November 7, 2008
I write to provide a unique viewpoint concerning File No. S7-14-08. During various stages of my nearly 20 year professional career, I have served as an estate and tax attorney, a stock broker, an insurance agent, an accountant, and an investment advisor representative. While at law school, I had the pleasure of studying securities law directly from a high-ranking Securities Exchange lawyer. I have also experienced first hand the regulatory environment of stockbrokers and insurance agents.
In deciding whether or not to define a Fixed Indexed Annuity as a security, to be regulated by the Securities Exchange Commission ("SEC"), I believe that three distinct issues must be addressed:
1. What are Fixed Indexed Annuities?
2. How broadly should we define the term "security" given the extraordinary demands currently placed on the SEC?
3. What approach can best protect consumers?
Defining Fixed Indexed Annuities
Annuities come in many forms with various terms and conditions. For purposes of this discussion, I believe it is appropriate to focus on the basic characteristics of three major types: traditional fixed annuities, fixed indexed annuities (referred to as Indexed Annuities by the SEC), and variable annuities.
Over the years, traditional fixed annuities have been rightly considered insurance products, not subject to SEC regulation and oversight. The basic characteristics of traditional fixed annuities are a set rate of interest declared annually for a set period of years, subject to penalties for early withdrawal. Particular traditional fixed annuities can differ greatly depending on the terms and conditions of the issuer. A typical traditional fixed annuity might provide a fixed interest rate of return of 4% for 5 years, with no restrictions at the end of the 5 year period, with penalty free withdrawals of 10% per year after one year, but subject to a significant penalty of 5% of principal if withdrawals exceed the annual penalty withdrawal amounts. With traditional fixed annuities, the consumers principal is protected so long as withdrawals do not exceed the penalty free withdrawal limits. If such withdrawals exceed the penalty free limit, the consumer may lose principal. Traditional fixed annuities are not subject to the whims of the stock market. The recent 30%+ drop in the stock market has not affected the performance of a traditional fixed annuity whatsoever. Typical traditional fixed annuities are somewhat similar to a Banks Certificate of Deposit, except that excess withdrawal penalties are typically much greater for traditional fixed annuities, traditional fixed annuities are not FDIC protected, and traditional fixed annuities provide income tax deferral.
In contrast, over the years, variable annuities have rightly been considered securities, subject to SEC regulation and oversight. At their essence, variable annuities provide sub-account investment options, comparable to mutual funds, wherein annuity account values can go up or down dramatically based on related stock market performance. The recent 30%+ drop in the stock market has greatly reduced the value of most variable annuities. In recent years, variable annuities have begun to offer additional protections to consumers. In their early years, these protections limited loss if the variable annuity was held until death. Recently, variable annuities have added protections to generate income if, but only if, the consumer decides to receive payments over many years. In many cases, these protections have typically done little to protect consumers from the loss of their principal.
Fixed Indexed Annuities are somewhat different from either Fixed Annuities or Variable Annuities. A typical Fixed Indexed Annuity is basically built from the framework of a traditional fixed annuity, but with a degree of performance variability depending on stock market performance. The basic characteristics of a Fixed Indexed Annuity are interest rate returns varying from year to year depending on stock market performance, but principal is protected and gains are periodically locked in and protected, with penalties for early withdrawal. A typical Fixed Indexed Annuity has a very reasonable chance of outperforming a traditional Fixed Annuity if the stock market behaves in historically normal manners, but can still perform better than some savings instruments even when the stock market performs poorly for extended periods of time. A typical Fixed Indexed Annuity might provide that interest is credited annually based on a fraction of the return of the SP 500, but never less than zero, over a period of 5 years, with 10% penalty free withdrawals after 1 year, and subject to a 10% penalty if withdrawals exceed the penalty free amount. While the interest returns may vary from year to year, the consumers principal is protected so long as withdrawals do not exceed the penalty free withdrawal limits. The whims of the stock market may reduce the interest rate returns for a given year, but the consumers principal is not at risk from these stock market fluctuations. The recent 30%+ drop in the stock market means that the typical Fixed Indexed Annuity will generate a zero rate of interest return during this period, but not a loss. With a typical Fixed Indexed Annuity, principal is protected, and gains periodically locked in, so long as withdrawals do not exceed the penalty free limits.
How broadly defined should we define the term "security" given SEC demands?
My Securities Law professor, a high ranking SEC lawyer at the time, always professed that the SEC should regulate and supervise practically every financial transaction, including all annuities, all bank activities including Certificates of Deposit and Savings Accounts, all brokerage and investment activities, and more. While SEC regulation and supervision of all annuities might, at first glance, be considered beneficial to consumers, additional regulation and supervision has costs and consequences. With respect to annuities, I believe that the SECs oversight power and regulatory authority should be expanded only in those areas where the risk of loss to principal is significant and material due to stock market forces, but not when the only risk of loss to principal is due to consumers seeking to make withdrawals in excess of contractual limits. I personally believe that society would be much better off if the SEC were given dramatic powers to oversee and regulate all Hedge Fund activities, but I do not see society benefiting from additional regulation over products that provide principal protection, if used properly.
What Approach Can Best Protect Consumers?
Over this past year, weve seen the stock market drop 30% or more, resembling a mini-crash. Individuals invested in traditional mixes of stocks and bonds have often lost 20% or more of their total wealth. For those individuals unable to withstand such volatility and losses, but seeking interest returns potentially greater than Certificates of Deposit or traditional Fixed Annuities, Fixed Indexed Annuities may be appropriate.
However, Fixed Indexed Annuities are complex products, often poorly explained by Insurance Agents. While I believe that State Insurance regulators can address these issues sufficiently to protect consumers, I propose an alternative approach to consider: develop a safe harbor rule in defining whether or not an annuity should be regulated as a security.
My Safe Harbor Suggestion
A major concern that I have for consumers is that they fail to understand certain key characteristics of a Fixed Indexed Annuity and then seek to withdraw all or most of the funds held at such annuity, triggering significant penalties for early withdrawal. In such instances, a consumer can lose principal in these otherwise principal protected annuities. I propose that the SEC grant a safe harbor to those Fixed Indexed Annuities that provide a Return of Premium (also known as a Return of Principal) rider, thereby classifying such annuities as insurance products not considered to be securities. With such riders, the Insurance Company issuing the Fixed Indexed Annuity provides that the consumer may cancel the annuity contract at any time and receive his entire premium, less any withdrawals he has already made. In essence, with this Return of Premium rider, the consumer will always receive the return of his entire principal.
I believe that all other matters pertaining to Fixed Indexed Annuities, such as insurance agent training, adequate disclosures, minimum interest rate guarantees, and more, should then be handled solely by the states and their insurance regulators. By granting a safe harbor to these types of Fixed Indexed Annuities, consumers can be better protected, insurance companies will have a bright line rule when developing their annuities, and the SEC can more intensely focus on addressing more urgent and dire matters, such as Hedge Fund regulation.
Thank you for your consideration of this matter.
Bob D. Hines, Jr., JD, MBA, CPA, CFP