The variable annuity has taken its share of hits in recent years, and as the rule currently stands, the product will likely have to evolve once again in order to remain viable if the pending Department of Labor (DOL) fiduciary rule is finalized in its current form.
Traditionally, variable annuities have been sold as a commission-based product and have been exempt from fiduciary standards under the prohibited transaction exemptions. As currently written, the proposed DOL rule would effectively revoke their exemption, making it much more difficult for variable annuities to be sold under the currently existing commission model. Despite this, most industry experts do not expect variable annuities to fade away — instead, advisors will have to look to a different model for selling these potentially valuable products once the DOL rule finally takes its definite shape.
Fee- versus commission-based variable annuities
Generally, a commission-based variable annuity is a product where the fee charged by the advisor varies. A fee-based variable annuity, on the other hand, charges a level asset-based fee that would likely be exempt from compliance with some of the new standards imposed by the proposed DOL fiduciary rule (discussed below).
As a result, many anticipate that, rather than attempting to comply with the strict standards imposed by the pending DOL rule, firms will switch from a widely applicable commission-based model to a fee-based model that charges an asset-based fee. While in some cases this could reduce the overall cost of the product, generally charging an annual fee rather than an upfront commission could still result in a product that costs the same amount over time.
However, it is also possible that many of the currently available riders to annuity products will be eliminated in order to produce a product that charges a lower overall fee, as advisors evaluate whether the lower cost, rider-free product can ultimately serve the same client needs over time.
The best interests contract exemption impact
Essentially, the best interests contract exemption (BICE) in the DOL rule would make it much more difficult for advisors to sell variable annuities as a commission-based product, because these products would impose a fiduciary standard on the advisor. As currently proposed, the fiduciary rule BICE would allow advisors to receive commission-based compensation (as well as certain other forms of compensation) only if the potential conflict presented by the commission is disclosed to the client and several other conditions are satisfied.
Namely, the exemption requires that the advisor, the institution issuing the product and client enter into a contract that clearly commits the advisor to acting in the client’s best interests, using the care, skill and prudence that would be exercised by a prudent person under the circumstances (the definition that generally governs a fiduciary’s duties in other contexts). Further, the institution involved must warrant that it has adopted procedures designed to reduce conflicts of interest.
The contract must clearly disclose any conflicts of interest that do exist, and must give the client instructions as to how he or she can obtain online access to compensation arrangements entered into by the advisor and the institution. The exemption also specifically states that the compensation paid to the advisor be “reasonable.”
Because of the compliance requirements, and the overall difficulty of determining when compensation charged is “reasonable,” it is widely predicted that many firms could choose to modify their practices to avoid becoming subject to the new fiduciary standards.
Although the DOL fiduciary rule has yet to be finalized, it is widely anticipated that some form of the best interests contract exemption will be included in the rule. This means that advisors who sell commission-based products will need to search for new ways to make annuity products available to clients looking to include these tools in their retirement income planning, while at the same time eliminating the risk that they will run afoul of the prohibitions imposed by the new rule.
For more on annuities and the DOL fiduciary rule, see: