Tuesday, January 5, 2016

Part 7: VAs: Due Diligence; Breakpoint Discounts ("Who Moved My Cheese?" Series)

This is part of a series of blog posts, "The Future of Financial Advice - 'Who Moved My Cheese'?" Different scenarios are posed, for discussion of whether, and how, financial advisors might comply with the fiduciary standard of conduct, applying primarily either ERISA's strict guidelines, the proposed "Best Interests Contract Exemption" under ERISA, or state common law (as influenced by SEC rules and/or enforcement or lack thereof).

For an introduction to all of these scenarios, discussing generally the requirements of the fiduciary duty of loyalty,  please first view Post 5 in this series. For a discussion of the negative impact of higher investment product fees on investor returns, please view Post 3 in this series.

[PLEASE NOTE: The mention of any particular mutual fund, fund underwriter, broker, or investment adviser does not constitute an endorsement by this author of such fund or firm, and is only utilized as a means of illustrating the concepts herein.]


Knowing that "breakpoint discounts" would be applied to the sale of a $500,000 mutual fund to a client, substantially reducing the commission paid on a Class A mutual fund share, a dual registrant recommends, instead, a variable annuity to the client that does not provide breakpoint discounts Does this recommendation meet the fiduciary's duties to the client?

Overview of Variable Annuities, and their Inherent Complexity.

There are many types of annuities, but perhaps there is no type more complex than variable annuities.

First, let's try to define a few different types of annuities.

A "non-qualified annuity" does not include qualified investments, such as a traditional IRA or a 403(b) retirement plan account. A "qualified annuity" is, essentially, a "group annuity" in a 403(b) account, or an "individual tax-sheltered annuity" for a traditional IRA account.

Either way, think of a variable annuity as an "insurance contract" wrapped around a collection of mutual funds (technically not mutual funds, but "separate accounts"), and often including a "fixed income account" as well. For ease of understanding, think of a group of 20-40 (or possibly many more) mutual funds being available inside the "insurance wrapper" of an annuity contract.

Annuities may be "deferred" - which means that the values accumulate within the annuity until the accumulated value is  ithdrawn, or they may be "immediate." An "immediate annuity" is like a pension check, paid out annually, quarterly, or monthly, for either a person's life, over two lives (two who are married to each other), a term certain (such as 10 years, or 20 years), or some combination of the foregoing (such as "lifetime annuity with a 10-year certain."

At times a previously "deferred" annuity is later "annuitized" - i.e., it is turned into an immediate annuity.

For purposes of this discussion, we will assume we are dealing with "deferred" "variable" annuities.

Our discussion includes "qualified annuities" (IRA-type annuities) (resulting from a rollover of a 401(k) plan, other qualified retirement plan account, or traditional IRA account, into the annuity). Our discussion also includes "nonqualified annuities" in which after-tax funds (i.e., money not held in an IRA account or qualified retirement plan account, generally) are used to purchase the variable annuity. (For ease of discussion, we won't discuss annuities for Roth IRA or Roth qualified plan funds.)

Confused yet? Most consumers are completely lost by this point. But that's just the beginning of the complexity. Because many variable annuities have all kinds of "bells" and "whistles" - in which additional "benefits" are provided, for a cost. And some of these "bells" or "whistles" come in the form of "guarantees."

There are many different types of "guarantees" - and tremendous differences in the costs ("mortality charges," generally) paid for such guarantees. Think of the "mortality charge" as the "cost of insurance" for any "guarantee" that is provided. Sometimes the "guarantee" is pretty straightforward, such as: "If you put in $1,000, this variable annuity will pay out at least the amount you put in - $1,000 - at the time of your death (less any withdrawals made by you during your lifetime), even if the market value of the mutual funds (technically, variable annuity sub-accounts) goes down between the purchase date and the date of your death." At other times the "guarantee" is more complicated, such as "this insurance company guarantees that, upon annuitization of this annuity, your 'annuitization value' will have grown by 4% a year, at a minimum, provided that you have done certain things, such as holding the annuity for a certain time period, or investing in a more limited range of funds within the variable annuity."

