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Annuities: The Other Variable in Abusive Fund Trading

Regulators digging into the widening scandal of abusive trading of mutual funds have turned their attention to variable annuities. And with good reason.

Based on the slew of money moving into and out of dozens of international funds within variable annuity accounts, the arena may have been a gold mine of questionable trading that took money right out of the pockets of long-term annuity investors.

Variable annuities -- a group of investment offerings, typically mutual funds, wrapped inside an insurance contract that guarantees part of the holder's investment -- seem to reside at the opposite end of the investment spectrum from go-go arbitragers and market-timers. The average participant is 65 years old, and 53% of annuity accounts hold less than $100,000, according to the National Association for Variable Annuities, an industry trade group. However, industry participants and watchers say a growing number of institutional clients have jumped into variable annuity contracts in recent years for market-timing purposes, because such contracts allow investors to move freely among funds on a tax-deferred basis.

In recent weeks, the curtain has been getting pulled back on questionable trading activity in funds with variable annuity accounts. Putnam, a unit of Marsh & McLennan (MMC), disclosed that its Variable Trust funds saw some market-timing in December 2002 and January. Meanwhile, the Securities and Exchange Commission sent letters to insurance companies that offer annuities, such as Hartford Life, Lincoln National, John Hancock and TIAA-CREF, asking about their efforts to combat market-timing and late trading. In the chart below, flags some suspicious funds within variable annuities.

The variable annuity industry, which has about $800 billion in assets under management, maintains that market-timing isn't endemic among its offerings compared with the fund industry.

"Market-timing has been around for a while -- as a result, insurance companies have imposed restrictions to curtail it," said Michael DeGeorge, general counsel at the National Association of Variable Annuities. "The industry is on the lookout."

Others disagree. "Market-timing is widely pervasive in variable annuities," said one industry official who said his firm aims to prevent such trading. "It's widely pervasive. If we wanted to, we could do a seven-figure trade every day."

Another official familiar with the industry concurred, saying, "market-timing in variable annuities, especially involving international funds, was probably quite significant."

In a search for potential trading abuses of funds within variable annuities, asked fund-research firm Lipper to run a screen for suspiciously high trading levels. In a screen of nearly 1,000 variable annuity funds, the median redemption rate as a percentage of assets is 29% -- in other words, the average investor holds the fund for more than three years. The 40 funds listed in the chart below had redemption rates as a percentage of assets at least 10 times that amount.

The high level of redemptions shows an enormous amount of money is moving through the variable annuity funds. When the high redemptions are nearly matched by equally high sales -- and in these 40 funds, in which the redemptions as a percentage of sales are all within 15 basis points of 100% or dead even, they are -- it raises a clear flag for abusive trading. It's not a smoking gun, but it is enough to merit closer scrutiny.

Quick-Draw Annuities
The following funds have redemptions as a percentage of sales more than 10 times the average fund in an annuity, raising red flags on abusive trading
Name of Fund Total Net Assets at Year-End 2002 in Millions Redemptions in Millions Redemptions as a Percentage of Year-End Assets Redemptions as a Percentage of Sales
Van Eck Worldwide Insurance Emerging Markets Fund $151.10$4,660.90 3,085%99%
ProFunds Bear 92.32,056.502,22898
SunAmerica International DVSD;11592,902.601,826104
ProFunds Ultra Small-Cap53.8947.51,761104
Alger American Small Cap; O378.93,861.301,019100
Scudder EAFE Equity Index; A (VIT)56.7472.483397
SunAmerica International Growth & Income; 1186.51,509.20809105
Scudder International;A (VAR 1)412.13,274.20795101
Invesco Dynamics (VIF)115.8828.9716100
Janus Aspen International Growth (SVC)3812,520.70662102
ProFunds OTC70.5465.466092
Fidelity Variable Insurance Products (VIP) Overseas; SVS177.61,102.40621102
United Institutional Funds:Emerging Markets Equity;I162.3965.559598
United Institutional Funds: International Magnum68.738355895
Panorama Series Oppenheimer International Growth (NS)62.8345.3550104
Jackson National Series Trust: Putnam International Equity79426.4540102
Franklin Foreign Securities; 2 (VIP)299.31,607.7053794
ING Partners-JP Morgan Fleming International279.51,487.40532102
Travelers Series Trust Lazard International97.9517.6529102
Van Eck Worldwide Insurance Hard Assets Fund97.951452595
AIM (VIF) International Growth; I247.61,290.00521104
ING (INV): International Equity; S140694496101
Janus Aspen Worldwide Growth (SVC)192.4953.349693
Hartford HLS International Opportunities; IA634.83,086.20486106
American Century International (VP)449.42,113.50470106
Valic (CO) (I) International Equity82.2375.645799
Penn Mutual International Equity 56251.8450105
ING (INV) Developing World;S63263417102
Rydex OTC77.4316.5409109
Gartmore Developing Markets; II (VIT)75.2287.8383106
Franklin Developing Markets; 2 X (VIP) 80.930838195
Jackson National Series Trust: Oppenheimer Global Growth50.9187.536898
Janus Aspen International Growth, Institutional6002,159.60360103
SunAmerica Global Equity; 1236.9837.3353114
Putnam (VT) International Equity; IB308.31,082.0035191
Credit Suisse International Focus86.5289.6335115
Mainstay (VP) International Equity; INIT61.8194.831596
ING (INV) AIM CP Mid-cap Growth; S144.6451.3312111
Morgan Stanley European Growth; X193.3599.8310113
Alger American Mid-Cap Growth; O 240.1740.2308101
Note: All funds operate on a calendar-year cycle that ended Dec. 31, 2002, except the SunAmerica funds, whose fiscal year ended Jan. 31, 2003, and the Valic fund, with a May 31, 2003, fiscal-year-end.
Source: Lipper, a Reuters company.

"For this chart to be so dominated by foreign funds, it seems very clear that market-timing is going on," said Russ Kinnel, director of fund research at Morningstar, after seeing the chart. "If there were no timing or stale-price arbitrage, then you would see more domestic stock funds because that's what dominates [variable annuity] sales," said Kinnel, adding, "Some insurance companies aren't serious about stopping market-timing."

International funds constituted 4.4% of variable annuity assets, according to the National Association of Variable Annuities.

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