Variable-annuity industry targeted

By DAVID MOON, Moon Capital Management
April 4, 2004

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 fine.

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Earnings withdrawn from an annuity are treated as ordinary income and taxed at rates up to 35 percent.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 trades.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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