Other types of guarantees might provide that the annuity owner will be provided with a monthly income stream of a certain minimum amount, if the owner "annuitizes" the annuity at some point in the future. The amount of the income stream is what is "guaranteed," although the formula to determine that base amount to which annuitization is applied can be quite complicated, as can the formulas utilized to determine the cost of providing such a guarantee.

Since different insurance companies often use different terms to describe certain types of "guarantees" or other features of variable annuities, and different formulas are utilized to determine the amount of certain "guarantees" or other benefits offered by particular annuity, and different formulas are used to determine the cost of those guarantees, the complexity of analyzing (and understanding) annuities can be daunting for consumers, as well as advisers. In fact, I've never met a consumer who fully understood how the guarantees in her or his variable annuity really worked. And, as an adviser, and even though I am also trained as an attorney, it can take me many, many hours to fully understand variable annuity contracts, the first time I review them.

For a more detailed, but still general, discussion of variable annuities and their features, see this FINRA Investor Alert. Also see this explanation from the SEC.

No-Load (No-Commission) Variable Annuities vs. Commissioned Variable Annuities

There are several insurance companies that sell "no-load" (no-commission) variable annuities that possess relatively low "mortality charges." Companies that market lower-cost annuities include (but are not limited to) Vanguard, Fidelity, TIAA-CREF, and Jefferson National.

Other insurance companies sell their variable annuities through registered representatives ("brokers," also called "stockbrokers") of broker-dealer firms. (Such representatives must also possess a life/annuity state license, in addition to a Series 6 or 7 securities license.) In such cases, most variable annuities carry a commission, or sales load. The commission is paid upon the sale of the variable annuity, in most cases, and a "deferred contingent sales charge" (DCSC) is assessed should the owner the annuity surrender it within a certain period of time. In essence, the DCSC recoups, for the insurance company, the commissions it paid upon the sale of the annuity.

Commissions paid on the sale of variable annuities by brokers vary. For variable annuities which are most similar to "A" shares of mutual funds, commissions of 6-7% are common, although commissions can be higher (10% in some cases) or lower (3-4% in some cases). Unlike mutual funds, most variable annuities sold by brokers today don't possess "breakpoint discounts." (See discussion of breakpoint discounts in Part 6.) On top of the commission paid, brokers may also receive (for some annuities) ongoing compensation for the sale of this types of variable annuity class, such as 0.25% a year (or greater).

Other "no-load" (no-commission) variable annuities, with higher annual "mortality expenses" exist. These function very much like Class C shares of mutual funds. Generally, the broker gets paid a higher annual fee (sometimes called a "trail") in such instances, often 1% or so.

There are many, many variations to the foregoing types of compensation arrangements, and fee/cost structures.

The Fiduciary Duty Problems Presented by a Variable Annuity with No Breakpoint Discounts

Obviously, a huge conflict of interest is present when a broker has the option to sell a variable annuity, without breakpoint discounts, than a mutual fund which possesses breakpoint discounts. This is especially true for investors making higher cash investments, such as $100,000, $250,000, $500,000, $1,000,000, or more, where breakpoint discounts on mutual fund sales substantially reduce the amount of commissions the broker receives. The broker possesses a substantial economic incentive to favor the sale of the variable annuity without breakpoint discounts over the sale of a mutual fund (or several funds within the same mutual fund complex).

How can the fiduciary duties of a financial adviser be fulfilled, in this instance? The best way is for the broker to agree with the client, in advance of ANY recommendation, on the level of compensation to be provided, with the broker's services detailed. For example, if a client is undertaking an IRA rollover, and desires to invest $500,000, the broker might execute a contract with the client stating: "For my services in selecting investments for your IRA rollover, my fee will be $______, or less." In the client services agreement, the fiduciary adviser should state whether he or she is receiving any ongoing compensation, and what services are to be offered in connection with such compensation."

Even then, is the fee to be paid "reasonable." If the only service provided is selecting a variable annuity (and sub-accounts within same), explaining it, and doing the paperwork for it, and if the amount invested is, for example, $500,000, and the commission paid upon its sale is 5%, then a $25,000 fee for a transaction of this kind would likely be unreasonable compensation.

