1. 1 Annuity Products, Sales Practices, and Risks FIRMA National Training Conference Washington, D.C. April 12, 2006

2. 2 Your Speaker* Thomas J. Pauloski, J.D. Director – Wealth Management Group Bernstein Global Wealth Management Chicago, Illinois Phone: (312) 696-7847 Fax: (312) 696-7979 E-mail: thomas.pauloski@bernstein.comthomas.pauloski@bernstein.com *The views expressed by the speaker at this session and in these materials are those of the speaker, not of Bernstein Global Wealth Management or its affiliates, and should not be construed as tax, legal, or investment advice.

3. 3 Roadmap Regulatory Overview Product Overview Typical Product Charges Tax Overview Optional Product Features Sales Practices Potential Risk Management Issues Appendix: NASD ® Notice 99-35

4. 4 Regulatory Overview

5. 5 NASD ® Notices and Alerts Notice 96-86 (December 1996): Suitability in variable life insurance and annuity sales Notice 99-35 (May 1999): Best practices in deferred variable annuity sales – see Appendix Notice 00-44 (July 2000): Best practices in variable life insurance sales Regulatory and Compliance Alert 14.2 (Summer 2000) at 12: Advertising of bonus credit variable annuities

6. 6 NASD ® Notices and Alerts (cont.) Investor Alert (May 27, 2003): Variable annuities – beyond the hard sell Investor Alert (June 30, 2005): Equity-indexed annuities – a complex choice Notice 05-50 (August 2005): Supervising sales of unregistered equity-indexed annuities Investor Alert (March 2, 2006): Should you exchange your variable annuity?

7. 7 NASD ® Proposed Rule 2821 Concerns about deferred variable annuities –Complex features, riders, and fees –Sales to elderly customers for whom long-term, illiquid products were not suitable –Failure of representatives to understand and explain product features –Advocating exchange without first ensuring that exchange was beneficial –Failure of member firms adequately to train and supervise representatives

8. 8 NASD ® Proposed Rule 2821 (cont.) Four main requirements –Suitability –Principal review and approval –Written supervisory procedures –Training of representatives Text of rule available at www.nasd.com

9. 9 National Banks and Annuities National banks may sell annuities, NationsBank v. Variable Annuity Life Ins. Co., 513 U.S. 251 (1995) Consumer protection regulations (12 C.F.R. pt. 14) address national banks and their “covered persons” –Anti-coercion –Required disclosures –Physical separation of banking and insurance activities –Adherence to state licensing standards

10. 10 Product Overview

11. 11 Annuities Annuity is series of periodic payments –Note: “Withdrawal” generally is not annuity Annuity contract is legal arrangement pursuant to which contractholder agrees to pay one or more premiums in exchange for right to receive annuity Annuitant is individual whose life governs duration of annuity payments No requirement that annuitant be in good health

12. 12 Function of Annuities Basic function: Systematic liquidation of investment fund Protects against possibility of outliving one’s income (in contrast to life insurance, which guards against premature death) Underwriting based upon same fundamental principles as life insurance –“Law of large numbers” –Premiums computed based upon mortality tables

13. 13 Perceived Advantages of Annuities No annual investment limit No financial underwriting limitations Fund builds on tax-deferred basis Nonprobate asset Provides secure source of income Some protection against creditors’ claims Simple

14. 14 Classification of Annuities Number of lives covered –Single-life –Joint-and-survivor: Payments cease at last death –Joint-life: Payments cease at first death Method of premium payment –Single-premium –Periodic payments –Flexible payments

15. 15 Classification of Annuities (cont.) When annuity payments commence –Immediate Payout vehicle Purchased with single-premium –Deferred (until annuity start date) Functions first as accumulation vehicle May be purchased with single, periodic, or flexible premiums Investment performance –Fixed –Variable –Equity-indexed (hybrid)

16. 16 Classification of Annuities (cont.) Disposition of proceeds –Duration of annuity payment period Lump sum Fixed period For life (or joint lives) For life (or joint lives) with minimum term certain –If stream of payments is selected Fixed amount Variable payments based on investment performance –Existence (or nonexistence) of refund feature (e.g., minimum payout if annuitant dies shortly after contract is purchased)

17. 17 Types of Annuity Contracts Flexible-premium deferred annuity Single-premium deferred annuity Single-premium immediate annuity Variable annuity Equity-indexed annuity

18. 18 Flexible-Premium Deferred Annuity Provides for accumulation of funds, with annuity payments deferred until some future date No set contribution amount or required payment frequency May include front-end load or surrender charge or both Interest is credited at not less than guaranteed rate

19. 19 Single-Premium Deferred Annuity Generally, no front-end loads, with provision for graded surrender charges Interest is credited at not less than guaranteed rate Often includes bail-out provisions, whereby contractholder can withdraw funds without surrender charge if interest rate falls below set rate

20. 20 Single-Premium Immediate Annuity Annuity payments commence immediately after insurer has received single (usually large) premium payment Often used to pay –Life insurance death benefit proceeds –Structured settlements

