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Class Action Challenges Propriety of 412(e)(3) Annuities
By Lance Wallach, CLU, CHFC Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness
Call Lance Wallach at (516) 938-5007
Call Lance Wallach at (516) 938-5007
On August 1, 2012, a putative class action lawsuit was filed in the District of Connecticut challenging the propriety of certain insurance contracts used to fund defined benefit plans described in section 412(e)(3) of the Internal Revenue Code. U.S. Telemanagement, Inc. v. Fidelity Security Life Insurance Co. et al., No. 3:12-cv-1110 JBA (D. Conn.).
Because we perceive that the complaint is attacking the appropriateness of the product, as well as the specifics of the product that the named defendant sold, it is a lawsuit that potentially could have industry-wide implications. In addition, as plaintiffs in some of the ERISA revenue-sharing lawsuits have attempted to do, the complaint alleges that the insurance company that sold the annuities acted as an ERISA fiduciary of the plans. This lawsuit thus extends the attack on insurance companies, as seen in the revenue-sharing class actions, that attempts to convert service providers into fiduciaries.
412(e)(3) Plans and Annuities
A 412(e)(3) plan is a tax-qualified, defined benefit pension plan that is funded with either annuities or a combination of annuities and life insurance. These sorts of plans are most often funded through annuities, and those annuities have come to be known as 412(e)(3) annuities, because of the section of the Internal Revenue Code that authorizes this sort of plan. Such 412(e)(3) plans are normally marketed to small businesses as vehicles that can provide large income tax deductions in connection with the establishment or continued funding of a pension plan. The annuities used to fund such a plan often are priced upon low assumed rates of return and other actuarial factors, which means that the employer is required to contribute a larger amount of money up front to fund the plan, and that in turn provides employers with larger tax deductions for their business.
The Lawsuit
The plaintiffs are two small Connecticut businesses that purchased 412(e)(3) annuities from defendant Fidelity Security Life (“FSL”), a Kansas City-based insurance company. Plaintiffs also named as a defendant CJA Associates, Inc., a corporation that is a registered agent of FSL, and is alleged to have promoted the sale of the annuities, and First Actuarial Corporation (“FAC”), a wholly owned subsidiary of CJA that is alleged to have been the sponsor of the plans. In addition, the complaint names an individual who is a registered agent of FSL and is alleged to have served as a tax and investment advisor to the two plaintiff businesses (the complaint also alleges that he was recently indicted by a grand jury for income tax fraud, but does not allege if it was related to his conduct in this case). All of the non-FSL defendants are alleged to have had some role in the sales process.
Both of the plaintiffs purchased 412(e)(3) annuities from FSL, allegedly as part of the promotional efforts of CJA. Plaintiffs allege that one of the two plaintiffs had their income tax deductions associated with the plans disallowed. There are no allegations about the tax treatment of the income tax deductions of the second plaintiff, but we assume from that omission that its tax deductions have not been disallowed or challenged.
Plaintiffs contend that the FSL annuities were inappropriate and unsuitable for defined benefit retirement plans for two main reasons. First, plaintiffs contend that the loads used to pay commissions associated with the annuities -- which they claim amounted to 95% of the first year’s contributions and various percentages later on -- were excessive when compared to other annuity products “readily available in the marketplace that achieved the same goals.” The complaint alleges that two other prominent insurance companies were offering comparable yielding annuities with no upfront loads or fees and had their total commissions built into the structure of the product “within the industry standard of 5-6%.” Second, plaintiffs contend that the principal advantage of the product -- its ability to generate large income tax deductions -- was illusory because the employer’s contributions are excessive in relation to the actual costs of the claimed plan benefits, which means that the tax deductions employers have taken are vulnerable to being disallowed. Plaintiffs point to the fact that one of the plaintiffs’ tax deductions were disallowed as evidence of this point.
The complaint asserts four claims: (1) breach of fiduciary duty under ERISA, (2) breach of ERISA’s co-fiduciary provisions, (3) non-fiduciary liability for knowing participation in a breach, and (4) prohibited transactions under section 406(a)(1)(C), the party-in-interest provisions. These are the same types of claims that we have seen asserted in ERISA revenue-sharing class action complaints against 401(k) plan service providers.
Like the claims in those cases, plaintiffs in this new class action claim that all of the defendants acted as fiduciaries of the two plans in various ways, and that defendants act in a similar fiduciary capacity for all plans in the putative class. Plaintiffs contend that all of the defendants acted as fiduciaries with respect to the conduct at issue because they exercised discretion and control over the plans’ assets, and offered investment advice for a fee with respect to monies of the plans (i.e., under section 3(21)(A)(i) and (ii) of ERISA). With respect to defendant CJA, which also allegedly acted as plan sponsor, plaintiffs also claim that it acted as a fiduciary because it had discretionary authority and responsibility in the administration of the plans (i.e., under section 3(21)(A)(iii) of ERISA).
