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Fixed annuity sales receiving added scrutiny from Finra

May 2, 2014 @ 11:33 am

By Bruce Kelly and Darla Mercado

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With broker-dealers selling a bigger share of indexed annuities, securities regulators are taking a closer look at policies and procedures around clients exchanging or giving up variable annuities in order to put those assets into products such as equity indexed annuities.

Broker-dealers are becoming more of a force in the world of indexed annuities, accounting for 11.4% of fixed annuity market share in 2013, up from 8.9% in 2012. Most of that growth is attributable to sales activity at large regional firms, according to Beacon Research.

Broker-dealers are leaning toward fixed annuities because of the product's living benefits, which insurance companies that issue variable annuities have been dropping.

During recent exams, the Financial Industry Regulatory Authority Inc. has put under its microscope some firms' policies and procedures related to exchanges into fixed annuities from variable annuities, according to two broker-dealer executives who asked not to be named. Such variable annuity exchanges are known as “1035 Exchanges” because they fall under section 1035 of the Internal Revenue Code.

“The 1035 exchange, overall, is something we're looking at,” acknowledged Susan Axelrod, executive vice president, regulatory operations with Finra. It's incumbent on broker-dealers to have the procedures and controls in place when such an exchange is recommended because it involves the sale of a security, she said.

“It is an important area to focus on,” she added. “We've seen some deficiencies in this area. Not all firms have stepped up on this to insure that procedures and controls are reasonable.”

The indexed annuity business is booming, with sales reaching $38.6 billion last year, up 13.2% from $34.1 billion in 2012, according to Wink Inc.

At LPL Financial, the largest independent broker-dealer with 13,600 affiliated reps and advisers, sales of fixed annuities, including indexed annuities, surged in the first quarter. LPL's commission revenue from the sale of fixed annuities reached $46.7 million over the first three months of the year, a 70.8% increase over the same period in 2013, according to the company's quarterly report. Sales of variable annuities at the firm, meanwhile, decreased slightly in the quarter 2.1%, down to $198.2 million.

LPL's “increase in fixed annuities is attributed primarily to increased sales of indexed annuities as well as a new three-year fixed annuity product that was introduced beginning in the fourth quarter of 2013, offering clients of advisers an attractive interest rate at a time when interest rates are expected to be relatively flat,” the company said in a filing with the Securities and Exchange Commission Monday.

Ms. Axelrod pointed out several red flags for the regulator to 1035 exchanges, including increased costs to clients and proper disclosure of fees.

“When you compare the exchanges, is there an increased cost to customer,” she asked. Another question is whether the adviser failed to disclose any surrender fees assessed when exchanging the variable annuity.

Finra will also take notice if the reason for a 1035 exchange is not correct, she said. For example, if a rep told a client that fees would be lower in the new product but are actually higher.

And Finra also looks at “the overall quality of documentation and cost benefit analysis,” she said.

Variable annuities are often a staple of senior investors' portfolios, and that fact makes the product stand out to Finra, Ms. Axelrod said.

She did not say whether Finra was looking specifically at variable annuity exchanges into equity indexed annuities.

Registered reps switching and replacing clients' variable annuities is a perennial compliance issue that broker-dealers face. The question for the rep and the firm is to spell out the benefit or advantage of the new product when compared to the old variable annuity.

Equity-indexed annuities — EIAs — have characteristics of both fixed and variable annuities, according to a 2006 Finra “investor alert.” Their return varies more than a fixed annuity, but not as much as a variable annuity. So, while EIAs give investors more risk but potentially more return than a fixed annuity, they also carry less risk and less potential return than a variable annuity.

Variable annuities are securities registered with the Securities and Exchange Commission. Fixed annuity contracts are not registered.

Finra's additional scrutiny of variable annuity 1035 exchanges into indexed annuities isn't necessarily leading to closer examination of transactions at major indexed annuity manufacturers. For instance, Allianz Life Insurance Co. of North America, the largest seller of indexed annuities, doesn't have any new information gathering efforts underway, according to Sara Thurin Rollin, a company spokeswoman.

Finra's Notice-to-Members 05-50, an August 2005 memo reminding broker-dealers of their supervisory duties with respect to indexed annuities, was intended to push firms to adopt procedures to oversee that business.

For instance, Securities America Inc. began using a purchase acknowledgement form for indexed annuities, noted Zachary Parker, first vice president of income distribution and product strategy. That form is designed to outline the rationale for product transfers and is part of the supervisory review process. “If it's a 1035 exchange, we look at it very closely,” he said. “We have our eyes on it, and I know the carrier looks at it.”

Nevertheless, procedures on overseeing indexed annuity business can vary from one firm to another.

“There are some smaller firms that don't require that indexed annuity business goes through a place where they can see it,” Mr. Parker said.

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