Now that the department of Labor (DOL) fiduciary rule has survived the budget process, virtually assuring its path to adoption in 2016, it is time to give some thought as to what this rule will likely mean for the future design of annuity products.
To predict how annuity products may change going forward, we must first understand that under the proposed DOL fiduciary rule, advisors will have two options for providing individual retirement account (IRA) recommendations.
The choices are…
Option No. 1: Advisor serves as a fiduciary under ERISA.
This option eliminates all conflicts of interest between the client and advisor. For example, commissions will no longer be an acceptable means of compensation. Advisors serving as a fiduciary under ERISA must either charge an hourly rate, a flat fee or a flat percentage of assets under management regardless of the asset class.
It is important to note here that an ERISA fiduciary differs greatly from a fiduciary under the Investment Company Act of 1940 (’40 Act). Since I am not an ERISA attorney, I won’t attempt to explain the differences between the two in their entirety. Ultimately, the key distinction is that the ERISA fiduciary cannot have any conflicts of interest, while a ’40 Act fiduciary has to “pledge” to disclose and manage the conflicts.
Option No. 2: Advisor chooses not to serve as an ERISA fiduciary and elects to work under the Best Interests Contract Exemption instead.
Under this option, the advisor can make IRA recommendations under the Best Interests Contract Exemption (BICE). This exemption is the DOL’s attempt to allow for a compensation model similar to the majority that exist today. The BICE essentially allows for conflicted forms of compensation (i.e., commissions and revenue sharing) as long as the compensation is “reasonable,” adequately disclosed and does not lead to biased recommendations in any way.
The BICE also requires a laundry list of disclosures around compensation and costs. In short, advisors will be required to disclose how much they and their firm will make on each specific recommendation along with the annual costs, in dollars, that will be incurred by the client.
Oh, and one other small detail — the advisor will have to execute a contract with each client, attesting to the fact that any recommendations will not be biased in any way. Any violation of this contract or omission of disclosure requirements of the BICE could lead to a breach of contract claim against the advisor and the firm.
Let’s consider how advisors may respond to these new requirements. The DOL’s most common soundbite regarding this rule is “If your doctor and lawyer must put your best interests first, shouldn’t your financial advisor?” I’ll save my thoughts as to whether or not doctors and lawyers serve as fiduciaries in a manner proposed by the DOL for another column, but here is what I will say: just as doctors order tests in order to reduce their potential liability, advisors will consider potential liability when making recommendations.
While serving as an ERISA fiduciary is the more restrictive of the two options, it is also the clearest as to what is allowed and what is not. I predict that many advisors will take this more conservative route.
The BICE, while allowing advisors to make relatively minimal changes to their existing business model, comes with many uncertainties. Questions such as what is “reasonable” compensation, what fees must be disclosed and how, and what other forms of payment must be disclosed will be debated by every financial institution. I suspect many of the answers to these questions will not be known until the lawsuits are filed after the next bear market.
Now that I have discussed how I see advisors responding to the proposed new DOL rule, let’s turn to the treatment of annuity contracts by advisors in reaction to the rule. Given the relatively long duration an annuity could and should be held, I could make an argument that a 7 percent upfront commission is reasonable.
After all, if the policyholder owns the annuity for 10 years or more, that essentially equates to 0.70 percent per year or less. Over the long run, even a commission of this size could be the cheapest option for the policyholder.