1035 Exchanges Inflate VA Sales: Report

By Frederick Schmitt

Variable annuity sales figures are inflated because the industry has no method for measuring when an investor exchanges one VA for another, a new report concludes.

The report by Boston-based Cerulli Associates and New York-based Lipper Analytical Services estimates that between 25 percent and 30 percent of new "sales" are in reality 1035 exchanges.

Section 1035 of the tax code allows investors to exchange one variable annuity or life insurance contract for another annuity contract without tax consequences.

In an attempt to clarify the issue, the Variable Annuity Research and Data Service Report (VARDS), Roswell, Ga., is creating a national benchmark to monitor the transfer activity.

The VARDS proposal seeks to have the 1035 exchanges shown as a percentage of all variable annuity sales.

As it is now, the 1035 transfers are creating an abundance of "artificial" new sales, said Cerulli consultant Andrew Guillette.

Although 1035 exchanges are not inherently bad, according to Mr. Guillette, the high level of activity is unhealthy for the industry because a large portion of market wealth is simply being shifted and not created.

"It's okay as long as they're used as a tax-deferred escape clause for clients, and not abused by brokers for the sole purpose of earning another commission," said Mr. Guillette.

"Clearly, there is a need to break out the 1035 exchanges so the industry can get a more accurate sales picture," he continued. "Right now, there are no standards and no consistency in reporting them."

Rick Carey, VARDS editor and publisher, said the 1035 exchange issue is one of "extreme importance." However, he cautioned against taking the Cerulli-Lipper numbers as absolute.

"I'm worried people will get the wrong impression," he explained. "There are all sorts of 1035 exchanges. Some are good and some are bad. That's why we need to clarify the issue and break it down."

The initial VARDS National 1035 Exchange Ratio is expected to be published within the next four months, and quarterly thereafter.

Mr. Carey also said a roundtable of industry leaders is being convened to "examine and recommend standardized accounting practices for industry reporting of redemptions in and out of variable contracts."

The group, whose membership will be announced next month, is expected to publish its findings this winter.

Further findings from the Cerulli-Lipper study indicate the 1035 exchange activity will slow down in upcoming years.

"The products are becoming more and more commoditized," Mr. Guillette said. "As policies increasingly begin to look alike, there will be less motivation for investors to switch."

Other report findings include:

VAs are growing at a faster rate than mutual funds. Since 1988, VA assets have grown 39.5 percent annually, compared with 21.9 percent for long-term mutual funds.

VA sales have significantly outpaced fixed annuities. VAs' market share of all annuities went from 17.5 percent in 1991 to 42 percent last year.

By the year 2000, multi-manager contracts will control at least 65 percent of variable annuity assets, up from their current market share of 46.5 percent.

The Cerulli-Lipper analysis is based on interviews with bank brokerages, registered representatives, brokerage firms, insurance companies, mutual fund companies and third-party marketers.

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