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January 14, 2004
NASD
FOR RELEASE:
CONTACTS:Wednesday, January 14, 2004
Nancy A. Condon 202-728-8379
Michael Shokouhi 202-728-8304
NASD Charges Waddell & Reed with Suitability Violations Relating to Thousands of Variable Annuity Exchanges and Seeks Customer Compensation; Two Senior Execs Also Charged
Washington, DC — NASD today filed a complaint charging Waddell & Reed, Inc. of Overland Park, Kansas, for recommending 6,700 variable annuity exchanges to its customers without determining the suitability of the transactions. These exchanges, known as "switching," generated $37 million in commissions and cost Waddell's customers nearly $10 million in surrender fees. NASD also alleged that according to its quantitative analysis, at least 1,400 of the firm's customers were likely to lose money by making these switches. Charges were also brought against the firm's former President, Robert Hechler, and its National Sales Manager, Robert Williams. In addition to other sanctions, NASD is seeking an order requiring the firm to disgorge commissions and compensate customers.
"Today's action should make crystal clear that brokers may not recommend that clients replace their variable annuity contracts when the broker has no reasonable basis for believing the replacement is in the client's, not the broker's, best interest," said Mary L. Schapiro, NASD Vice Chairman and President of Regulatory Policy and Oversight. "Engaging in a campaign to make such recommendations without an assessment of the suitability of the exchange, simply because it will advance the firm's own commercial interests, is completely unacceptable."
According to the complaint, between January 2001 and August 2002, Waddell engaged in an aggressive campaign to switch the variable annuity contracts of its customers from those issued by one insurance company, United Investors Life Insurance Co. (UILIC), to very similar annuities provided by another insurance company, Nationwide Insurance Co. In doing so, Waddell & Reed failed to take adequate steps to determine whether there were reasonable grounds for the customers to enter into these exchanges, such as determining whether the customers were likely to benefit or lose money from the exchanges, and failed to establish sufficient guidance for the sales force to use in determining the suitability of the exchanges. In fact, many customers were likely to lose money through these switches, which typically would raise concerns about the suitability of these transactions.
In addition, over 700 customers were switched into one Nationwide annuity, rather than another Nationwide annuity that was less expensive and offered far more benefits and greater flexibility to the clients, but provided a lower payout to Waddell's sales force. One of the firm's advisors, in comparing the payouts, noted, "I have no problem selling an annuity that may cost .45 (basis points) more on M&E charges because I have to support my family and pay my assistant and other business overhead."
The misconduct began after Waddell failed to obtain an agreement to receive a share of certain fees collected by UILIC, the original issuer of annuities sold by Waddell. Waddell found another issuer, Nationwide, which agreed to share with Waddell, some of the fees it collected from Waddell's customers. From the customer's perspective, the underlying investment options available in Nationwide's annuities were otherwise virtually identical to the UILIC contracts.
Beginning in late January 2001, following the agreement with Nationwide, Hechler and others engaged in an aggressive campaign to encourage Waddell's sales force to replace UILIC annuities previously sold with those offered by Nationwide. Among other things, Hechler issued a series of memoranda to the sales force repeatedly encouraging them to replace existing UILIC variable annuities with Nationwide variable annuities by questioning UILIC's intentions to provide service to Waddell's clients, and compensation to the sales force, along with questioning UILIC's financial strength.
In response to the pressure from senior management, some Waddell regional vice presidents took steps to encourage exchanges. One vice president sent an e-mail to his division managers on March 6, 2001, encouraging a "campaign of every advisor contacting every UILIC client" to explain what was happening with the UILIC relationship, and later set up a "Call-a-Thon" for advisors in his region to call all of their customers with UILIC variable annuities. During this campaign some Waddell advisors expressed concern that these switches were not in the best interests of their clients. One advisor even noted that management's comments were intended to "prod and scare" advisors into making switches.
Although the president of UILIC assured Hechler on March 14, 2001, that UILIC would continue to provide compensation to Waddell's advisors and provide service to both policyholders and advisors, Hechler did not relay this information to Waddell's sales force for almost two months, during which the switching campaign continued unabated. During that time, Hechler's actions led to a dramatic increase in the number of switches from UILIC to Nationwide variable annuities.
During March 2001, the number of switches from UILIC contracts to Nationwide contracts jumped 540 percent over the previous month, and the number jumped another 490 percent in April 2001. By August 2002, Waddell had replaced 6,772 UILIC variable annuities, moving approximately $617 million in assets away from UILIC, costing customers more than $9.8 million in surrender charges, and generating approximately $37 million in commissions to Waddell. Additionally, Waddell earned approximately $700,000 from fee-sharing arrangements with Nationwide in 2001, and Waddell will continue to accrue such fees annually.
