The annuity industry is at a crossroads. LIMRA recently reported that first-quarter 2016 variable annuity sales were $26.6 billion, down 18% from the previous year. Early indications suggest that variable annuity sales have dropped at least another 10% or so in the second quarter. In fact, LIMRA is estimating that variable annuity sales will be off 15–20% in 2016 compared with 2015 and then another 25–30% in 2017.
In contrast, LIMRA reported that first-quarter sales of indexed annuities were up 35% to $15.7 billion, making them the growth engine for the industry. LIMRA reported that all of the top 10 indexed annuity carriers saw sales increases during the first quarter.
Yet in April, the Department of Labor (DOL) threw a giant roadblock in the way of the indexed annuity sales train. Much to the industry's surprise, the DOL's final fiduciary rule moved indexed annuities out of the less onerous fiduciary standard required by exemption 84-24 and into the new Best Interest Contract Exemption (BICE) along with variable annuities and other commissionable securities products. Many in the industry are of the opinion that the decline in variable annuity sales is mostly due to advisors’ uncertainty about the DOL rule. If that is indeed the case, then one must wonder if indexed annuity sales will soon suffer the same fate.
Personally, I’m not convinced that the drop in variable annuity sales is solely, or even mostly, due to the DOL rule. The fact of the matter is that variable annuity sales have been in a steady decline since 2011. Lessons learned during the 2007–09 financial crises, along with persistently low interest rates, have forced variable annuity companies to steadily scale back many of the overly generous living and death benefit features found in the contracts at the beginning of this decade.
On top of this, some companies chose to further reduce their exposure to the risk associated with both existing and new living benefits by offering buyouts, prohibiting additional deposits, eliminating popular investment options and/or requiring volatility management programs (which have generally performed poorly) on many of the remaining investment options. All of these changes precipitated the long sales decline. The DOL rule simply provided the knockout punch. How much further variable annuity sales will fall once the DOL rule goes into effect is anyone's guess.
Many variable annuity companies initially decided to either double down on their indexed annuity business or enter the business for the first time so as to stay competitive in the annuity space while still adhering to the DOL requirements. The companies that already focus on indexed annuities also thought their future was very bright. While exemption 84-24 also requires a best interest standard for IRA recommendations, it does not require an actual contract and has significantly fewer disclosures than the BICE. The prevailing view was that 84-24 would require few, if any, changes in indexed annuity sales practices. While I would've debated that view, the DOL's final rule made it a moot point.
So what happens now? In theory, the BICE allows advisors and their financial institution to maintain their current business model. As long as the financial institution executes the required contract, sets up the appropriate supervisory procedures and provides the necessary disclosures, products need not change in terms of features, costs or commissions. But let me stress again that this is likely only true in theory.
I think Michael Kitces of the Pinnacle Advisory Group (and holder of almost every financial designation on the planet) summed it up best in his April 11, 2016, post on the DOL rule when he wrote: “Financial services … companies claimed that they can offer … commission-based, and sometimes even proprietary products to consumers, while also receiving revenue-sharing agreements, and simultaneously still act in the client's best interests as a fiduciary. And so the Department of Labor's response became: ‘Fine. If and when consumers disagree, you’ll have a chance to prove it to the judge when the time comes.’”
The important thing to understand is that, while the BICE allows advisors and firms to continue to receive differential compensation, the greater the degree of differential compensation, the greater the challenge to prove the compensation had no impact on your recommendation. Therefore, the natural reaction will be to minimize the differential compensation. That means commissions across products may, over time, move to a narrower, and likely lower band. This could occur not only within the same asset class, but across asset classes as well.
With this as a backdrop, I offer the following predictions when it comes to how annuities are designed and distributed in a post-DOL fiduciary world:
Annuity commissions will come down across the board. ERISA expects compensation to be in line with common industry practices. Therefore, as long as any products you currently recommend do not pay you more than what is typical within the industry, you would meet this test. In addition, the industry could certainly make the case that given how long a client is expected to hold an individual annuity, current commission structures cost clients less per year than many other products. But will financial institutions take the chance that this argument will meet the prudent man standards? If even just a few financial institutions elect not to take the chance and therefore require that the products be redesigned in order to reduce the compensation, all of a sudden the other financial institutions may find that their compensation is no longer in line with common industry practices. And now that indexed annuities must fall under the BICE, they will experience the same commission pressure.
