Pslra, Slusa, and Variable Annuities: Overlooked Side Effects of a Potent Legislative Medicine - Michael J. Boren

JurisdictionUnited States,Federal
Publication year2004
CitationVol. 55 No. 2

PSLRA, SLUSA, and Variable Annuities: Overlooked Side Effects of a Potent Legislative Medicineby Michael J. Borden*


This Article highlights a harmful and far-reaching unintended consequence of two major pieces of securities litigation reform legislation1 that were passed as part of the Republican party's Contract with America in the mid-1990s. These reforms were justified, in part, on the grounds that they would benefit investors by improving disclosure of financial information by corporations. However, for many aggrieved investors, the effect of the legislation was just the opposite. Because of inadequate and misleading disclosures made by life insurance companies and their registered representatives, consumers were induced to purchase inappropriate investments carrying excessive fees that reduced the value of their retirement nest eggs. Had the purveyors of these variable annuities adequately disclosed the nature of the product and fully explained the complicated factors that go into a decision to purchase a variable annuity, most consumers would not have purchased variable annuities with tax-deferred moneys from their Individual Retirement Accounts ("IRAs") and 401(k)s.

As a result of these misleading sales practices, tens to hundreds of millions of dollars that ought to have provided retirement security to average Americans have instead been counted as profits by life insurance companies or commissions by their agents. To make matters worse, once the fraudulent nature of these transactions was brought to the attention of investors by the Securities and Exchange Commission ("SEC"), the National Association of Securities Dealers ("NASD"), the news media, and plaintiffs' attorneys, the investors found themselves barred from pursuing a judicial remedy by the business friendly provisions of the Securities Litigation Uniform Standards Act ("Uniform Standards Act" or "SLUSA")2 and the Private Securities Litigation Reform Act of 1995 ("Reform Act" or "PSLRA")3 —the very acts that were meant to enhance corporate disclosure to benefit investors.

Throughout the mid- and late-twentieth century, large companies compensated their employees with more than cash renumeration by providing a variety of benefits. Employees enjoyed benefits such as health and life insurance, discounts on products sold by their employer and its affiliates or partners, day care for their children, company cars, subsidized meals, paid vacation and sick days, and pensions.

Two recent trends have resulted in a significant decrease in the prevalence of these benefits. First, fewer Americans are spending their entire careers working for the large corporations that have historically provided these types of benefits. Second, the companies themselves are offering less generous perquisites. Specifically, the kinds of pensions that were once a mainstay of the typical long-term corporate employment arrangement are no longer available to the average worker. While fixed benefit retirement plans were the norm for decades, today's workers no longer have the luxury of such dependable sources of retirement income. The government has stepped in and attempted to fill the gap with IRAs, 401(k)s, 403(b)s, and other tax-deferred qualified plans. What the government has not done, and cannot do, is provide the expertise that corporate pension administrators have long wielded for the benefit of employees. As a result, individuals in the last twenty to thirty years have shouldered the responsibility of planning for their own retirements through management of their savings accounts and the purchase of investment instruments with moneys from various sources, including IRAs and 401(k)s.

But mom and pop investors are not usually qualified to navigate the shark-infested waters of the investment industry. The well-to-do typically have employed stock brokers, experts in the field upon whom the law imposes a fiduciary duty vis-a-vis the client. Stock brokers, however, have traditionally been an accessory of the affluent. Who advises the less well off? A breed of investment professionals known as financial advisors has come forward to serve the broad segment of the public whose account balances are too meager to appeal to white-shoe brokers. The aggressive sales practices of investment advisors and the companies they represent have caused many middle class investors to make ill-advised purchases of products that carry excessive fees.