21. 21 Variable Annuity Benefits vary with investment performance of assets held pursuant to contract Assets are held in carrier’s separate account, which is not subject to claims of carrier’s general creditors Contractholder bears investment risk Traditionally, no guaranteed interest is credited Annuity payments may be: –Fixed –Variable (based upon “accumulation unit” values)

22. 22 Variable Annuity (cont.) Death benefit payable if annuitant dies during accumulation period When annuity contract is described as “variable” –Seller of the contract must have both life and securities licenses –If contract is not “private placement” Contract form must be registered under Securities Act of 1933 Carrier must file and issue prospectus Carrier’s separate account must be registered under Investment Advisers Act of 1940

23. 23 Variable Annuity (cont.) Optional features –Stepped-up death benefit –Guaranteed minimum income benefit –Long-term care insurance rider –Bonus credit

24. 24 Equity-Indexed Annuity Hybrid product that includes certain features of fixed and variable annuities Contract is credited with return based on equity index (e.g., S&P 500), usually with guaranteed minimum Common methods of “paying” for guarantee –Credit limited to percentage (e.g., 80%) of increase in index –Credit subject to upper limit or cap (e.g., 7% maximum credit) –Increase in index reduced by administrative fee or spread (e.g., credit equals increase in index minus 3% administrative fee)

25. 25 Equity-Indexed Annuity (cont.) Points in time at which increase in index is measured may differ from contract to contract Credits generally do not include –Dividends paid with respect to stocks comprising index –Income from reinvestment of dividends Generally, equity-indexed annuities are not registered with SEC, but instead are regulated by state insurance department

26. 26 Typical Product Charges

27. 27 Initial Loads Initial premium payment may be reduced by either or both of –Sales load –Premium tax Many products are now structured so that these charges, in effect, are deferred

28. 28 Ongoing Charges Additional charges may apply after contract purchase, including –Mortality and expense (M&E) risk charge –Administrative fee –Investment management fees for variable subaccounts –Fees for transfers among variable subaccounts –Surrender charge (imposed only upon surrender of contract within specified time frame) –Fees for optional contract features (e.g., guaranteed minimum income benefit) Total charges often amount to 250 to 350 bppa

29. 29 Tax Overview

30. 30 Basic Income Taxation of Annuity Products Build-up of cash value generally is not currently taxed Transfer of funds from one investment subaccount to another generally is not subject to current tax Withdrawals (other than annuity payments) and loans are treated first as taxable distributions of ordinary income Portion of each annuity payment received generally is treated as nontaxable return of “investment in the contract” –Balance of payment is taxable as ordinary income

31. 31 Basic Income Taxation of Annuity Products (cont.) Distributions prior to age 59½ generally are subject to penalty of 10 percent penalty of taxable amount –Exceptions for disability and substantially equal payments for life Inside build-up in contracts owned by “nonnatural persons” is not tax-deferred No gain or loss generally is recognized when exchanging one annuity contract for another Beneficiary of death benefit (if any) generally is subject to tax on gain at ordinary rates –Distinguish death benefit proceeds under life insurance contract, which generally are not subject to tax

32. 32 Basic Gift and Estate Taxation of Annuity Products Lifetime transfer of contract for less than full and adequate consideration is subject to gift tax Value of death benefit proceeds payable to beneficiary at annuitant’s death generally is includable in annuitant’s gross estate to extent that annuitant (or his or her employer) purchased contract

33. 33 Optional Product Features

34. 34 Stepped-Up Death Benefit In standard variable annuity contract, death benefit equals account value at annuitant’s death prior to annuitization Stepped-up death benefit option guarantees that death benefit will equal or exceed one or more of –Premiums paid minus withdrawals –Account value as of specified date or dates (e.g., each contract anniversary date), at contractholder’s election –Multiple of death benefit that otherwise would apply Cost of this feature may range from 10 to 35 bppa

35. 35 Guaranteed Minimum Income Benefit In most variable annuity contracts, annuity payments will either –Vary based on account value; or –Terminate if account value falls to zero Guaranteed minimum income benefit will guarantee specified minimum annuity payment (e.g., 7% of guaranteed benefit amount), even if investment losses cause account value to fall below level that otherwise would be required to support that minimum payment Cost of this feature may range from 40 to 75 bppa (current), 90 to 150 bppa (guaranteed)

36. 36 Long-Term Care Insurance Rider Annuity contracts may bundle other insurance or insurance-related products with traditional annuity features For example, some annuity contracts include optional long-term care insurance, which would pay for home health care or nursing home care if annuitant becomes seriously ill Such coverage may be better or cheaper if purchased outside of annuity wrapper

37. 37 Bonus Credit Credit to contract or account value, typically based on percentage of premium paid (e.g., 1% to 5% of initial premium) Risks include –Higher contract charges (e.g., surrender charge, M&E) –Longer surrender period –Bonus may apply only to initial or first-year premium –Contractholder may forfeit bonus in certain situations (e.g., withdrawal, payment of death benefit)

