Now that it has become clear that sales and recommendations with respect to fixed indexed annuity products will cause an advisor to become subject to the final Department of Labor (DOL) fiduciary rule, the real question has shifted to what advisors need to know in order to continue selling these popular products.
Sales of variable annuities may have faltered in recent years, but the popularity of fixed indexed annuity products has actually surged — meaning that many advisors must now turn their focus to determining whether these products are in their clients’ “best interests.” This determination demands a more rigorous investigation and an enhanced understanding of both the annuity contract itself and the individual client’s financial situation and goals.
Because the stakes are higher than ever before with respect to liability risk, the importance of getting it right has correspondingly intensified.
Analyzing the Product
Fixed indexed annuity (FIA) products will now be subject to the best interest contract exemption (BICE) of the DOL final fiduciary rule, meaning that the advisor will be required to act as a fiduciary with respect to recommendations provided in connection with these products. Generally, this requires the advisor to assess the prudence of the particular product so that he or she can understand and provide advice with respect to the terms and risks of the product — which, in the case of FIAs, can be complex.
It will become important for advisors to understand how a client’s participation in investment gains from the index to which the annuity is linked may be limited by spreads or participation caps, and other fees that may be associated with the product. This also includes knowledge of how changes in the relevant index impact the client’s individual account — i.e., how interest is credited to the account value. The method that is in the client’s best interests will depend upon the individual client’s tolerance for risk.
For example, the annual point-to-point method is often popular because of its simplicity. The beginning index value is compared to the ending index value on the FIA contract's (annual) anniversary date, and the percentage of change is calculated. If the ending value is higher, the client generally receives interest, and if it is lower, no interest will be credited. While this method seems simple on the surface, the addition of caps and spreads can complicate matters.
A cap effectively “caps” the client's credited interest at the cap amount (if the index gained 10% and the cap is 6%, then 6% will be credited. But if the gain was 1%, the client would receive the 1% credit because it is less than the cap amount).
A spread is subtracted from the value of the gain — so if the index gained 10% and the spread was 5%, the account would be credited with 5% interest. If the index gained only 1%, no interest would be credited because the spread is greater than the gain. If annual point-to-point with a spread is used, the interest credited can be reduced to zero even if the percentage of change in index value is positive.
This is only one issue that may arise with interest crediting — the advisor will need to investigate potential complications that may arise with the specific method used (and how those complications may impact the client) in order to satisfy his or her obligations.
In addition to understanding index crediting methodology, the DOL has provided specific examples of various aspects of the annuity product that may be important, including (1) surrender charges and fees, (2) the index or indices to which an indexed product is linked, (3) any participation caps, (4) the product’s investment risk, (5) how the interest credited to the product is calculated, (6) any riders that may be added to the product, including those providing for guaranteed income, (7) the insurance carrier’s ability to revise the terms of the product, and (8) additional fees and expenses that may apply.
Compliance With the BICE
Even if the advisor has a thorough understanding of the annuity product and client profile, he or she must generally comply with the best interest contract exemption in order to continue selling FIAs. This generally means that the financial firm must enter into a contract with the client acknowledging that it and the advisor are acting in a fiduciary capacity (i.e., will act in the client’s best interests). Note that the firm itself is party to the contract, and that it assumes liability for the recommendations of advisors.
The exemption also requires that the advisor avoid misleading statements and receive no more than reasonable compensation, which must be disclosed. The advisor is not specifically required to monitor investment performance, but must disclose whether or not investment performance will be monitored and, if it is, how frequently and the reasons why a client will be alerted to any changes in performance.
The firm must also warrant that it has adopted policies and procedures designed to mitigate conflicts, and promise to comply with those polices and procedures.
The introduction of the DOL final fiduciary rule has certainly complicated matters for advisors who sell fixed indexed annuity products. Despite this, a careful investigation of the product features and examination of the client’s risk profile and financial goals can give the savvy financial advisor an edge in continuing to sell these popular products.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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