In November 2015, the Obama administration eliminated and phased out Social Security claiming strategies, calling them unintended loopholes. After Mr. Obama fixed Social Security, our savior of social injustice, along with his administration, he decided to fix the financial industry. The result was the Department of Labor conflict-of-interest rule. This rule created its own unintended consequences, which are not only massive but also extremely intriguing.
First, let me say this: I like the idea of all advisors, even bank tellers, being held to a fiduciary standard. But I don’t agree with the rule the way it’s written. The particulars and the ambiguities of the rule show the DOL’s lack of understanding regarding product distribution channels and its inability to use tangible math (such as reasonable compensation — most advisors think every penny they are paid is reasonable).
Here’s a quick recap of the rule. Since the 1970s, we’ve had what’s called Prohibited Transaction Exemption (PTE) 84-24. This exemption allows fiduciaries to sell commissionable products, such as annuities and mutual funds. The new rule drags fixed index annuities (FIAs) out from under the warm PTE 84-24 umbrella and shoves them into the cold confines of the Best Interest Contract Exemption (BICE) juvenile detention center with variable annuities (VAs) and mutual funds. Proposed rules in 2010 and 2015 showed no indication that this was to come.
The new rule, among other things, limits compensation to what’s reasonable, seeks to eliminate conflicts of interest including trips and rewards, and requires a financial institution to sign as a fiduciary. This is fine and dandy in the VA world, because VAs are primarily sold through broker-dealers who already act as the financial institution between the producer and the insurer. But in the FIA world, often there is no financial institution intermediary. So either insurers, who have tens of thousands of 1099 contract employees must decide to take on the liability of producers they’ve barely trained and often have never met, or the distribution of FIAs must change.
Here’s an easy fix: Require all insurance producers to create a limited liability company and have that LLC apply for an insurance agency license through the state. Then ask the DOL to give insurance agencies an exemption so they can be listed as a financial institution. Voila! There’s now a financial institution between the producer and the insurer. That might work, but there’s a much better way. (We’ll come back to this, I promise.)
The DOL rule will be the death of:
- Variable annuities with an income rider
- Bank CDs with maturities greater than 3 years
- Index annuities provided at point of sale (pay particular attention to this)
The death of CDs
First we’ll do number two. Crap, that’s not what I meant. (Tell me puns aren’t funny!)
If you read through the rule or the many abstracts found online, buried within is the fiduciary regulation of qualified CDs. The banks asked for an exemption and the DOL bluntly said no. Good for you sirs and madams of the DOL.
Imagine the world of CDs going forward — a minimum wage (not to be confused with the Bernie Sandersites’ “working wage”) bank teller will now be held as a fiduciary. Right now this financially illiterate pest spews out bad math faster than Dave Ramsey to convince bank customers to leave their money at the bank in a CD rather than in the financial products you’ve suggested. This will happen no longer my friends. No longer. Now, they’ll be regulated as a fiduciary, and as such, corporate will tell them to no longer give advice. Kudos since they weren’t qualified to give advice anyway.
It doesn’t end there though.
How will a bank justify the lower returns and lower liquidity of a bank CD in comparison to a multi-year guaranteed annuity (MYGA)? Given the relatively few MYGAs with surrender periods less than 3 years, CDs with shorter maturities should survive, but those with a maturity greater than, say, 36 months will become extinct. Only the qualified ones you say. Wrong. Come on. It’s only a matter of time until these rules pervade into the nonqualified investment arena.
The death of FIA distribution
Now onto the death of the current distribution of FIAs. I know, I know. What a travesty for our industry. Or is it? Remember this article is about unintended consequences. The unintended consequence to the FIA market will simplify and purify the product back to how it was initially designed. I’m telling you right now, this is super exciting. If only I could type as fast as I can talk!
When in doubt do what the government does. Just break it up.
First, imagine the mortgage world simplified. (Yes this is about annuities, but stay with me.) Can you imagine if the mortgage world only allowed the sale of 30-year fixed-rate mortgages? Everyone from age 18 to 94 understands a 30-year fixed-rate mortgage. After the loan is placed, the buyer has a mandatory blackout period of 6 months to a year. At this point, the buyer can exchange a 30-year fixed-rate mortgage for any mortgage offered by the lender at the current market rates. No more new underwriting, appraisal or closing costs are required when staying with the same lender.
You may choose to change the mortgage for any number of reasons, but they will be reasons you came up with — reasons you understand. Not reasons only a broker, or better yet a math whiz, can explain. Can you imagine the money the average homeowner would save by eliminating these charges that are only justified by a small interest rate decrease with a breakeven point past the average mortgage holding period? Just as importantly, can you imagine the amount of cost savings the mortgage companies would realize? Right now it’s the same mortgage being sold, re-sold and repackaged. Does this sound like annuities at all?
Moving qualified indexed annuities out from under the protection of PTE 84-24 doesn’t lead to their extinction like some carriers seem to think. In fact, it’s the opposite. With change comes innovation. The answer is in front of us. We can simplify and strengthen. We can increase market share and profitability per dollar deposited.
