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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 - Get Report), 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 92.3 2,056.50 2,228 98
SunAmerica International DVSD;1 159 2,902.60 1,826 104
ProFunds Ultra Small-Cap 53.8 947.5 1,761 104
Alger American Small Cap; O 378.9 3,861.30 1,019 100
Scudder EAFE Equity Index; A (VIT) 56.7 472.4 833 97
SunAmerica International Growth & Income; 1 186.5 1,509.20 809 105
Scudder International;A (VAR 1) 412.1 3,274.20 795 101
Invesco Dynamics (VIF) 115.8 828.9 716 100
Janus Aspen International Growth (SVC) 381 2,520.70 662 102
ProFunds OTC 70.5 465.4 660 92
Fidelity Variable Insurance Products (VIP) Overseas; SVS 177.6 1,102.40 621 102
United Institutional Funds:Emerging Markets Equity;I 162.3 965.5 595 98
United Institutional Funds: International Magnum 68.7 383 558 95
Panorama Series Oppenheimer International Growth (NS) 62.8 345.3 550 104
Jackson National Series Trust: Putnam International Equity 79 426.4 540 102
Franklin Foreign Securities; 2 (VIP) 299.3 1,607.70 537 94
ING Partners-JP Morgan Fleming International 279.5 1,487.40 532 102
Travelers Series Trust Lazard International 97.9 517.6 529 102
Van Eck Worldwide Insurance Hard Assets Fund 97.9 514 525 95
AIM (VIF) International Growth; I 247.6 1,290.00 521 104
ING (INV): International Equity; S 140 694 496 101
Janus Aspen Worldwide Growth (SVC) 192.4 953.3 496 93
Hartford HLS International Opportunities; IA 634.8 3,086.20 486 106
American Century International (VP) 449.4 2,113.50 470 106
Valic (CO) (I) International Equity 82.2 375.6 457 99
Penn Mutual International Equity 56 251.8 450 105
ING (INV) Developing World;S 63 263 417 102
Rydex OTC 77.4 316.5 409 109
Gartmore Developing Markets; II (VIT) 75.2 287.8 383 106
Franklin Developing Markets; 2 X (VIP) 80.9 308 381 95
Jackson National Series Trust: Oppenheimer Global Growth 50.9 187.5 368 98
Janus Aspen International Growth, Institutional 600 2,159.60 360 103
SunAmerica Global Equity; 1 236.9 837.3 353 114
Putnam (VT) International Equity; IB 308.3 1,082.00 351 91
Credit Suisse International Focus 86.5 289.6 335 115
Mainstay (VP) International Equity; INIT 61.8 194.8 315 96
ING (INV) AIM CP Mid-cap Growth; S 144.6 451.3 312 111
Morgan Stanley European Growth; X 193.3 599.8 310 113
Alger American Mid-Cap Growth; O 240.1 740.2 308 101
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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