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,

TheStreet.com

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,

TheStreet.com

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.

312

"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.

There are a few important points and caveats to make regarding the chart. The screen unearths only red flags on abusive trading -- not smoking guns. Also, annual redemption figures aren't as granular as day-to-day trading data, which might more clearly reveal time-zone arbitrage or other improper trading activity.

Also, some industry officials and watchers said the data shouldn't be given too much importance. "Is it a 'sky is falling' situation? I don't think so," said Paul Huey-Burns, former assistant enforcement director of the SEC, who recently joined law firm Dechert LLP as a partner. "I don't want to minimize it, but we need to be careful that the anecdotal evidence that we're seeing doesn't cause a groundswell that undermines all the good that funds and annuities have done for people."

Nonetheless, "usually the best indicator of market-timing is watching the money coming in and going out," said the variable annuity official.

Of the 40 variable annuity funds on the list, 32 are focused on overseas investing -- including the Putnam VT International Equity fund, which the firm has acknowledged saw market timing in December 2002 and January. Of the remaining seven funds, four are offered by Rydex and ProFunds, two fund firms whose

raison d'etre

is allowing investors to market-time, so regulators have no truck with them -- and it is telling that their funds aimed at rapid-fire trading still don't top the list.

Among the other four, two funds are from

Fred Alger

, which has been a focus of the late-trading investigation by Spitzer's office, and one comes from

Invesco

, whose parent company may face impending securities fraud charges by Spitzer.

The last is the

Van Eck Worldwide Insurance Hard Assets

fund, a natural-resources fund from a small New York mutual and hedge fund firm whose

Emerging Markets

fund ranks at the top of the redemptions list -- the $4.66 billion in redemptions were more than 30 times greater than the fund's $151.1 million in net assets. Officials at Van Eck, a New York-based asset manager, didn't return calls for comment.

In total, the "red flag" funds on the chart housed $7.1 billion in assets at the end of 2002, and had $43.5 billion in redemptions during 2002. The $7.1 billion constitutes less than 1% of the $795.5 billion in assets under management in variable annuities in 2002 -- and it's highly unlikely that all the money in these funds would be "market timing" money. However, 80 other funds within variable annuities -- with combined assets of more than $20 billion -- had redemptions as a percentage of net assets in excess of 100%, according to Lipper. And three-quarters of those funds had redemptions as a percentage of sales within 20 basis points of an even 100%.

Unlike a

recent screen

TheStreet.com

ran to unearth red flags at certain mutual funds, searching for potential improper trading in funds within variable annuity accounts isn't as simple as naming the specific funds. Why? It has partly to do with the nature of variable annuities.

Exploring the Variables

Simply put, variable annuities have more tentacles then the average mutual fund. Variable annuities are typically offered by insurance companies such as

AIG

(AIG) - Get Report

and Dutch-based

ING

(ING) - Get Report

-- although they are also sold through a variety of channels, including brokers such as

J.P. Morgan

(JPM) - Get Report

and banks such as

Wachovia

(WB) - Get Report

.

The insurer or other annuity provider offers an insurance contract to the annuity holder, but the underlying investment options are often not the insurer's products. (Of course, the lines are getting blurred, as

Vanguard

,

T. Rowe Price

(TROW) - Get Report

and other investment firms get into the variable annuity business and insurers increasingly offer in-house funds.)

So, for instance, noticing the three

Janus

(JNS)

Aspen offerings on the red flag list doesn't necessarily mean that Janus -- which has acknowledged having market-timing arrangements in its funds, confirming allegations first made by Spitzer -- had anything to do with the frequent trading activity in the Janus

Aspen Worldwide Growth

fund or the two share classes of

Janus Aspen International Growth

. Indeed, a Janus spokesperson said earlier this week that the firm's "12 discretionary arrangements" with market-timers didn't involve variable annuity accounts.

The question then becomes: Which insurers offer these Janus Aspen funds? At least 10, according to

Barron's

Web site, which lists variable annuity accounts and the funds within them -- among them offerings from

Conseco

(CNO) - Get Report

, ING,

Lincoln

,

MassMutual

, and

Citigroup's

(C) - Get Report

Travelers.