These exchanges of variable annuities were costly to customers in a number of ways. Many customers had to pay surrender charges to switch out of their old policies, and all customers who switched incurred a new surrender charge period that limited their ability to surrender their new annuity contracts. In addition, customers who switched into the Nationwide variable annuities paid higher ongoing expense fees than they had been charged under the old policies. Waddell, on the other hand, made money through the commissions charged on each exchange and through the portion of the annual fees paid by customers that Nationwide shared with Waddell.
Despite repeated requests from its the sales force and their supervisors, Waddell failed to provide adequate guidance, analytical tools or criteria for making the critical suitability analysis required under NASD rules for recommending exchanges. As a result, many variable annuity exchanges were recommended by the sales force without having reasonable grounds for believing that the recommendations were suitable for the customers based on their security holdings and their financial situations and needs. In addition, based on NASD's quantitative analysis, in over 1,400 instances, at the recommendation of Waddell, customers entered into exchanges that were likely to result in customers losing money.
Williams, Waddell's National Sales Manager, who actively participated in the switching campaign and had supervisory authority over the sales force and its management, had responsibility for ensuring that transactions are appropriately reviewed for suitability. He was aware, through communication with the sales force, that there were serious shortcomings with Waddell's process for reviewing the suitability of switches from UILIC to Nationwide variable annuities, and that members of the sales force felt pressure to make switches from the firm and Hechler.
NASD has charged the firm with suitability and supervisory violations, Hechler with causing the firm's suitability violations by encouraging the sales force to switch customers and Williams with supervisory failures in connection with the variable annuity exchanges.
Under NASD rules, the individuals and the firms named in the complaint can file a response and request a hearing before an NASD disciplinary panel. Possible sanctions include a fine, suspension, bar, or expulsion from the NASD.
Information regarding variable annuities can be found in the following NASD Investor Alerts:
- Variable Annuities: Beyond the Hard Sell.
- Should You Exchange Your Life Insurance Policy?
- Should You Exchange Your Variable Annuity?
Investors can obtain more information and the disciplinary record of any NASD-registered broker or brokerage firm by calling NASD's BrokerCheck. NASD makes available BrokerCheck at no charge to the public. In 2003, members of the public used this service to conduct more than 2.9 million searches for existing brokers or firms and requested almost 180,000 reports in cases where disclosable information existed on a broker or firm. Investors can link directly to the program by going online to www.nasdbrokercheck.com. Investors can also continue to access this service by calling 1-800-289-9999.
NASD is the leading private-sector provider of financial regulatory services, dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services. NASD touches virtually every aspect of the securities business - from registering and educating all industry participants, to examining securities firms, enforcing both NASD rules and the federal securities laws, and administering the largest dispute resolution forum for investors and member firms. For more information, please visit our Web Site at www.nasd.com.
©2006 NASD. All rights reserved. | Legal Notices and Privacy Policy. -
National Association of Securities Dealers (NASD)
Updated March 2, 2006
If you have a life insurance or annuity contract, you may have been approached to exchange it for a new model, one with better or the latest features. You need to know that even though tax law makes the exchange income tax free and the new contract may sound better for you, you may be losing – not gaining – if you make the exchange.
NASD is issuing this Alert because we have found investor confusion about variable annuity exchanges, and we have brought cases where investors were investing in variable annuities that were not suitable for them.
This Alert will give you information on how to determine if an exchange is right for you, and how you can find out what you need to know to make a smarter decision.
Some Background
You may know that an annuity is a contract between you and an insurance company where the company promises to make periodic payments to you, starting immediately or at some future time. You buy the annuity either with a single payment or a series of payments.
You should also know that annuity contracts come in three flavors: fixed, variable and equity-indexed. Fixed means that the earnings and payout are guaranteed by the insurance company. Variable means that the amount that will accumulate and be paid will vary with the stock, bond, and money market funds that you chose as investment options. Unlike fixed contracts, variable annuities are securities registered with the Securities and Exchange Commission (SEC). Sales of variable insurance products are regulated by the SEC and NASD. Equity-indexed annuities (EIAs) have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity.
Variable annuities may impose a variety of fees when you invest in them, such as: surrender charges, which you owe if you withdraw money from the annuity before a specified period; mortality and expense risk charges, which the insurance company charges for the insurance risk it takes under the contract; administrative fees, for record keeping and other administrative expenses; underlying fund expenses, relating to the investment options; and charges for special features, such as a stepped-up death benefit or a guaranteed minimum income benefit.
The Internal Revenue Service allows you to exchange an insurance contract that you own for a new life insurance or annuity contract without paying tax on the income and the investment gains earned on the original contract. This can be a substantial benefit. Because this is governed by Section 1035 of the Internal Revenue Code, these are called "1035 Exchanges."*
But this benefit comes with some important strings.
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The tax code says that the old insurance contract must be exchanged for a new contract – you cannot receive a check and apply the proceeds to the purchase of a new insurance or annuity contract.