One might seek to argue that the commission on the sale of a variable annuity pays for ongoing services of an advisory nature (and the "trailing fees" paid by many variable annuities also may compensate, at least in part, for such ongoing advice). However, what if the client expects to receive several years of advisory services for the commission paid, but then the client terminates the advisory relationship. In such instance, to avoid a breach of fiduciary obligations in the nature of a prohibited "termination fee," and to ensure that only reasonable compensation is paid, part of the commission should be rebated to the client. Yet, many states prohibit the rebating of commissions on variable annuity sales, by statute.

The best solution is for the financial adviser to be paid directly by the client, for the adviser to eschew all third-party compensation, and for the financial adviser to shop the more limited universe of no-load variable annuities, in those (possibly few, as will be discussed below) situations where the use of a variable annuity is indicated.

The Compliance / Examination / Liability Risks of Variable Annuities.
An executive at a large broker-dealer firm recently told me that he had yet to see one of his brokers win an arbitration case involving a variable annuity. Why?
   INVESTOR'S ATTORNEY: "Mr. Broker, please turn to page 243 of the prospectus for this variable annuity."
   BROKER: "O.k."
   INVESTOR'S ATTORNEY: "Now, Mr. Broker, please explain what this section means."

Since the broker nearly always can't explain the terms of the annuity prospectus, the broker nearly always loses these cases in arbitration.
In other words, if you can't explain all of the features of a variable annuity, and the terms of the variable annuity contract, you are unlikely to win an arbitration case. And yet, I have personally seen many, many financial advisers who sell these products without understanding them.

In 2015 FINRA set forth its examination priorities, which included this paragraph: "FINRA's focus on sales practice issues with variable annuities—both new purchases and 1035 exchanges—will include assessments of compensation structures that may improperly incent the sale of variable annuities, the suitability of recommendations, statements made by registered representatives about these products and the adequacy of disclosures made about material features of variable annuities. FINRA examiners will also focus on the design and implementation of procedures and training by compliance and supervisory personnel to test the level of brokers' and supervisors' product knowledge, to prevent and detect problematic sales practices in variable annuities and to assess compliance with requirements that firms file retail communications concerning variable annuities with FINRA within 10 business days of first use. FINRA will particularly focus on the sale and marketing of "L share" annuities as these shares typically have shorter surrender periods, but higher costs." [Emphasis added.]

FINRA also promulgated Rule 2330(b), setting forth specific responsibilities broker-dealer firms and their registered representatives possess in connection with the recommendation and sale of variable annuities: "No member or person associated with a member shall recommend to any customer the purchase or exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe that the transaction is suitable in accordance with NASD Rule 2310 and, in particular, that there is a reasonable basis to believe that :

  • the customer has been informed, in general terms, of various features of deferred variable annuities, such as the potential surrender period and surrender charge; potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of 59½; mortality and expense fees; investment advisory fees; potential charges for and features of riders; the insurance and investment components of deferred variable annuities; and market risk;
  • the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization, or a death or living benefit; and
  • the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable (and, in the case of an exchange, the transaction as a whole also is suitable) for the particular customer based on the information required by the provisions of this Rule; and
  • in the case of an exchange of a deferred variable annuity, the exchange also is consistent with the suitability determination required by paragraph this rule, taking into consideration whether (i) the customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), or be subject to increased fees or charges (such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements); (ii) the customer would benefit from product enhancements and improvements; and (iii) the customer has had another deferred variable annuity exchange within the preceding 36 months.
  • Prior to recommending the purchase or exchange of a deferred variable annuity, a member or person associated with a member shall make reasonable efforts to obtain, at a minimum, information concerning the customer's age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the deferred variable annuity, investment time horizon, existing assets (including investment and life insurance holdings), liquidity needs, liquid net worth, risk tolerance, tax status, and such other information used or considered to be reasonable by the member or person associated with the member in making recommendations to customers." [Emphasis added.]
Undertaking Due Diligence, as a Fiduciary, on Variable Annuities.

Generally, as seen above, FINRA requires that the variable annuity recommendation be "suitable" and that the variable annuity recommendation possesses some benefits for the customer.

