SEC Answers a Comment About Tax Talk in Annuity Ads

Benji Johnson, a lawyer who used to sell annuities, helped U.S. Securities and Exchange Commission officials write guidelines for how marketers should describe tax benefits in annuity ads.

Johnson drew the advice out of the SEC by commenting on its draft annuity registration form regulations for registered index-linked annuities and annuities with market-value-adjusted features.

He mentioned what he believes to be unrealistically positive portrayals of annuity tax benefits in RILA and MVA annuity ads in his comment letter.

Fewer than 20 commenters weighed in on the draft annuity registration form regulations, the SEC took a comprehensive approach to addressing the comments, and the result was that the SEC ended up including a guideline responding directly to Johnson's concerns.

Under the new final rule, "consideration should be given to whether portrayals of the tax-deferred value of the annuity, especially where this value is compared to the value of a taxable account, should reflect the advantages of taxable accounts," if the taxable accounts have any advantages, SEC officials write in advice given in the preamble, or official introduction, to the final rule.

If, for example, cash coming out of a taxable account could be taxed at a lower rate than the cash coming out of a RILA contract or an MVA annuity at the same point, the ad should mention that, officials say.

What it means: Sometimes, ordinary agents and brokers can affect how federal agencies operate simply be sending in a comment letter on draft regulations.

The annuity registration form project: Life insurers had been asking the SEC to let them update annuity registration rules for more than 20 years.

Insurers could file traditional variable annuity separate accounts using the relatively simple SEC Form N-3, which serves accounts registered as management companies, and Form N-4, which serves accounts registered as unit investment trusts.

Companies have used Form N-6 for separate accounts inside variable life policies.

Insurers have had to file RILA contracts and MVA annuities using Form S-1 or Form S-3, which are the same forms an insurance company would use to register with the SEC to sell stock to the public.

The kind of annuity that U.S. life insurance companies sell today is an "upside down life insurance policy." It can turn cash into a stream of benefits, rather than turning premiums into one lump-sum death benefit payment.

In practice, annuities and life insurance policies can perform similar functions in similar ways, but they operate under different laws and regulations, based on policymakers' thinking that life insurance policies exist primarily to manage the risk of premature death and annuities exist primarily to provide retirement income.

A RILA contract is an annuity with a crediting rate tied to the performance of investment indexes.

An MVA annuity is an annuity with a feature that may cut the asset value if the annuity owner takes cash out early. The insurer cuts, or "adjusts," the value based on where an interest rate index stands on the day the contract owner takes the cash out. Usually, a MVA feature comes with a multi-year guaranteed annuity, or MYGA, contract.

Insurers argued that it was absurd for them to have to put their office rent, executive salary information and other generation aimed mainly at shareholders in documents aimed at annuity buyers.

The SEC finally made a simpler RILA and MVA annuity filing process possible through a provision tucked into a 2022 appropriations bill.

The new final rule, which was released in July, will let insurers file new RILA contracts and MVA annuities on Form N-4 and may increase the supply of RILAs and MVA features, by simplifying the filing process.

Taxes and the new registration rules: SEC officials talk about annuity tax provisions because the new annuity registration form regulations will require any annuity that has to be registered with the SEC to include a "key information table."

One section in the key information table will have the subhead "Taxes." Under the subhead, in the left-hand column, the issuer will put the question: "What Are the Contract's Tax Implications?"

In the right-hand column, the issuer will describe the tax implications.

Questions also came up when SEC officials were discussing how RILA and MVA registration rules interact with SEC Rule 156, "Materially Misleading Statements and Representations."

"Rule 156 does not prohibit or permit any particular representations or presentation," SEC officials write in the annuity registration rule preamble. "Rather, it is an interpretive rule that provides factors to be weighed in considering whether, in the specific context of investment company sales literature, a statement involving a material fact is or might be misleading for purposes of the Federal securities laws."

In the past, many participants in the insurance industry thought of RILAs as being a specific type of SEC-registered annuity and of multi-year guaranteed annuities with MVA features as ordinary fixed-rate annuities.

Under the new SEC final rule, the SEC appears to distinguish RILAs from variable contracts and to classify MVA annuities as fixed annuities. When it refers to both RILAs and MVA annuities at the same time, it calls them non-variable annuities.

Rule 156 will now provide guidance for insurers on how to create ads for buyers of non-variable annuities without presenting materially misleading communications, officials say.

Benji Johnson's letter: Johnson discussed a number of thoughts about RILA rules in his letter.

He suggested, for example, that insurers have been right about the idea that much of the information included on the Form S-1 registration statements is irrelevant to RILA buyers.

He encouraged the SEC to make sure investors get a "single plain English disclosure," rather than both a prospectus and a contract.

"Investors do not read prospectuses," Johnson told the SEC.

He then blasted how many annuity sellers present information about RILA contracts' tax features.

"RILA (and all annuities) are tax-deferred," Johnson acknowledged. "Annuity sellers often provide charts showing the benefit of tax deferral."

But "these benefits are grossly exaggerated," Johnson said.

Too often, Johnson said, an annuity performance chart, or illustration, will mislead the user by assuming that all taxable investments are taxed at ordinary income tax rates and assuming that all gains on taxable investments are paid every year.

Frequently, the charts "compare a (pre-tax) tax-deferred value to an after-tax taxable account," he said. "This is inappropriate because there is no way of getting money out of the tax-deferred account without paying taxes, so showing a pre-tax value is misleading."

The charts may also ignore product fees, which may eat into any remaining tax benefit, he said.

"The SEC must prohibit these presentations," he said. "It is not enough to have fine print explaining the assumptions."

Taxes also factored into Johnson's criticisms of how some annuity marketers present information about the cash annuity holders' beneficiaries get when the holders die.

"Death benefits are not benefits," Johnson wrote. "Many annuities are marketed as providing death benefits. However, these so-called 'benefits' are worse than any other investment because they are fully taxed at ordinary income rates, as opposed to getting a stepped-up cost basis."

The SEC's reaction: SEC officials refer to the Johnson comment letter more than 20 times and summarized his views about how marketers often portray annuity tax provisions at length.

SEC officials declined to add new requirements for descriptions of annuity tax features or other features in ads to the draft regulations they released in 2023.

"Rule 156 is an interpretive rule that provides factors to weigh in considering whether, in the specific context of sales literature, a statement involving a material fact is or might be misleading for purposes of the federal securities laws," officials write in the preamble to the final rule.

"These amendments address commenter concerns about potentially misleading statements in RILA sales literature by providing insurance companies with guidance about the contextual analysis to use in determining whether a particular representation in non-variable annuity advertising could be materially misleading," officials add.

Most of the final preamble deals with issues other than taxes.

In the Rule 156 section, for example, officials talk about how to describe the RILA buffer features that may limit holders' account value losses in market downturns.

Highlighting downside protections could be "misleading without qualifying explanations or statements, including the context of the cost or limitation of those protections (e.g., upside limitations," officials write.

Credit: Chris Nicholls/ALM