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The tax code also says you can make a tax-free exchange from: 1) a life insurance contract to another life insurance contract or an annuity contract or 2) from one annuity contract to another annuity contract. You cannot, however, exchange an annuity contract for a life insurance contract.
Why Make a Section 1035 Exchange?
There are various reasons why a variable annuity contract holder may want to exchange an existing variable annuity contract.
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Many annuity contracts now offer premium – sometimes called bonus – credits toward the value of your contract, of a specified percentage ranging from 1-5% for each purchase payment you make.
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Also, in recent years, there have been new developments in annuity features, especially in variable annuities, that are valid reasons to consider an exchange. The number of investment options has increased. Less expensive variable annuity contracts have been created. Death and living benefits have been enhanced. Also, with the growth in the stock market in the 1990s, many insurance contract holders have wanted to take part in that growth. These are all valid reasons for considering exchanging one insurance contract for another.
Why Not Make a Section 1035 Exchange?
Generally, the exchange or replacement of insurance or annuity contracts is not a good idea, for a variety of reasons.
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"Bonus" or "premium" payments made to you are usually offset by the insurance company’s adding other charges it makes to you.
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Other contract provisions, like surrender charges, eventually expire with an existing contract. However, new charges may be imposed with a new contract or may increase the period of time for which the surrender charge applies.
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You may also have to pay higher charges, such as annual fees for the new contract.
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You may not need the costly new features of the new contract.
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In many instances your broker is getting paid a higher commission for a variable annuity than he or she would for the sale of another securities product, such as a stock, bond, or mutual fund.
What You Should Watch For
You should exchange your annuity only when you determine, after knowing all the facts, that it is better for you and not just better for the person who is trying to sell the new contract to you.
Much of the sales growth of variable annuities in recent years has been from Section 1035 Exchanges. Even though some variable annuity enhancements have made variable annuities more attractive, you need to be sure that the exchange meets your objectives and benefits you. Variable annuities are long-term, retirement-oriented investment vehicles, and exchanging them may not benefit you.
Caution! Variable annuity sales have dropped along with the decline in the equity marketplace. A recommendation for the exchange of an existing annuity contract for a new annuity contract may be the only way a salesperson can generate additional business. However, the new variable annuity contract may have a lower contract value and a smaller death benefit. As in any circumstances, you should exchange your annuity only when it is better for you and not just better for the person trying to sell you a new annuity.
Brokers or insurance agents recommending the exchange of an annuity contract must tell you important facts about the pros and cons of the exchange. Your broker or insurance agent is permitted to recommend such an exchange to you only if it is in your best interest and only after evaluating your personal and financial situation and needs, tolerance for risk, and the financial ability to pay for the proposed contract. This "suitability" obligation is based on NASD rules.
Many states and brokerage firms require forms to reflect customer acknowledgment of a replacement transaction. These forms are to be signed by the annuity contract owner and the salesperson. These forms may provide a comparison of the features and costs of an existing contract to a proposed contract, and point out what you need to focus on when considering the exchange. You should review these forms closely.
Regardless of whether such forms are provided to you, you should specifically ask the person recommending that you exchange your variable annuity:
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What is the total cost to me of this exchange?
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What does the change in the surrender period or other terms mean for me?
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What are the new features being offered? Why do I need or want those features?
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Are those features worth the increased cost?
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Will you be paid a commission for the exchange, and if so, how much is it?
You should not sign any exchange form or agree to exchange or purchase an annuity until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current contract.
What Regulators Do to Protect You
NASD and the SEC have been conducting a series of special sales practice examinations that have focused on the sales of variable contracts – variable annuities and variable life insurance.
These examinations have resulted in a number of cases that have found that some brokers and insurance agents recommended unsuitable variable products for their customers, and that the firms employing those brokers and insurance agents did not supervise them properly to prevent those unsuitable recommendations.
In addition, NASD’s examinations of its members selling variable contracts routinely investigate for inappropriate sales of variable contracts, including unsuitable variable contract exchanges or replacements.
Remember, however, that no matter how much regulators try to protect you, you are your own best protection by knowing what to avoid in the first place.
If You Have Questions or Complaints
If you have questions or complaints about an annuity contract exchange, you can contact NASD, the SEC, your state securities administrator, and your state insurance commissioner.
Reference Material
For additional information about variable annuity contracts, go to:
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NASD Regulatory & Compliance Alert, Summer 2000, "Advertising Of Bonus Credit Variable Annuities"
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NASD Investor Alert - Variable Annuities: Beyond the Hard Sell
To receive the latest Investor Alerts and other important investor information sign up for Investor News.
* The insurance industry uses the term "replacement" for a transaction in which a new insurance or annuity contract is to be purchased from the proceeds of an existing life insurance or annuity contract. A Section 1035 Exchange is a type of replacement transaction. Although the term "1035 Exchange" is often used to describe any form of replacement activity, especially regarding variable annuity replacement activity, technically not all replacements are Section 1035 Exchanges and as a consequence are not tax-free.
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