But a financial adviser working under the much higher fiduciary standard of conduct is required to do much more. Rather than just evaluate only the benefits of the annuity, the fiduciary adviser must also undertake due diligence to confirm that the costs of the variable annuity product are justified by the benefits present. This is a much more detailed, and stringent, cost-benefit analysis.

A place to start with a cost-benefit analysis is this series of questions, from the SEC, designed to provide guidance to customers of broker-dealer firms: "Before you decide to buy a variable annuity, consider the following questions:

  • Will you use the variable annuity primarily to save for retirement or a similar long-term goal?
  • Are you investing in the variable annuity through a retirement plan or IRA (which would mean that you are not receiving any additional tax-deferral benefit from the variable annuity)?
  • Are you willing to take the risk that your account value may decrease if the underlying mutual fund investment options perform badly?
  • Do you understand the features of the variable annuity?
  • Do you understand all of the fees and expenses that the variable annuity charges?
  • Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges if you have to withdraw money?
  • If a variable annuity offers a bonus credit, will the bonus outweigh any higher fees and charges that the product may charge?
  • Are there features of the variable annuity, such as long-term care insurance, that you could purchase more cheaply separately?
  • Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?"

But much more extensive due diligence is required. I suggest the following criteria be examined (and this list is not exhaustive). In my view, a fiduciary financial adviser should be able to comprehend, and be able to effectively explain to the client in a manner which ensures client understanding, many concepts relating to variable annuity products, including but not limited to the following:

1)     there is no tax advantage for holding a variable annuity in a traditional IRA, Roth IRA, 401(k), or other qualified retirement plan;

2)     the client should normally not purchase a variable annuity with funds that the client will likely need for current (or near-term) expenses;

3)     that withdrawals from the annuity before the client attains age 59-1/2 may be subject to a 10% federal penalty tax [and ways to avoid such penalty, such as 72(t) elections, rollovers to qualified retirement plans possessing age 55 withdrawal rights without penalty, etc.];

4)     the computational methods utilized in determining any guaranteed amounts which might be available either upon the death of the annuitant(s) or upon annuitization, and the nature of each guarantee and any limitations on when the guaranteed amounts are secured;

5)     the annuity’s various fees and expenses, including but not limited to annual mortality and expense charges (and whether fees/costs vary), annual administration expenses, contingent deferred sales charges, expenses associated with any riders (enhanced death benefit, GMWB, etc.) provided under the contract, the annual expenses of the variable annuity’s sub-accounts, and their composition, including management fees, administration fees, and 12b-1 fees; the brokerage commissions paid (due to transactions occurring within the funds) by any subaccounts recommended to the client, as a percentage of the average net asset value of the subaccount, and whether such brokerage commissions are paid to the insurance company or its affiliates and/or to any firm associated with the investment adviser or affiliates of such firm, and whether such brokerage commissions include any soft dollar compensation; securities lending revenue obtained by such subaccount and the extent to which the gross security lending revenue is shared with the investment adviser or any other service provider and whether such service providers are affiliated with the insurance company or the investment adviser’s firm or any of their affiliates; additional transaction and opportunity costs resulting from securities trading within the fund, the subaccount’s annual turnover rate (computed as the average of sales and purchases within the fund divided by average net asset value of the fund); the percentage of cash holdings of the subaccount over time and the likely resulting opportunity costs arising therefrom;

6)     the financial strength of the insurance company and the importance of such financial strength, especially during a period of annuization;

7)     the rate of return of the variable annuity’s fixed account, the exposure of fixed account assets to the claims of the general creditors of an insurance company upon default; whether state guaranty funds likely protect against a default by the insurance company and if so to which extent; whether different annuities should be purchased – from different companies – to better protect against the risks of insurance company default; the likelihood of insurance company default on a historical basis given the starting financial strength of the company as measured by the various rating agencies; the Comdex score for the insurance company;

8)     the impact of fees and costs of the variable annuity contract on the account value of the variable annuity, and the availability of and any limitations on the various guarantees offered by the insurance company either as a core of the policy or as a rider;

9)     an estimate of the likely long-term rate of return of the variable annuity contract, as structured by the investment adviser, versus the likely long-term rate of return of alternative investment strategies and alternate products (including alternate variable annuity products), and an estimate of the likelihood that the protected value of the annuity will be higher than the returns of non-guaranteed products, over various time periods;

10)   the annuitization rates offered under the annuity contract, whether those rates are guaranteed, how these rates may change over time, how these rates compare to similar single premium lifetime annuity rates in the marketplace, and the negative or positive effective rate of return the client(s) will receive during the annuitization period assuming death of the client(s) occur at various ages.

11)   any options existing for spousal lifetime annuitization and/or term certain, or any combination thereof, and how these options should be considered given the medical history of the clients and their family members;

12)   whether, during annuitization, the client would be better served by annuitization of a portion of the client’s portfolio, whether an annual inflation increase would better serve the client in terms of providing needed lifetime income, whether there exist optimal ages or times (from the date of purchase of the annuity contract) to consider undertaking annuitization, and whether a ladder of annuitized investments undertaken over time, at various ages, would better serve the client;

13)   for nonqualified annuities: the taxation of withdrawals from the annuity contact, the lack of long-term capital gain treatment, the lack of stepped-up basis upon the death of the account holder(s), and the withdrawals mandated by heirs of the annuitant(s) and the combined estate tax / federal income tax / state income tax consequences of income in respect of a decedent; and how withdrawals from such nonqualified annuity contract might be undertaken to take advantage of any lower marginal income tax brackets (both during lifetime of the annuitants, and as to beneficiaries); and the impact of withdrawals on related income tax planning issues for a client including taxation of social security retirement benefits, the amount of Medicare premiums paid, and alternative minimum tax computations; and the taxation of principle and income upon annuitization of the nonqualified variable annuity contract; the lack of foreign tax credit availability to the client when foreign stock funds are utilized as subaccounts of the variable annuity;

14)   the impact of any cash withdrawals upon any guarantees or features of the variable annuity contract;

15)   the various risks attendant to the investments in any fixed income account or the subaccounts in the variable annuity; and

16)   the understanding that higher cost investments nearly always result in lower returns for investors over the long term, relative to lower cost investments that are substantially similar in composition and risk exposures.

An Illustration of a Cost-Benefit Analysis for a Broker-Sold Variable Annuity.

I have seen the sales of variable annuities by many agents/registered representatives who fail to understand the product itself – its fees, costs, potential benefits, and limitations.
For example, a common broker-sold variable annuity contract I encounter contains a guaranteed minimum withdrawal benefit rider. With this rider, the annual expenses of the annuity range from 3% to 4%, and perhaps higher.
These costs were broken down as follows, for the series of the variable annuity that does not possess an up-front and substantial commission (paid via a deferred contingent sales charge, or DCSC). A product that lacks a DCSC is more appropriate for a fiduciary advisor, given the requirement of reasonable compensation):
1.80%: Annual mortality & expense charges (decreases to 1.3% after 9 years)
0.15%: Annual administration charge  
1.10%:  Annual expense percentage for the spousal highest daily lifetime income rider, a very popular feature when this annuity is sold. Since this charge is assessed on the greater of the actual account value or the “protected withdrawal value,” when the actual account value falls below the protected withdrawal value the effective annual expense percentage would be greater than 1.1%. Additionally, the insurance company can raise this annual charge to as high as 2.0% a year.

0.79% to 1.59%: The annual expense ratios for the funds are: 0.79%, 0.85%, 0.87%, 0.88%, 0.92%, 0.91%, 0.92%, 0.94%, 0.94%, 0.95%, 0.99% 1.02%, 1.03%, 1.05%, 1.07%, 1.11%, 1.12%, 1.14%, 1.21%, 1.46%, and 1.59%. These fund annual expense ratios assume the spousal highest daily lifetime income rider is chosen, as noted above. When the rider is chosen, the fund selection is limited by the terms of the contract; 10% must be allocated to the fixed income account and the remaining 90% must be allocated to the insurance company’s selected mutual funds, rather than the much larger universe of funds permitted under the annuity contract if no lifetime income rider is chosen. The interest rate on the fixed income account is determined by the insurance company each year, based upon several factors, including the returns of the insurance company’s general account. Each optional living benefit also requires the contract owner’s participation in a predetermined mathematical formula that may transfer the account value between the VA’s permitted sub-accounts and a proprietary bond fund. It is assumed that the insurance company generates revenue for itself on its fixed income account equal to the lowest annual expense ratio of the available sub-accounts, for purposes of this analysis. Most of these funds are “funds of funds” and include balanced funds (with equity and fixed income allocations) or tactical asset allocation strategies.

