Commission-free annuities designed for use within fee-based accounts have been available for over a decade. However, the few major distributors trying to make fee-based annuities a significant portion of their total annuity sales have struggled.
Additionally, total sales in this area have languished: In 2016, Morningstar estimates that total fee-based variable annuity sales were only $1.2 billion, slightly more than 1.00% of the total sales.
Despite this track record, the insurance industry introduced almost two dozen fee-based variable and indexed products in the last 12 months. In this column, I’ll explore the challenges facing fee-based annuities in the past decade, why annuity companies are offering more fee-based products, and discuss the future success, or lack thereof, of today's fee-based annuities.
Past & Present Challenges
To understand the challenges facing fee-based annuities, it's important to understand why advisors have shied away from these products to date. First and foremost is the perception of benefit versus cost.
The first generation of fee-based variable annuities typically cost about 0.60% annually. Since they had no surrender charge, the comparable commissionable product would be a C-share, which typically costs about 1.70% by comparison. However, even if you add only a 1.00% asset-based fee, you quickly realize that fee-based annuities are at best a wash in terms of net cost to the client.
With no apparent client cost benefit, the operational challenges the first generation of fee-based annuities faced simply created too great of an obstacle in the eyes of most advisors. Fee-based annuities are not typically incorporated well into the performance systems offered by broker-dealers.
Then, there is that pesky asset-based fee. There's debate around whether the fee should come from the annuity, which can potentially create taxes and negatively affect the living benefit, or from other assets in the fee-based account.
Jefferson National created the road map for the second generation of fee-based variable annuities. Its product has only a $20 monthly fee and no mortality and expense charge. However, the Jefferson National product also had no living benefit and no death benefit.
This lack of benefits and Jefferson National's relatively low ratings limited the product's appeal. Now that Nationwide has purchased Jefferson National, the ratings issue has been solved. In addition, Nationwide's balance sheet and actuarial expertise have allowed Jefferson National to add an optional death benefit to the variable annuity product.
Realizing that cost is now a much bigger factor than ever, other insurance companies are following the Jefferson National model. Jackson National, for example, has introduced a fee-based variable annuity contract that costs just $10 per month with no mortality and expense charge. However, it carries a small three-year surrender charge equal to 2.00% in years one and two and 1.00% in year three.
At first glance, it might seem strange to place a surrender charge on a product that does not pay a commission. After all, the surrender charge is typically designed to recover the commission if the contract is surrendered too soon.
Jackson's explanation is the modest charge allows it to have no mortality or expense charge. Without the surrender charge, its lapse rate assumptions would force them to add a mortality and expense charge.
Given that no one should buy a tax-deferred annuity of any kind if they don't expect to hold it for a number of years, I have no issue with the surrender charge in lieu of the mortality and expense charge. Still, I expect some advisors will object to this out of principle.
Most of the other second generation fee-based variable annuities are being priced at around 0.30% per year with no surrender charges. Eventually, the market will decide which design, if any, is best.
Why Introduce Fee-based Annuities?
Given the challenges discussed in this column, why have annuity companies continued to consider fee-based annuity structures? The “why?” can be answered in three letters — DOL.
While there are many opinions about how best to interpret and implement the Department of Labor Fiduciary rule, almost everyone agrees on one thing — the DOL rule will accelerate the trend of advisors moving from a commission-based model to a fee-based model.
The DOL rule allows financial institutions to continue to recommend commissionable products by using the Best Interest Contract Exemption (BICE); however, the reality is that the BICE will require far more compliance oversight and paperwork than a level-fee model. Annuity companies will have to capitalize on the growing number of fee-based-only advisors as a result of the DOL rule to turn around the current sales slump.
Can Fee-Based Annuities Ever Be Justified?
Many in the industry balk at fee-based annuities because they have trouble justifying the total cost to the client after the advisory fee. Even with lower cost fee-based annuities coming to the market, today they are struggling with a couple of core issues. Can advisors rationalize the cost of the fee-based product plus the advisory fee compared to the traditional commission designs and, given this, how do they minimize conflicts when recommending a commission-based vs. a fee-based solution in efforts to comply with the DOL rule?
