet another case, the Prudential Insurance Company of America in Newark, N.J., last November also won dismissal of a suit.

The case was filed in the U.S. District Court in Philadelphia by Paul Prusky, president and owner of two investment advisory businesses in Ardmore, Pa.: Windsor Securities Inc. and MFI Associates Ltd.

The businesses had invested $50 million in a Prudential annuity. Mr. Prusky had negotiated the contract to state specifically that daily transfers would be allowed.

Mr. Prusky relied on a 4: 15 p.m. daily transfer time for exchanges, and Prudential later pushed back the exchange time to 4 p.m.

Although insurance companies mostly have won recent cases, they fear that additional suits could follow.

For their part, market timers defend their investing style.

"This notion of holding on to any investment in today's environment is foolish," says Martin Oliner, a New York lawyer who is chairman, president and chief executive officer of First Lincoln Holdings.

"People at Enron didn't think you should sell their shares either," he adds. "The bigger question here is, if you're given an assurance by the insurance company of certain tenets, can the insurance company then go ahead and change their mind?"

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