Annuity risks   Regulators are shifting focus to insurance-products sales practices.

Variable annuities come up on regulators' radar

Todd Mason

During every poker game there's a fool at the table, experienced players like to say. And if you can't figure out who it is, guess what? It's you.Marie Nappi, 80, wasn't sure what variable annuities were, but she liked what she heard from the stockbroker sitting in her living room in West Philadelphia.

She and her husband, Michael, 82, had heard the broker, Joseph J. Osherow, on a local radio program, and then attended a seminar he gave at a local hotel. "He sounded so honest on the radio," Nappi said. "He said, 'I'll treat you like I treat my own father.' "

The timing, just as the three-year bear market began in 2000, could not have been worse. In filing for arbitration in October, the Nappis claimed losses of $172,000 on the variable annuities that Osherow sold them. Variable annuities, an insurance version of a stock mutual fund, fluctuate in value with the market.

The couple filed their arbitration claim against Osherow's former employer, First Union Securities Inc. The couple contend that Osherow counseled them to sell $800,000 in fixed annuities and $200,000 in U.S. Savings Bonds - money the Nappis had accumulated in 60 years of marriage, he working as a machinist and she as a seamstress.

Those investments would have held their value during the bear market, according to their arbitration claim, which also seeks $120,000 in lost interest income.

The brokerage firm, now named Wachovia Securities, declined to comment. Osherow's new employer, Morgan Stanley DW Inc., also declined to comment. Osherow, who no longer has a radio program, did not return telephone calls.

While the mutual-fund scandal has claimed center stage in recent months, some regulators are now shifting their sights to variable annuities. The NASD, formerly known as the National Association of Securities Dealers, last week proposed regulating annuity sales practices at the heightened levels reserved for such risky investments as options.

n a joint study with the Securities and Exchange Commission, the NASD cited abusive sales of annuities to elderly investors and to people who mortgaged their homes to make the investments. The NASD says both cases are dubious uses of annuities, which are investment contracts paired with life insurance benefits to gain tax advantages. Their earnings are not taxed until the money is withdrawn.

But annuities often must be held for decades to make their tax advantages worthwhile - time that elderly investors may not have. Meanwhile, people of modest means may not need tax shelters at all.

"This is an area where a lot more attention needs to be paid, by the firms and by investors," Mary L. Schapiro, the NASD's top enforcement officer, said in an interview.

Investors "need to understand the fee structure," she said. "They need to understand that their money may be tied up for a long time. They need to understand the tax consequences."

Tax cuts on capital gains and dividends have eroded the value of annuities, while increased contribution limits for retirement plans provide abundant tax-shelter opportunities.

Even so, variable annuity sales last year were $126.4 billion, up 9.9 percent from 2002, according to the National Association for Variable Annuities. As of March 31, variable annuity assets stood at $1 trillion.

Annuities are sold because they make money for brokers, said Roy T. Diliberto, a Philadelphia financial planner and former president of the national Financial Planning Association. "There are a lot of abuses out there," he said.

Debra G. Speyer, the Nappis' attorney, said brokers had an incentive to push annuities because they carried commissions of 7 percent. Sales commissions on popular mutual funds range from 3 percent to 5.75 percent.

The American Council of Life Insurers, an industry trade group, disputes the notion that annuity sales are subject to more sales abuse than mutual funds, stocks or bonds.

"The life insurance industry is mystified by the NASD's emphasis" on insurance products, said Carl Wilkerson, a council vice president.

Changing direction from a few years ago, insurers are selling annuities that guarantee minimum investment earnings, or distributions in retirement. Because these features control some of the risk for the investor, annuities cannot be compared with mutual funds, said Rick Carey, editor of the industry newsletter VARDS Report.

Still, the NASD wants annuity salespeople to make clear that investors are paying commissions indirectly and tying up their money as a result. Brokers collect from insurance companies, which recover the money through fees paid by investors. Investors who sell annuities too soon pay surrender charges.

Marie Nappi says she paid penalty charges on the fixed annuities they sold. She said Osherow brushed off the couple's concerns about the charges, saying their gains on the new investments would offset the penalties in a matter of months.

Churning, or replacing annuities needlessly, is a target of the NASD enforcement campaign. The regulator in January alleged that Waddell & Reed Financial Inc. made a wholesale switch of 6,700 annuities after the brokerage struck a deal with a different insurer, generating $37 million in commissions and subjecting clients to $10 million in surrender fees.

The Overland Park, Kan., investment company has said that the transfers complied with NASD regulations.

Suitability is another focus. The NASD would require brokerage executives to sign off on pending annuity sales, verifying that the investment is suitable for the investor, and not merely lucrative for the broker.

Annuity investors pay extra fees for the insurance benefit. Morningstar Inc. says the average annual fees for the variable annuities in its database is 47 percent higher than comparable mutual-fund charges.

T. Rowe Price Group, the Baltimore mutual-fund family, which also sells annuities, tells annuity investors that they will need 25 years of tax-deferred growth to overcome higher fees and the dividend and capital-gains tax breaks they give up.

Marie Nappi leaves her modest row home each morning to visit her husband in a nursing home. "It made him sick," Nappi said of the couple's financial loss. "We worked so hard."