Damage Control For Victims

Helping a widow whose dying husband was sold annuities.

The essential facts of this story are true; I am not making this up.

Three years ago Donald Millani, 65, told his broker that he had been diagnosed with terminal cancer and probably had just a few more months to live. What would the broker advise him to do with his $2 million investment account and his $1 million IRA?

"Annuities," said the advisor. "Just the thing. There's this new product that gives you a 5% bonus for signing, and it let's you build an aggressive portfolio while the death benefit guarantees your principal. If the investments go up, all the better."

Three months later, Donald died. The stock funds inside the variable annuities had lost value, but the death benefits enhanced by the 5% bonuses were available to his healthy 62-year-old widow, Gloria. When Gloria asked the broker what she should do with her inheritance, the answer was, "Annuities. Just the thing. There's this new product that gives you a 5% bonus for signing and your principal is guaranteed."

Mrs. Millani, who had never made an investment decision in her life, asked her son Jonathan, a history professor, to go with her to the broker's office. They made it as clear as they could, she said, that she wanted safety above everything. It seemed to both mother and son that the money Donald had left was more than enough to take good care of Mom, and they didn't want to take any chances with it. In a conversation laced with "guarantees," the broker assured them that deferred variable annuities were just what they wanted.

Two years later, Gloria found her way to our offices to see if we could help her understand what had happened, because it seemed to her that her $3 million had shrunk dramatically and she wondered what had become of all those guarantees.

Sorting It Out

Mrs. Millani brought me her entire collection of documents and correspondence related to her investments; stacked haphazardly in a cardboard filing box, they filled it to overflowing. I spent an hour listening to her recollection of the events. Apparently, the monthly statements she'd been receiving from the broker showed that the value of her accounts was steadily falling. She showed me copies of letters she'd written to the broker asking him what was wrong and to please do something. She recounted phone calls she had made to him in which he reportedly assured her that everything was fine. "The markets are just volatile. They will come back, and there is nothing to worry about."

Her telling was not without emotion, especially since this visit was right around the anniversary of Donald's death. I assured Gloria that I would work my way through her box of documents and try to understand what she had invested in, and come up with some strategy to at least stop the bleeding. Then we'd see what help we could offer to the securities lawyer she had already contacted.

Over the weekend I logged about 12 hours sorting statements and letters, jotting notes and creating a spreadsheet of the annuity contracts showing dates, features, original and current values, investment elections, owner, beneficiaries and so forth. What I saw was very upsetting; it helped me understand, yet again, why the first quality people look for when seeking a financial advisor is trustworthiness. Unfortunately, the majority of us who are trying to do an honest, skillful job have to contend with the notoriety of the charlatans and incompetents.

There were, indeed, 12 variable annuity contracts purchased on three or four different dates within two months after Gloria's husband died; three of the 12 were qualified annuities (IRAs) originally totaling just over a million dollars. Every annuity was invested 100% in aggressive growth and technology funds. The total original value was $3.1 million, and in approximately two years it had shrunk to $1.2 million.

Perhaps more disturbing than the papers I found were the papers that were not in the box. There were no copies of signed applications for any of the annuities. There was no evidence of an effort to discover this widow's cash flow needs before recommending the products. Nor was there any evidence of an effort to understand Gloria's estate issues, although every contract indicated a beneficiary. (As an aside, one of the named beneficiaries was Gloria's deceased husband; now there's a great estate-planning idea.)

With one exception, the only "guarantees" I could find among the policies were the guaranteed death benefits. I later told Gloria that there were guarantees, but someone had neglected to tell her that she had to die to take advantage of them. The one feature I discovered, in the smallest of the contracts, was a Guaranteed Retirement Income Protector (GRIP). This feature allows Gloria at a certain age (I think it was 70) to annuitize either the market value of the investment account or the original contract value, whichever is higher. This account's value is now one-third of its starting value, so it will be important for her to hang onto that contract.

As I explained the cold realities to Gloria in a subsequent meeting, she was alternately livid at the way her trust had been abused and relieved to hear from me that she was not crazy ... it was as bad as it had seemed to her. "Well, what do we do now?" she asked, extending an open palm toward the cardboard box of documents.

"First of all, Gloria, I agree with you that you appear to have a legitimate basis for a legal challenge to the way your affairs have been handled. I do not practice law, so we have to be very careful to delegate all legal issues to a person who is skilled and licensed to handle these matters. The same thing goes for insurance; there are licensing issues, and I have to be careful to defer to licensed professionals where that is appropriate. Next week I will call your attorney and offer him what assistance I can from the perspective of my experience."

What To Do Now?