38. 38 Sales Practices

39. 39 Section 1035 Exchange Tax laws allow certain insurance policies and annuity contracts to be surrendered and replaced with new annuity contract without imposition of income tax on surrender proceeds Generally used to allow contractholder to obtain more favorable annuity contract on tax-advantaged basis Risks include –Whether exchange qualifies as nontaxable –Imposition of surrender charge on existing policy or contract –Exchange may trigger new, longer surrender period –Possibility of higher contract charges under new arrangement

40. 40 Annuity Arbitrage Sale technique involving pairing of single-premium immediate annuity with life insurance policy –Often involves exchange of one or more existing insurance policies and/or annuity contracts –Annuity payments from new contract are used to pay insurance premiums on new policy Economic benefit derives from differences in medical underwriting –Annuitant perceived by carrier issuing annuity contract to have certain health risks –At same time, insured (same individual as annuitant) perceived by carrier issuing insurance policy to be in excellent health

41. 41 Annuity Arbitrage (cont.) One reason for popularity: Insurance producer earns two commissions –One on new annuity contract –Second on new life insurance policy Potential risks similar to those described for Section 1035 exchange Broader issue: Will carriers ultimately fail due to flaws in underwriting policies and procedures?

42. 42 Potential Risk Management Issues

43. 43 Potential Risk Management Issues General suitability of investor –Sophistication –Net worth and income –Complexity of product Features Charges Options and riders Investor’s risk tolerance Long-term horizon –Surrender charge and 10-percent penalty –Investor’s age –Short-term liquidity needs

44. 44 Potential Risk Management Issues (cont.) Conduct of sale –Approved materials, including prospectus –Explanation of product features and charges Internal procedures –Compliance with applicable laws State and federal securities laws State insurance laws NASD ® rules –Registered principal review of each sale

45. 45 Potential Risk Management Issues (cont.) Contract replacement practices –Enhancements available in new contract –Charges assessed upon exchange –New surrender charge period Sales within qualified retirement plans –Tax-deferral feature is redundant when annuity is held by qualified plan –Nontax product features must outweigh product costs Financial strength of carrier Tax consequences / consultation with tax advisor

46. 46 Appendix: NASD ® Notice 99-35

47. 47 NASD ® Notice 99-35 Notice 99-35 provides guidelines for NASD ® members relating to their supervisory responsibilities with respect to variable annuity sales –Not mandatory –Designed to help members implement appropriate procedures –Supervisory requirements may be found in NASD ® Rule 3010 Includes internal review annually

48. 48 NASD ® Notice 99-35 (cont.) Differentiate potential annuity benefits vs. mutual funds –Tax-deferral –Death benefit –Guaranteed income for life Securities law registration requirements –Variable contract under 1933 Act –Carrier’s separate account under 1940 Act –Distributor as broker/dealer under 1934 Act

49. 49 NASD ® Notice 99-35 (cont.) Guideline categories –Customer information –Product information –Liquidity and earnings accrual –Investment in qualified retirement plans –Replacement of existing contracts

50. 50 NASD ® Notice 99-35 (cont.) Customer information guidelines –Make reasonable effort to obtain information about customer, including: Age Investment objectives Risk tolerance Tax status –Discuss all relevant facts with customer, including: Customer’s liquidity needs Product fees and charges

51. 51 NASD ® Notice 99-35 (cont.) Customer information guidelines (cont.) –Ensure that application and customer information is complete –Forward information promptly to registered principal for review –Registered principal check for accuracy and consistency

52. 52 NASD ® Notice 99-35 (cont.) Product information guidelines –Registered representative must thoroughly understand product specifications –Customer should be given current prospectus –Use only sales materials approved by registered principal

53. 53 NASD ® Notice 99-35 (cont.) Liquidity and earnings accrual guidelines –Lack of liquidity may make product unsuitable for short-term investor –Inquire whether customer has long-term investment horizon –Ensure customer understands surrender charge and penalty for early withdrawal –Establish procedure when investment will exceed: Stated percentage of customer’s net worth; or Stated dollar amount

54. 54 NASD ® Notice 99-35 (cont.) Qualified retirement plan guidelines –Disclose to customer that tax-deferral feature is unnecessary when purchase is for qualified retirement plan –Recommend variable annuity only when nontax benefits (e.g., lifetime income) support purchase –Conduct “especially comprehensive suitability analysis” when plan is subject to minimum distribution requirements

55. 55 NASD ® Notice 99-35 (cont.) Replacement of existing contract guidelines –Develop “exchange or replacement analysis document” Complete for all replacements Signed by customer, registered representative, and registered principal –Determine whether replacement product is suitable, considering Product features and enhancements Costs and fees, including surrender charge New surrender charge period

56. 56 NASD ® Notice 99-35 (cont.) Replacement of existing contract guidelines (cont.) –Monitor registered representatives who have particularly high rate of replacements –Adopt other measures reasonably designed to ensure that replacement sales comply with applicable rules