I believe this type of thinking suffers from two faulty assumptions. First, the conflict only exists if an advisor can recommend both a fee-based annuity and a commission-based annuity. Advisors offering only a fee-based model are not faced with this conflict. For them, every product they recommend will have the same asset fee.
Therefore, when considering costs, fee-based advisors only need to compare the cost of the fee-based annuity to other possible product solutions. For example, it's not a choice between a fee-based annuity and a commission-based annuity. It's a choice between a mutual fund or bond fund and a fee-based variable or indexed annuity.
Second, those who believe the commissionable annuity net of fees is more cost effective are typically assuming a 1.00%-plus asset fee in their analysis. Technology and fee compression will increasingly make it difficult for advisors to justify a 1.00%-plus fee if all they are doing is managing money.
Utilize a 0.50% fee rather than a 1.00% fee in your cost analysis, and you reach a completely different conclusion. That may not be today's reality, but it very well could be in the not-too-distant future.
Some have also questioned how one can justify an ongoing advisory fee for an annuity. They would argue that a variable annuity with a living benefit typically has such strict investment restrictions that few, if any, subaccount reallocations can be made.
In addition, fixed and indexed annuities are typically buy-and-hold investments with little work to be done until the surrender charge period ends. Given the SEC's increased focus on inactive fee-based accounts, commonly referred to as reverse churning, the concern is justifiable.
However, I believe that the SEC is judging the validity of the fee-based account based on the number of transactions mostly because the industry poorly documents all of the unbillable services that fee-based clients typically receive from an advisor. For instance, it is not uncommon for advisors to assist their clients on the best way to fund a college education, which health care plan to select at work, whether or not the client should take that pension buyout, or even something as simple as buying vs. leasing a car.
As advisors do a better job of documenting these services, I would expect the SEC to focus less and less on the number of actual transactions that occur in a fee-based account. Long story short, considering the likely changes to the annuity industry, I believe advisors and the industry can justify fee-based annuities.
Will the Industry Succeed?
Given the stakes, failure may not be an option for the annuity industry. As the number of fee-based-only advisors rises, an inability to attract those advisors will lead to ever lower sales. At this point, though, I give the industry only a 50/50 chance of success.
I will caveat that estimation by looking at variable annuities vs. fixed and indexed annuities separately. While most of this column focuses on the variable annuity side of the business (because until very recently, fee-based fixed and indexed products were not available), the fixed and indexed annuity companies see the writing on the wall and are now introducing fee-based versions of their products as well.
In my view, the fixed and indexed companies have a huge advantage over the variable annuity companies. When you take the commissions out of a fixed and indexed annuity, all of the commission savings can go into the rates and caps.
If an advisor can sell a 3% fixed annuity, how much easier will it be to sell a 4% fixed annuity? Similarly, how much easier will it be to sell an indexed annuity with a 6% cap rather than a 4.5% cap?
Variable annuity companies have a much greater challenge marketing their value proposition. The only thing they can do is reduce or eliminate the mortality and expense charge.
While this fee reduction is just as beneficial as increasing the rates or caps on fixed and indexed annuities, it is not as transparent as increasing rates or caps. The sad truth is that many clients just don't appreciate fee savings, but all clients recognize the value of an increase in return guarantees.
First, let me say that this is a very hazy crystal ball. Having expressed that disclaimer, I believe that overall industry annuity sales will drop dramatically over the next 12 to 24 months as advisors adjust to the new paradigm.
However, once the adjustment is made, sales of all annuity product types will potentially rise again. With that being said, unless advisors relearn the story of tax-deferred growth, variable annuity sales will probably never return to the record levels of 10 years ago.
The growth will come mostly from fixed and indexed annuity sales as baby boomers become more conservative and seek to minimize taxes. Plus, as those baby boomers continue to march into a retirement in which many are insufficiently prepared, the need for guaranteed lifetime income will be greater than ever.
Even with this strong wind at its back, the industry is faced with a rough road ahead.
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