Plaintiffs are pursuing their claims as a class action, and seek to represent the following class: all investors of employee benefit plan trust money under a CJA or FAC prototype or master employee benefit plan whose plan trust money was invested in FSL’s section 412(e)(3) annuities. The class is defined to exclude any investors who signed agreements to arbitrate any disputes arising from their investments.
Plaintiffs seek unspecified damages, but they ask the Court to presume that, if the investments had not been made in the FSL annuities, the assets would have been invested in the most profitable alternative investments available to them. As is common in ERISA cases, plaintiffs do not allege what more profitable alternative investments were available, aside from other annuities with comparable returns.
Potential Impact of this Case
We see at least three potential impacts from this new case. First, there is a potential that this class action will spawn a new wave of class actions directed at insurance companies that have sold 412(e)(3) annuities. Although plaintiffs nominally contend that the FSL annuities were unsuitable “as structured,” the complaint reads like a general attack on the suitability of such annuities under any circumstance, and a general attack on the insurance companies who acted as service providers with respect to retirement plans that were funded with 412(e)(3) annuities. Thus, as with the revenue-sharing class actions, where plaintiff’s counsel sued most major insurance company service providers, the Fidelity Life class action could be the first among many filed against the insurance industry.
Second, this lawsuit continues the unrelenting efforts by the ERISA class action plaintiffs’ bar to try to transform insurance companies – mere sellers of retirement products and services – into ERISA fiduciaries. We first observed these efforts in earnest in the revenue-sharing class actions we have defended, and this case appears to continue the trend in which plaintiffs attempt to recast ministerial tasks or sales efforts as fiduciary conduct. The rulings in this case could contribute to the developing body of law regarding what activities can cause entities to qualify as ERISA fiduciaries.
Third, this lawsuit could trigger other non-412(e)(3) lawsuits claiming that other life insurance or annuity-based retirement products and services are “too expensive” or “unsuitable” for retirement plans. We have already observed these same sort of efforts in the ERISA stock drop cases we have defended, in which plaintiffs contend that company stock was unsuitable, and more recently, in some of the plan sponsor revenue-sharing cases, in which plaintiffs contend that certain mutual fund offerings used as investment options are too expensive. This lawsuit could cause the ERISA class action plaintiffs’ bar to look for other types of products for which it could pursue similar claims.
The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
ABOUT THE AUTHOR: Lance Wallach
Lance Wallach, CLU, ChFC, CIMC, speaks and writes extensively about financial planning, retirement plans, and tax reduction strategies. He is an American Institute of CPA’s course developer and instructor and has authored numerous best selling books about abusive tax shelters, IRS crackdowns and attacks and other tax matters. He speaks at more than 20 national conventions annually and writes for more than 50 national publications.
Copyright Lance Wallach, CLU, CHFC
More information about Lance Wallach, CLU, CHFC
412(e)(3) Plans and Annuities
A 412(e)(3) plan is a tax-qualified, defined benefit pension plan that is funded with either annuities or a combination of annuities and life insurance. These sorts of plans are most often funded through annuities, and those annuities have come to be known as 412(e)(3) annuities, because of the section of the Internal Revenue Code that authorizes this sort of plan. Such 412(e)(3) plans are normally marketed to small businesses as vehicles that can provide large income tax deductions in connection with the establishment or continued funding of a pension plan. The annuities used to fund such a plan often are priced upon low assumed rates of return and other actuarial factors, which means that the employer is required to contribute a larger amount of money up front to fund the plan, and that in turn provides employers with larger tax deductions for their business.
The Lawsuit
The plaintiffs are two small Connecticut businesses that purchased 412(e)(3) annuities from defendant Fidelity Security Life (“FSL”), a Kansas City-based insurance company. Plaintiffs also named as a defendant CJA Associates, Inc., a corporation that is a registered agent of FSL, and is alleged to have promoted the sale of the annuities, and First Actuarial Corporation (“FAC”), a wholly owned subsidiary of CJA that is alleged to have been the sponsor of the plans. In addition, the complaint names an individual who is a registered agent of FSL and is alleged to have served as a tax and investment advisor to the two plaintiff businesses (the complaint also alleges that he was recently indicted by a grand jury for income tax fraud, but does not allege if it was related to his conduct in this case). All of the non-FSL defendants are alleged to have had some role in the sales process.
Both of the plaintiffs purchased 412(e)(3) annuities from FSL, allegedly as part of the promotional efforts of CJA. Plaintiffs allege that one of the two plaintiffs had their income tax deductions associated with the plans disallowed. There are no allegations about the tax treatment of the income tax deductions of the second plaintiff, but we assume from that omission that its tax deductions have not been disallowed or challenged.