0.20%: Each mutual fund (i.e., sub-account) pays brokerage commissions (for certain stock trades) and principal mark-ups and mark-downs for bond trades. In addition, stock trades incur other transaction costs in the form of bid-ask spreads, market impact, and opportunity costs due to delayed or cancelled trades. In addition, fees are paid to an affiliate of the fund out of a portion of any securities lending revenue. In addition, cash held by a fund results in a different kind of opportunity cost. There is no method to accurately discern the impact of these “hidden” fees and charges and costs, from publicly available information. However, it is likely that these fees and charges and costs vary from a low of perhaps 0.2% to a high of 1.0% (or even higher). For purposes of this analysis, it is assumed that these fees and charges amount to only 0.2%.

---- Some states and some municipalities charge premium taxes or similar taxes on annuities. The amount of tax will vary from jurisdiction to jurisdiction and is subject to change. The current highest charge (Nevada) is 3.5% of the premiums paid. Often this premium tax, if assessed, is deducted by the insurance company from the premium payment. However, for purposes of this analysis it is assumed that there is no premium tax assessed.         
Given the limited asset allocation choices that are mandated by the insurance company if the spousal lifetime benefit rider is chosen, it is likely that the gross returns (before any fees and expenses) within the variable annuity would average 7.5% annually, over the very long term, based upon long-term historical average returns of the asset classes included in such funds. Yet, after deduction of fees of 4% (or greater) (decreased to 3.5% or greater after the first 9 years), the net return to the investor is likely to be only 3.5% over the long term, and perhaps even less. However, for the first ten years of the annuity contract, the annuity contract offers a “roll-up rate” of 5% (compounded) for the “protected value” – the value if annuitization takes place. However, this 5% roll-up rate is terminated if lifetime annuitization takes place during the first ten years.
While the annuity offers a “guarantee” in the sense that, if lifetime annuitization is elected at a future date, the highest daily value of the annuity will be used when applying the annuitization rate, it is obvious that, given the high fees and costs of this variable annuity it is highly unlikely that the variable annuity will reach a high principal value over the long term. There simply exist too much extraction of rents – fees and costs – for the sea encompassed within this variable annuity to ever reach a good “high water mark” in most long-term market environments. In fact, over a period of 20 years or longer, there is only a very small probability that the variable annuity value, against which lifetime annuitization is based, will exceed the rates of return on a balanced portfolio of low-cost stock and bond funds (even assuming investment advisory fees and fund fees for such a balanced portfolio totaling 1% a year). Hence, for longer-term investors, the “guarantee” is often illusory.

Additionally, the annuitization rate offered by the insurance company is quite low, compared to the rates for immediate fixed income annuities from insurance companies with excellent financial strength on the marketplace today. This is true even though annuitization rates offered today are quite low, relative to those historically offered, due to the low interest rate environment of today. Here’s a comparison:
Age of Younger Spouse
The Annuity Reviewed Above: Spousal (100%) Lifetime Annuitization Rates
(Per Prospectus Supplement dated July 15, 2015)
Comparable Single Premium Immediate Annuities:
 Spousal (100%) Lifetime Annuitization Rate (per January 2015 survey by www.annuityshopper.com)
ACGA Suggested Charitable Gift Annuity Rates – Spousal (100%) (as of April 2015)
4.0% to 4.4%
3.9% to 4.2% (depending on age of older spouse)
4.3% to 4.8%
4.2% to 4.5%
5.0% to 5.4%
4.6% to 4.9%
5.9% to 6.3%
5.0% to 5.6%
As seen in the table above, the client would typically be far better off shopping for a single premium immediate annuity in the marketplace. Even purchasing a charitable gift annuity, in which the American Council on Gift Annuities targets a residuum (the amount realized by the charity upon termination of an annuity) of 50% of the original contribution for the gift annuity, would usually be better. And, as noted above, if annuitization is to occur in the future, it is highly likely that today’s extremely low interest rate environment would moderate, resulting in even higher annuitization rates at that time.
Given this substantial limitations of this variable annuity product, it is difficult to see how any fiduciary investment adviser who, after performing due diligence on variable annuities such as this one, would recommend it to a client with a long-term investment time horizon. Other investment strategies and solutions exist which are highly likely to generate outcomes much more favorable to the client over the client’s lifetime.
Even more rare is the client who understands the variable annuity he or she has purchased. In fact, for broker-sold variable annuities, in all my years of practice I never met a client who, having already been sold a variable annuity with these or similar features, came close to fully understanding the features of the variable annuity, and the often-illusory nature of the “guarantee” provided. Most clients assume that the guaranteed value will be available if the full amount is withdrawn in full; hardly any clients realize that the variable annuity must be annuitized, over lifetime, at a relatively low annuitization rate. And none of the clients I met understood the high level of fees and charges assessed against the annuity account value (or, worse yet, assessed against the higher protected value, leading to higher costs).