Gloria's very first request to me had been, "Stop the bleeding." She had asked the broker over and over during the past two years to "do something," and nothing, absolutely nothing, had been done to change the investment allocations in her annuities. I decided that at least I could review the investment options available in each policy and suggest a way to diversify her portfolio of aggressive equity funds and dampen the overall volatility. I explained to her that in so doing, we would also reduce the ability of the portfolio to bounce back if technology enthusiasm should return to the market. I don't think she really understood that.

Naturally, every contract listed the broker as her representative. So I drafted a letter for her signature to advise her broker to liquidate certain of the technology funds and replace them with several specific fixed-income and utility stock funds as a way to begin reordering her portfolio.

Next, we drafted letters for her signature asking the broker to provide forms for requesting a withdrawal from the nine nonqualified annuities in the amount that she could take free of surrender charge once each year. At least, I thought, we could begin to reduce the amount she has in these contracts that I consider inappropriate. For the three IRAs, the letter we wrote to the broker for her signature asked that the allowable "free" withdrawals be made to her IRA brokerage account to preserve the tax-deferred status.

We did manage to extract something like $200,000 from the nonqualified annuities, but the broker ignored her written instruction with respect to the IRAs, suggesting that she just change her investment allocations in those policies. An anniversary date came and went, costing Gloria that withdrawal opportunity.

What I really wished I could do, of course, was to take all the money out of the annuities (except the one with the GRIP feature), and deposit the proceeds into ordinary brokerage accounts where investment choices would not be limited to the (mostly very poor) house funds these annuities provided. This would also remove part of Gloria's remaining assets from the burdensome annual expenses built into these annuities. But, no surprise, the surrender charges were substantial. Little did I suspect just how substantial!

Bad enough that in the third year after purchase, the surrender charges still ran to about 7%. But the pièce de resistance was that the surrender charges are levied against the original investment amount, not the current market value! So an annuity that was originally a $500,000 investment and that had shriveled to $150,000, would have a surrender charge of $35,000 (7% of the original investment, but 23% of the current value!) I would have to call that a prohibitive barrier to withdrawal ... which, of course, is exactly what it was designed to be.

Communication between Gloria and the broker was entirely crippled by her anger and his defensiveness (heightened by the initiation of an arbitration process.) After checking with her attorney, it was decided to remove the broker as the representative on the policies and establish Gloria's relationship directly with the four insurance companies. We drafted letters for her signature to change her annuities to "house accounts" so that, with our guidance, she could initiate regular "penalty-free" withdrawals after every anniversary date, and from time to time could give instructions to the carriers to change her investment allocations. To date we have been successful with eight of the 12 policies; insurers have ignored the request on the other four, and we are pursuing the matter.

Summary

We all know that variable annuities, while they have a legitimate place in the lineup of modern financial products, are frequently misused. Many of us have had dissatisfied owners show up in our offices looking for guidance. We have learned from experience that there are limits to the assistance we can render, depending on each person's circumstances. Gloria's story is representative, and offers some perspective that might be helpful the next time you are asked to assist someone who may have been badly served by a former advisor.

The place to begin is to read the annuity contracts in question and organize the important information for reference and comparison. This should include: insurer and policy number, representative, address and phone, date of issue, whether a signed contract is available, owners, beneficiaries, original investment, death benefit, special features and riders (such as a guaranteed retirement benefit, inflation protector, etc), current market value, investment subaccounts, available investment elections, terms of surrender fees and "penalty-free" withdrawals, and all the built-in expenses.

After organizing all the pertinent information, I develop my advice by exploring five questions:

Might a legal complaint be appropriate?

Might a 1035 exchange be appropriate/affordable?

Are withdrawals appropriate/affordable?

Might immediate annuitization be appropriate?

Can the annuity investment portfolio be improved?

It is important to keep in mind the need to defer to attorneys, expert witnesses and insurance professionals with respect to those issues for which we are not licensed. Recent media reports indicate that an increasing number of annuity complaints have been successful in arbitration, so if a case that shows up on your desk looks egregious, I wouldn't hesitate to recommend that the client seek counsel.

Short of seeking restitution, a new advisor can still be helpful. As an advisor to the aggrieved annuity owner, you may develop several different objectives, depending on the circumstances. In the case of older annuities, surrender charges may have declined to the point that it makes sense to suggest a 1035 exchange to a lower-cost deferred annuity where two years of reduced expenses alone will overcome the surrender penalty. Where surrender fees are overwhelming, as in Gloria's case, a better alternative may be to gradually work out of the product by using the annual free withdrawal terms.

When the relationship to the originating advisor is untenable, changing to a "house account" may help free the holder to make changes in the investment selections. In this case, of course, the new advisor will need to become familiar with the list of investment alternatives available to each policy and craft an annuity portfolio that makes sense in the client's overall investment context.

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.