Indexed annuities generally have both indexing options and a fixed interest rate option. These should be priced without bias, meaning the carrier does not make a larger or smaller spread regardless of the allocation between the different options. Therefore, break the annuity up and it will be regulated as it always has under PTE 84-24.
For example, what if there was a new annuity called the Total Heights Gold Annuity Series (hypothetical title only, not inspired by any actual annuity titles whatsoever, so don’t even try to find three matching annuities from three carriers). Let’s say the series has six indexing annuities and one fixed-rate annuity all on the same 10 year surrender charge schedule. Like the mortgage example, all premiums are first deposited into the simplest option — the fixed-rate annuity. After a blackout period of say 6 months or 1 year, the buyer can choose to exchange any whole percentage amount to any of the 6 indexed annuities available within the Total Heights Gold Annuity Series.
At the point of compensation, the annuity sold is a fixed-rate annuity and is therefore regulated under PTE 84-24. BICE is not applicable. At the point of exchange, there is no additional compensation given to the representative, either directly or indirectly. Given the specific definition of a “recommendation,” this model would greatly reduce if not eliminate the ability for the exchange to qualify under BICE. Most likely, it would fall under the educational carve-out that is no longer referred to as such.
The insurer, however, does make a spread on the general account. Could this be considered compensation and thus the insurer held as a fiduciary? No, the DOL specifically states spreads do not count as compensation defined as a qualifier for BICE. Again, this would limit if not eliminate the DOL’s ability to regulate the sale of a fixed-rate annuity that has the ability to be exchanged for an indexed annuity under BICE.
Clients will bring premium dollars to an insurer for what they know the annuity will at least do (the fixed rate) rather than what some hypothetical backtesting calculator says the annuity might do. The client will always purchase an annuity for a reasonable fixed rate of return, safety of principal and often a guaranteed lifetime income available without requiring annuitization. Isn’t this the way it should’ve been all along?
The client might exchange the annuity for an indexed annuity in the future, but it will be at whatever current market caps are at. Interestingly, there wouldn’t be a need for minimum market caps and insurers could eliminate strategies seldom used, thus reducing internal product costs. This cost savings would lead to greater rates, and upfront bonuses could be better used as an interest enhancement.
Here’s an example. If a current fixed-rate option within an FIA is 1.5 percent, this might be increased to 1.75 percent with the cost savings detailed above. The 8 – 10 percent upfront bonus on a 10-year chassis could be applied over 10 years. This should increase the annual fixed rate by between 0.75 and 1.25 percent due to the spread the insurer on the lower reserve requirement created by not crediting the bonus upfront along with the expected penalty-free withdrawals and/or election of lifetime income benefit rider (LIBR) benefits prior to the 10th year. This additional rate would also be used to bolster caps and spreads. That being said, I think we’d see a cost-neutral new fixed-rate bucket option of 2.5 percent to 3 percent, and caps/spreads increased by 60 to 100 percent.
This annuity would sell, and it would sell for the right reasons. It would fall under PTE 84-24, and it would simplify and purify the reasons people buy annuities to what they were originally intended to be. Annuities should be bought as a source for a reasonable and predictable rate of return, safety of principal and an option for guaranteed annual cash flow.
The death of LIBR attachments
Lastly, what about the death to the LIBR attached to variable annuities? I wonder if anyone still cares at this point, but since you’re still reading I can only assume you do. Under the fiduciary cloak, you will use an annuity for one thing at a time — for growth or for income, but not both. When something, even an annuity, tries to be a jack of all trades, it’s the master of none.
With an annuity needed for growth, a fiduciary will use a low-cost, investment-only variable annuity. Low cost because common sense tells us that fees drag down performance. As a fiduciary, how will you justify a 3 percent annual fee on a growth annuity? You can’t! Typically we get the higher fee from a lot of little fees. But like I told my wife on a vacation once, “Hun, a lot of little bottles equals a big bottle.” Hence the fees add up, and a VA with greater fees has less growth potential than the VA with lower fees ceteris paribus.
Now with an annuity needed for income, a fiduciary will use a fixed or fixed index annuity with a LIBR. Why? With a fixed chassis the insurance company takes less risk. Less risk equals less cost and less cost leads to greater benefits. The fixed chassis often provides greater guaranteed income at a lower guaranteed cost.
Why our industry still rocks
There was a time when our profession was as respected as much as if not more so than any other. We’ve got the most rewarding profession there is. Our profession can be far superior to other professional pathways. For example:
- Doctors — Most of their profession is helping people recover, not prosper. How many people see their doc even when everything’s good? Doctors spend more time dealing with pain and bad news than joy and good news.
- Lawyers — What do attorneys do? They sue people and help people break-up marriages. Simple but true.
- Advisors — We get to help people build wealth so they can someday stop doing the things they dislike and start doing only the things they like. We help people manage the tangible culmination of 40 years, or 80,000 hours, of labor. How cool is that?
We are a profession destined to change and better lives. There’s much to be figured out with the DOL conflict of interest rule, but the unintended consequences are exciting.
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