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?