Variable Annuity Exchanges and Replacements: Stockbroker Liability for Failing to Facilitate a Tax-Free 1035 Exchange

taxes1.jpgToday’s blog posting examines another recent trend that I am seeing both at my California securities law practice and at the University of San Francisco Investor Justice Clinic where I am an adjunct law professor. In the past few weeks, there has been a sudden increase in complaints from investors who were advised to replace their old variable annuity contracts with new ones and, to make matters worse, their financial advisors (i.e., stock broker and/or investment advisor) failed to exercise due diligence by making sure that the transaction qualified as a tax-free exchange pursuant to Section 1035 of the Internal Revenue Code. In a “1035 exchange,” a variable annuity owner replaces their current annuity contract with a new one without paying any tax on the income and investment gains attributable to the old variable annuity. However, if an investor simply surrenders their old annuity in return for cash and uses the cash to purchase a new annuity, the ability to perform a 1035 exchange can be lost and the investor will have to pay taxes on the surrender. Any financial professional who fails to facilitate a 1035 exchange of a customer’s variable annuity opens themselves up to a securities arbitration claim seeking damages for the customer’s fees, costs and taxes incurred as a result.

Another problem that often arises when exchanging or replacing a variable annuity is the potential for surrender charges. Customers are subject to charges whenever an annuity is surrendered before expiration of the applicable surrender period, which typically runs for 6 to 8 years from the date of purchase. Surrender charges also reduce the amount that an investor will have available to reinvest in a new annuity, thereby lowering the investor’s potential return. Also, when a new replacement annuity is purchased, the investor’s funds will be subject to a new surrender period, which means that their funds will be locked up for an additional 6-8 years.

Variable Annuities Are Inappropriate for Seniors

The high fees, surrender charges and market risk associated with variable annuities make them a poor investment choice for many elderly investors or seniors over the age of 65. If an investor is 65 years or older, under California law, any attempted annuity replacement is considered unnecessary unless the selling agent can demonstrate that the replacement conferred a “substantial benefit” to the customer.

Increased Regulation and Oversight of Variable Annuities

Recently, the Financial Industry Regulatory Authority (FINRA) adopted new rules governing broker recommendations to purchase and exchange of variable annuities. The rules also require brokerage firms to implement supervisory procedures to detect and prevent ‘inappropriate exchanges” of variable annuities. Variable annuities are now one of the handful of securities products that have their own custom suitability requirements, along with the trading of warrants, futures, options and direct participation programs (DPPs).