Licensed and regulated by the states, investment advisors are sometimes employed by large insurance or financial services companies, and are sometimes independent, like insurance agents. In fact, frequently they are also insurance agents. Middle-class Americans, with modest amounts of money to invest, sometimes encounter investment advisors in the small offices or shop fronts conveniently located in shopping centers and malls. A degree of legitimacy is conferred by the familiar brand names under which these advisors operate: American Express Financial Planners and Nationwide Financial Advisors, for example. The consumer's familiarity with the investment company's brand name frequently engenders a sense of confidence and trust that is not always well placed.

A recent example of the dangers of such encounters provides a cautionary tale about the vulnerability of today's middle class investors seeking to provide themselves the kind of financial security in retirement that a career at IBM or Ford Motor Corporation once offered. The confluence of profit-motivated companies, their commission-driven sales people, and unsophisticated investors has produced a financial windfall for the companies and their agents. It has also cost their clients substantial sums of money and produced a great deal of litigation in recent years.

Variable annuities are a hybrid security and life insurance product that offer investors the appealing combination of tax-deferred investment growth and a guaranteed lifetime income. The importance of these benefits cannot be underestimated. As all but the wealthiest individuals know, when retirement age approaches and one contemplates terminating all earned income and relying solely on investment income, one fears that one's assets will not be sufficient to generate enough income for life. The worst scenario is to be old and infirm, with rising medical expenses and a dwindling nest egg. These concerns tend to induce aging individuals to work longer and to trim their spending in an effort to allay their fears of asset depletion. Such concerns also induce forward-looking workers to seek ways to maximize their retirement savings.

The benefits of variable annuities are manifest and appealing, but they come at a price. The sales commissions, fees, and charges associated with annuities are higher than for other insurance and investment products. Obviously, salesmen who work mainly for commissions will want to sell the products from which they derive the most money. This is where the trouble begins. Because both the advisors, at the point of sale, and the insurance companies, whose products they sell, make high margins on the sales of annuities, salesmen exert a great deal of pressure on consumers to buy them. In addition to pressure from the companies, the advisors have their own private incentives to increase their sales of annuities.

If annuities are such great retirement vehicles, then what is the problem with investors buying them in great quantity? The problem is that unsophisticated individuals of modest wealth do not frequently have $100,000 lying idle in their savings accounts. However, they often do have substantial sums amassed in their IRAs and 401(k)s. So with vigorous encouragement from sales agents, they purchase the annuities with the money in those tax-qualified plans and get the tax-deferred investment and the guaranteed lifetime income. If this strikes you as troublesome, then you are in good company. You are in the company of plaintiffs' lawyers, knowledgeable investors, regulators, and the executives and investment advisors working for the companies who sell annuities. If nothing seems amiss, then you are also in excellent company with the millions of consumers who have purchased expensive deferred annuities with moneys from their qualified plans.

The problem is that when investors buy variable annuities using funds from tax qualified plans, they are buying something they already have by operation of law—tax deferral—and they are paying dearly for it. The investor realizes no incremental benefit from the second dose of tax deferral. This belt-and-suspenders approach to sales of annuities earned hundreds of millions of dollars in revenues for the insurance industry and eventually generated huge fees for lawyers representing both plaintiffs and defendants in ensuing litigation. Beginning in 1998, plaintiffs' firms sued several leading life insurance companies, alleging that the sales of variable annuities into qualified plans amounted to fraud, deceptive trade practices, negligent misrepresentation, and breach of fiduciary duty. In 2000 the federal courts of appeals began dismissing these cases on the grounds that the claims were preempted by the Uniform Standards Act.

Part I of this Article explains the text and legislative history of the Reform Act of 1995 and the Uniform Standards Act of 1998. Specifically, Part I highlights the lack of attention with which the crucial definition of "covered security" in the 1998 law was drafted.4 Part II explains the investment instrument known as the variable annuity and its fundamental inappropriateness as an investment for many purchasers, namely those buying a variable annuity to place into a tax-qualified plan such as an IRA or 401(k). Part Ill describes changes in the ways Americans and their employers provide for retirement security. Part Ill also demonstrates that because of those changes, purchasers of annuities have suffered important financial harms that should...

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