NASD Reminds Members of Their Responsibilities Regarding Hypothetical Tax-Deferral Illustrations in Variable Annuity Communications

 

May 10, 2004

 

NASD Rule 2210(d)(1) requires that all member communications with the public provide a sound basis for evaluating the facts regarding a particular security and that they include material disclosures necessary to ensure the communications are fair, balanced, and not misleading. This Alert offers guidelines to assist members in developing compliant illustrations that depict the impact of taxes upon investment returns in a variable annuity as compared to a non-specific taxable account. NASD is concerned that these hypothetical illustrations rely upon assumptions that are not based upon current tax law or other reasonable factors. Members should review their public communications that contain these illustrations to ensure they comply with existing rules and standards.

 

Discussion

 

A variable annuity is an insurance contract that is subject to state insurance laws as well as federal securities laws and rules. Generally, variable annuities have two phases: the “accumulation phase,” when customer contributions are allocated among the underlying investment options, and the “distribution phase,” when the customer withdraws money through various annuity payment options. One of the principal features of variable annuities is the tax-deferred treatment of earnings during the accumulation phase.

 

As part of the marketing process, members often attempt to illustrate the benefits of the tax-deferral feature through a hypothetical comparison of a variable annuity investment to a generic taxable account. Current tax laws provide that earnings from a variable annuity are taxable only upon withdrawal as ordinary income. In contrast, earnings from a taxable account are generally taxed annually and at rates that vary depending upon the nature of the earnings and the individual’s tax bracket. For example, capital gains and dividends may be taxed at different tax rates depending upon various factors, including the individual’s tax bracket.

 

Members need to consider the following factors when preparing hypothetical illustrations that are designed to depict the tax-deferral feature of variable annuities:

  • Members must use identical gross investment rates of return for the hypothetical taxable account and variable annuity. The variable annuity portion of the illustration must reflect the charges associated with the annuity. Alternatively, the disclosure accompanying the illustration must specifically identify the applicable charges, state that the charges have not been reflected in the illustration, and explain that had they been reflected, the return of the variable annuity would be lower.

  • Members must use and identify the actual federal tax rates applied in the hypothetical taxable illustration. The illustration may also reflect an actual state tax rate for communications used in that state only. If federal or state tax rates change, members may need to update their illustrations to be accurate and not misleading.

  • Members should use tax rates that reasonably reflect the tax brackets of the likely recipients of the communication. Members also should consider whether it is reasonable to assume that a customer would remain in the same tax bracket for extended periods of time (e.g., thirty years).

  • Members should disclose that lower maximum tax rates on capital gains and dividends would make the investment return for the taxable investment more favorable, thereby reducing the difference in performance between the accounts shown. Customers should also be advised to consider their personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision as these may further impact the results of the comparison.

Conclusion

 

Member firms should routinely review their marketing communications with a view to ensuring that (1) illustrations designed to show the comparative tax benefits of variable annuities are based upon tax rate and investment return assumptions that are consistent, fair and reasonable at all times while the communication is in use, and (2) the tax rate assumptions in such illustrations are accurate in all respects as of both the date the material is prepared and throughout the period during which the material is in use. Such illustrations must also fully and fairly disclose all underlying assumptions as well as the fact that changes in tax rates and tax treatment of investment earnings may impact the comparative results.

 

Any questions regarding this Alert may be directed to the Advertising Regulation Department at (240) 386-4500.