Concluding Observations.

Not all variable annuities are poor products.

Yet, many broker-sold variable annuities possess extraordinarily high total fees and costs, of an ongoing nature, which results in a "failed" grade during a fiduciary's cost-benefit analysis. It is commonly said that variable annuities of this nature are "sold" and not "purchased," for a knowledgeable purchaser would hardly ever seriously consider many of the broker-sold variable annuities in the marketplace today, given the extremely high fees and costs of such products which render the "guarantees" largely illusory.

However, "no-load" variable annuities are becoming more popular. More and more insurance companies are designing new, lower-cost variable annuity products for the fiduciary adviser marketplace. Yet, when guarantees are offered, insurance companies must accurately price the costs (and risks) of these guarantees; given the inherent uncertainty of the future volatility and returns in the capital markets and - as a result - the risks assumed by the insurance company in terms of payouts on these guarantees, the costs of variable annuity guarantees that provide any significant benefit will likely remain high.

Even for lower total-fee-and-cost variable annuity products, the complicated nature of variable annuity products requires the financial adviser to undertake a significant investment to understand all of a product's features, benefits, limitations, and costs. And, even then, some clients may not be able to understand the salient features of the variable annuity correctly (which, in a fiduciary context, would rule out the ability to recommend the product). If short, if you as a fiduciary financial adviser don't understand the variable annuity and its features and costs thoroughly, and if you cannot achieve client understanding of the core attributes of the variable annuity product, then don't recommend it.

Variable annuity products possess a place in the financial adviser's toolbox. But it is likely, after a complete fiduciary due diligence process is undertaken, that even lower-cost variable annuities should be utilized far less often than is currently seen. The cost-benefit analysis for clients simply fails, the majority of the time, when considering other investment strategy and investment products that are available in today's vast marketplace.

NEXT POST: Part 8 of "'Who Moved My Cheese': The Future of Financial Advice."

Ron A. Rhoades, JD, CFP® is the Program Director for the Financial Planning Program and an Asst. Professor of Finance at Western Kentucky University, at its beautiful main campus in Bowling Green, KY. He is a CFP certificant, a regional board member of NAPFA, a consultant to the Garrett Planning Network, and a member of the Steering Group for The Committee for the Fiduciary Standard. Ron previously served as Reporter for the Financial Planning Standards of Conduct Task Force and Fiduciary Task Force. An estate planning and tax attorney (Florida), and a fee-only investment adviser, Ron provides instruction to highly motivated students at Western Kentucky University in courses such as the Personal Financial Planning Capstone, Applied Investments, Estate Planning, and Retirement Planning.

This blog represents Ron's personal views and is not necessarily indicative of the views of any institution, organization or firm with whom he may be associated.

Ron is scheduled to provide two presentations in early 2016 on the DOL's rules and the general impact of the fiduciary standard on the financial services industry:
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Public comments to this blog are welcome, provided that no advertising occurs and that decorum is maintained. To reach Professor Rhoades directly, please e-mail him at: Ron.Rhoades@WKU.edu. Thank you.

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