Therefore, in such instances, it's difficult to pinpoint where the abusive trading may be taking place within the various annuity accounts -- only Janus and the various annuity providers know where the money originates and the trading activity, and efforts to obtain further information from Janus and several variable annuity providers were unsuccessful. However, all of the owners of the funds suffer from the excessive trading -- even if they own them through another variable annuity.

In other instances, determining where potential international market-timing of funds was taking place was less onerous. For instance, the

Panorama Series Trust Oppenheimer International Growth fund

, which had $62.8 million in net assets and $345.3 million in redemptions, is sold exclusively in MassMutual variable annuities as part of the privately held insurer's Panorama funds.

Certain MassMutual variable annuities also included other funds that turned up on the red flag list, including the Janus Aspen Worldwide Growth fund and the

Scudder EAFE Equity Index

fund. MassMutual was provided with the data and a list of questions about its annuity business, but didn't return calls for comment.

Several other insurers and fund firms were provided with the relevant data and asked to comment. A spokeswoman for Hartford, whose

Hartford HLF International Opportunities

fund turns up on the list and whose annuities include a handful of the funds on the list, declined to comment specifically on the data. However, the spokeswoman, Cynthia Michener, said the nation's largest variable annuity provider has taken "increasingly tough measures to deter market-timing, including the recent introduction of fair valuation in an effort to take away the incentive to trade abusively in international funds."

Officials at ING were provided with the data on the four ING funds that turn up on the red flag list as well as questions regarding the Security Life of Denver's Estate Designer variable annuity, which counts

seven red flag funds among its 25 offerings. The spokeswoman declined to comment on the specific question but said it's the firm's "policy to discourage inappropriate market-timing activity."

A spokesman for Invesco parent Amvescap declined to comment. Attempts to reach Fidelity early Friday morning weren't immediately successful, but in the firm's prospectus for its VIP funds, which are used by several annuity providers, Fidelity said the fund "does not permit market timing because short-term or other excessive trading into or out of the fund may harm performance," adding, "the fund may reject any purchase orders that, in FMR's opinion, may be disruptive to the fund."

A spokesman with Jackson National Life said the insurer identified certain variable annuity subaccounts with unusually high redemption rates and the firm's board of trustees "immediately began discussions around Fair Value Pricing procedures."

By early 2003, the procedures were established and the funds in question saw substantial drops in redemption rates to below the industry average. "Jackson National Life is committed to protecting the best interests of all its customers and the financial professionals who do business with the company," spokesman Tim Padot said.

While it isn't yet clear whether some insurers, like the mutual funds in the Canary Capital scandal, deliberately set up proprietary relationships with a select few clients that undermined the rest of their annuity holders, it is clear that some unwitting variable annuity providers may have been caught prepared to respond to the improper market-timers within their funds.

"My firm has practices in place, such as software, to sniff market-timing out -- we will politely but firmly put an end to it," said one official in the variable annuity business. "But insurance companies are historically technically ignorant; they haven't invested in the systems to combat it."

The investigations into the variable annuity industry are just gearing up, and it's difficult to say exactly how extensive improper trading may be. Other questions await answers as well.

Were any abusive traders in annuity accounts ever aided by certain providers via special arrangements, or was the abusive trading merely a case of certain parties taking advantage of the structure of annuities while insurers were a bit slow on the uptake about their real intent? Did variable annuity providers uniformly apply their market-timing restrictions?

Is late trading -- the clearly illegal practice involving executing fund trades after the 4 p.m. close but getting the same-day fund price instead of the next day's in violation of forward-pricing rules -- an issue?

Were brokers, trading-platform providers or any other intermediaries involved in abusive trading "under the radar" of insurers and fund firms? And, lastly, why didn't the onerous surrender charges and other fees associated with variable annuities keep abusive traders out?

Morningstar's Kinnel has an answer for the last question. "If you trade to your heart's content for a year or two, then take the money out after getting a 40% return, those withdrawals don't seem so onerous," he said.

While the other questions surely will be debated by regulators and the industry itself in the coming months, one thing is already clear: The industry is no longer the same. The variable annuity industry "has been somewhat behind the mutual fund industry in terms of awareness of market patterns and trading patterns," said Dechert's Huey-Burns. "People have thought of these as retirement products. As a result, the variable annuity industry has been a little bit slow to the table -- but the learning curve is increasing rapidly."