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May 23, 2016 at 12:35 AM
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.
