From the June 2010 issue of Boomer Market Advisor • Subscribe!

June 1, 2010

An Issue of Retirement Product Compensation

An executive at a major distribution company recently told me he doesn't think fee-only financial advisors who recommend immediate annuities should be compensated for the value of the annuity because "they're not managing anything." I not only think this viewpoint is a mistake, it causes advisors to ignore a product that makes sense for clients. I think compensation is justified. Here's why.

Let's start with the assertion that there are clearly some people who should use immediate annuities. We can quibble about how many. I interviewed a number of professors of economics and finance who think many healthy retirees who have less than $5 million of assets should annuitize at least some of their portfolio. At the same time I interviewed a number of financial advisors who think that very few retirees should use immediate annuities. But most think an immediate annuity is appropriate for at least some people. Here is an example of a person that many think an immediate annuity would serve well: a 70-year-old unmarried woman, who is healthy, has longevity in her family, has no children and no bequest motive, is worried about running out of money, is risk intolerant and would appreciate the extra cash flow that an immediate annuity could provide over the return on AAA corporate bonds, money market funds and certificates of deposit.

Let's say that she has $750,000 in assets and her financial advisor recommends that put $75,000 in an immediate annuity. If the advisor is compensated by a percentage of assets under management, the distribution company executive would recommend that the financial advisor's compensation be cut by 10%. I think the advisor should be compensated by a percentage of the present value of the annuity. This is very easy to calculate. In the first year, when the woman is age 70, the value of the lifetime income stream the annuity pays is $75,000, which is what she paid for it. In the second year, the value would be what a 71-year-old woman would pay for that income stream, and so on. The insurance company has these prices. Valuing a guaranteed lifetime income stream is the easy part. Here are three reasons for my thinking the fee-only advisor should get a continuing fee for this immediate annuity.

First, when the advisor placed the woman in the immediate annuity, did his or her workload decrease by 10%? Of course not. There is still a portfolio to manage, and it will still take the same amount of time with the same issues to deal with.

Second, when it comes to compensation, it makes more sense to take a portfolio approach. We tell investors that they should not focus on individual investments, but the entire portfolio. Asset allocation means seeing how the whole fits together. Surely in any particular year there will be "winners" and "losers." We tell investors that the investments that decreased were not necessarily a mistake, and they should look at the performance of the overall portfolio. When we compensate advisors we should also take a portfolio approach.

Third, compensation works best when the interest of the advisor is aligned with the interest of the client. In this case, if the advisor does not get compensated for the immediate annuity sale there is a misalignment. What is good for the client who wants more lifetime cash flow is bad for the advisor who would see his or her compensation come down by 10%. That system is far from ideal. The overwhelming majority of financial advisors want to do what's best for their clients, but forcing advisors to take unfairly reduced compensation clearly makes it harder for some to recommend an immediate annuity.

Immediate annuities provide an income stream that has value for the rest of the person's life. When it is in place the advisor still has a good deal of work to do with the rest of the portfolio, to provide the income, growth and liquidity that the client needs. The work is the same and the compensation should not be cut.

Mathew Greenwald is president of Washington, D.C.-based Mathew Greenwald and Associates.

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