By DAVID MOON, Moon Capital Management
Speaking at a recent Securities Industry Association conference in New York,
an official with the office of New York Attorney General Eliot Spitzer sounded a
warning to the variable annuity industry about the same types of improper
trading issues that plague the mutual fund industry. Spitzer associate
David Brown presaged the Attorney General’s Office is concerned about this issue
and signaled that the annuity industry is about to face criminal scrutiny.
The scrutiny is long overdue.
Although the New York official’s comments pertained to trading practices
within the mutual funds component of variable annuities, the area is, in my
opinion, the largest boondoggle in the entire investment industry. In
almost twenty years, I have never seen an area more full of misleading sales
practices and products designed almost exclusively for the benefit of the
investment firm or sales agent.
A distant relative of mine recently inherited $50,000. Having no idea
what to do with what was for him an enormous sum, he asked a teller at his local
bank branch about CDs. My cousin explained his plans to buy a house in the
next couple of years, using this windfall to pay for much of it.
Instead of buying a two-year CD, as he intended, he walked out of the bank as
the proud owner of a $50,000 variable annuity. He doesn’t understand
annuities, it costs too much, exposes him to unsuitable risks and restricts his
access to his money for seven years. Other than that, the product was
I am certain there are appropriate uses for well-designed variable
annuities. They are just hard to find. Annuities add additional
administrative costs to mutual funds, then add usually expensive and unneeded
life insurance to the package. The irony is that most annuitants are
attracted by the promise of tax benefits, when current low rates on capital
gains and dividends actually create a tax detriment for annuities.
Earnings withdrawn from an annuity are treated as ordinary income and taxed
at rates up to 35 percent. If my cousin had invested the money outside of
the annuity, his taxes wouldn’t have been deferred, but his capital gains and
dividends would only be taxed at 15 percent. It could take as long as
thirty years or more for the benefit of tax deferral to offset the higher tax
rates applied to the annuity withdrawals.
The added scrutiny of
recent scandals hasn’t helped solve the problem. A friend recently showed
me some annuity sales materials “proving” the superiority of a particular
annuity versus both CDs and a direct stock market investment. Hidden deep
in the package were details of a 22 percent first year surrender charge.
It would take 15 years before the surrender charge declined to zero. That
is outrageous. Legal, but outrageous. It’s about time someone looked
into this industry – and looked at more than just the timing of
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).