Plaintiffs contend that the FSL annuities were inappropriate and unsuitable for defined benefit retirement plans for two main reasons. First, plaintiffs contend that the loads used to pay commissions associated with the annuities -- which they claim amounted to 95% of the first year’s contributions and various percentages later on -- were excessive when compared to other annuity products “readily available in the marketplace that achieved the same goals.” The complaint alleges that two other prominent insurance companies were offering comparable yielding annuities with no upfront loads or fees and had their total commissions built into the structure of the product “within the industry standard of 5-6%.” Second, plaintiffs contend that the principal advantage of the product -- its ability to generate large income tax deductions -- was illusory because the employer’s contributions are excessive in relation to the actual costs of the claimed plan benefits, which means that the tax deductions employers have taken are vulnerable to being disallowed. Plaintiffs point to the fact that one of the plaintiffs’ tax deductions were disallowed as evidence of this point.
The complaint asserts four claims: (1) breach of fiduciary duty under ERISA, (2) breach of ERISA’s co-fiduciary provisions, (3) non-fiduciary liability for knowing participation in a breach, and (4) prohibited transactions under section 406(a)(1)(C), the party-in-interest provisions. These are the same types of claims that we have seen asserted in ERISA revenue-sharing class action complaints against 401(k) plan service providers.
Like the claims in those cases, plaintiffs in this new class action claim that all of the defendants acted as fiduciaries of the two plans in various ways, and that defendants act in a similar fiduciary capacity for all plans in the putative class. Plaintiffs contend that all of the defendants acted as fiduciaries with respect to the conduct at issue because they exercised discretion and control over the plans’ assets, and offered investment advice for a fee with respect to monies of the plans (i.e., under section 3(21)(A)(i) and (ii) of ERISA). With respect to defendant CJA, which also allegedly acted as plan sponsor, plaintiffs also claim that it acted as a fiduciary because it had discretionary authority and responsibility in the administration of the plans (i.e., under section 3(21)(A)(iii) of ERISA).
Plaintiffs are pursuing their claims as a class action, and seek to represent the following class: all investors of employee benefit plan trust money under a CJA or FAC prototype or master employee benefit plan whose plan trust money was invested in FSL’s section 412(e)(3) annuities. The class is defined to exclude any investors who signed agreements to arbitrate any disputes arising from their investments.
Plaintiffs seek unspecified damages, but they ask the Court to presume that, if the investments had not been made in the FSL annuities, the assets would have been invested in the most profitable alternative investments available to them. As is common in ERISA cases, plaintiffs do not allege what more profitable alternative investments were available, aside from other annuities with comparable returns.
Potential Impact of this Case
We see at least three potential impacts from this new case. First, there is a potential that this class action will spawn a new wave of class actions directed at insurance companies that have sold 412(e)(3) annuities. Although plaintiffs nominally contend that the FSL annuities were unsuitable “as structured,” the complaint reads like a general attack on the suitability of such annuities under any circumstance, and a general attack on the insurance companies who acted as service providers with respect to retirement plans that were funded with 412(e)(3) annuities. Thus, as with the revenue-sharing class actions, where plaintiff’s counsel sued most major insurance company service providers, the Fidelity Life class action could be the first among many filed against the insurance industry.
Second, this lawsuit continues the unrelenting efforts by the ERISA class action plaintiffs’ bar to try to transform insurance companies – mere sellers of retirement products and services – into ERISA fiduciaries. We first observed these efforts in earnest in the revenue-sharing class actions we have defended, and this case appears to continue the trend in which plaintiffs attempt to recast ministerial tasks or sales efforts as fiduciary conduct. The rulings in this case could contribute to the developing body of law regarding what activities can cause entities to qualify as ERISA fiduciaries.
Third, this lawsuit could trigger other non-412(e)(3) lawsuits claiming that other life insurance or annuity-based retirement products and services are “too expensive” or “unsuitable” for retirement plans. We have already observed these same sort of efforts in the ERISA stock drop cases we have defended, in which plaintiffs contend that company stock was unsuitable, and more recently, in some of the plan sponsor revenue-sharing cases, in which plaintiffs contend that certain mutual fund offerings used as investment options are too expensive. This lawsuit could cause the ERISA class action plaintiffs’ bar to look for other types of products for which it could pursue similar claims.
The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
ABOUT THE AUTHOR: Lance Wallach
Lance Wallach, CLU, ChFC, CIMC, speaks and writes extensively about financial planning, retirement plans, and tax reduction strategies. He is an American Institute of CPA’s course developer and instructor and has authored numerous best selling books about abusive tax shelters, IRS crackdowns and attacks and other tax matters. He speaks at more than 20 national conventions annually and writes for more than 50 national publications.
Copyright Lance Wallach, CLU, CHFC
More information about Lance Wallach, CLU, CHFC
While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
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