Surrender charges will serve a different purpose in annuity product design. Today, surrender charges mostly serve as a means for an insurance company to recover the commission it fronted if the client surrenders the contract in the early years of the contract. Once commissions come down, this will become far less important. Surrender charges will likely serve the purpose of impacting client pricing in much the same way the length of a bond maturity does. If the client is willing to accept a higher and/or longer surrender charge, then that client will get a higher expected return in the form of a better interest rate on a fixed annuity, higher caps on an indexed annuity and lower annual policy fees on a variable annuity.
Within five years, product manufacturers will no longer pay commissions on packaged products — including annuities. When a client buys an individual security, it is the broker-dealer that prices in the commission. Yet when that same client buys a packaged product such as a mutual fund or annuity, it is the product manufacturer that prices in and pays the commission to the broker-dealer. This structure is much less transparent to the client, and if there is one thing regulators don't like, it is a lack of transparency.
Eventually, the industry will realize that it is far easier to control the potential legal liability if the distributor is the one that controls the compensation. If the product manufacturer is relieved of the responsibility of determining the appropriate commission, the distributor can add in whatever commission it deems appropriate. This would lead to two beneficial changes. First, the manufacturer could offer the same product in both a fee-based account or a commission-based account. The distributor would simply add in a commission if it was sold in a commission-based account and refrain from doing so if it was sold in an advisory account. Second, product manufacturers could no long compete based on commissions. Their sole differentiation would be the product and service they offer.
Most annuity independent marketing organizations (IMOs) as they are currently structured will cease to exist. By moving indexed annuities out of 84-24 and into the BICE, the DOL may have mortally wounded the IMO business model. In the final rule, the BICE must be between the client and the financial institution. Under the rule, unless the IMO has its own broker-dealer or RIA, it does not qualify as a financial institution; therefore it cannot execute the required contract (not that they would have probably been willing to do so anyway).
That means the insurance company would have to be willing to stand in as the financial institution and take on the fiduciary responsibility for all of the individual insurance agents that currently sell its indexed annuities. It's inconceivable to me that any insurance company will elect to take on this function for a group of agents over which they have little, if any, control. IMOs could elect to simply work in the nonqualified space, but that leaves them out of at least half of the indexed annuity market. Some indexed annuity carriers have already stated that they will develop fixed annuities with living benefits and attempt to utilize that as the preferred IRA option. However, I believe it is naive to think that commission compression on variable and indexed annuities won't eventually also impact fixed annuities even though they can be sold under 84-24.
For years, annuity critics have claimed that most annuities are recommended mostly because of the “high” commissions on the product. No matter where you stand on this issue, one thing is very clear: we’re about to find out how true it is. Given that a reduction in commissions rarely leads to an increase in sales, it's logical to assume that sales will indeed come down, but not for the reasons people may think.
Over the years, distributors and manufacturers alike have developed extensive supervisory procedures to ensure that the annuity recommendation was not a result of the commission. Any advisor that sells annuities can attest to the fact that the required documentation and paperwork to sell an annuity, especially a 1035 exchange, far exceeds the requirements to sell a mutual fund or CD. If annuity commissions come down relative to other packaged products, and the required procedures do not change to reflect that, advisors will sell considerably fewer annuities.
On the other hand, a reduction of surrender charges and fees due to the reduction of commissions will make the products more attractive relative to those other alternatives. And, one hopes, insurance companies will use this opportunity to change the horrible term “surrender charge” to something that sounds a lot less painful (no one likes a “charge” and no one likes to “surrender”).
Finally, despite the increase in indexed annuity sales by banks and broker-dealers, about 60% of total indexed annuity sales are through independent insurance agents, many of which are served by IMOs. Roughly half of that business is done within IRAs. There is no question that much of that business will come to a grinding halt come April 10 of next year.
When I put all of this together and look in my very hazy crystal ball, I would not be surprised to see an initial 50% decrease in both variable and indexed annuity sales by this time next year. Fixed annuity sales will probably increase by about 50% as independent insurance agents use this product as an indexed annuity replacement.
Eventually, I see indexed annuity sales recovering as advisors see the benefits of better client pricing. indexed annuities are already frequently used as an alternative to other fixed income investments. As indexed annuity pricing improves, this will occur more. However, it will take a number of years for banks and broker-dealers to grow sales sufficiently to make up for the inevitable drop in sales from the independent insurance agent side of the business. One thing is very sure. When LIMRA lists the top 10 sellers of annuities two years from today, the list is going to look very different.
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