Part 8, Equity Indexed Annuity Due Diligence and Compensation Practices ("Who Moved My Cheese" Series - The Future of Financial Advice)

[At the risk of insurance company backlash (the last time I wrote about equity-indexed annuities (EIAs), an insurance industry "consultant" made accusations against me, to the President of the college at the time, where I had taken a position), I again offer my observations on equity-indexed annuities. These perspectives are offered from the view of a fiduciary adviser, considering whether EIAs should be recommended to his clients, and applying the heavy due diligence obligations imposed by the fiduciary standard of conduct.]

Equity-indexed annuities (EIAs), also known as fixed indexed annuities, are an investment (and insurance) product that, in my experience, many investment advisers and the clients who purchase them do not fully comprehend. EIAs have been heavily criticized by many advisers (including this author), due in part to the often-high surrender fees (and, hence, commissions) paid upon the sale of this product, the insurance company’s control over the cost structure of the product over time (and hence, the returns the client actually receives), and the misrepresentations often made to clients in connection with their sale – particularly when EIAs are equated to be similar to investing in stock indexes (i.e., the sales pitch: “Participate in the stock market’s upside while escaping its downside.”)

Waiting for the "Good" EIA Product.

Yet, in theory, the concept of EIAs is a good one, if several attributes were to become present.

1. Correct Marketing. The EIA was emphasized as a fixed income alternative (and not as an alternative to stock market investing). This may be a difficult move for insurers to undertake; even in their July 21, 2015 comment letter to the U.S. Dept. of Labor, The Committee of Annuity Insurers noted that the principal guarantee of EIAs “provides assurances against market losses but also access to equity-like return.” Likewise, the Indexed Annuity Leadership Council’s comment letter of July 20, 2015 stated in part: “Fixed annuities offer protection against market loss as the insurance company assumes the market risk.”

2. Financially Strong Issuer. An insurance company with a very high financial strength rating issues the EIA (many of the insurance companies issuing such products today possess relatively low financial strength ratings, leading to an assumption of default risk by the client, even when tempered by state guaranty funds that might be available up to certain limits).

3. Fully Transparent Fees and Costs; Stripped-Down Features. The EIA fully transparent with the expenses associated with the product, providing a reasonable return to the insurance company (similar to the return provided to for-profit mutual funds found in many lower-cost actively managed mutual funds today). In the absence of riders such as a GMWB rider, and with only a small interest rate floor (in the fixed account option of the EIA), the insurance company possesses little exposure to equity or bond market risks in these products. Hence, in theory there is little reason a low-cost EIA could not be constructed, with a fixed return provided to the insurance company (and disclosed to the investor).

It should be noted that all current EIA products I have reviewed appear to cede significant control to the insurance company (which control could be abused) in the setting of caps, participation rates, and spreads; it would be better for the insurance company to state up front the compensation it will receive from the product, and let the remaining returns (whatever they might be, given the index chosen and the amount of funds available to purchase options on such index) flow to the investor.

4. No Sales Load; No Surrender Fees; Always Liquid. The EIA possesses no sales load, and no surrender fee (thereby permitting the investment made in the EIA to remain fully liquid). Unfortunately, most EIA products sold today have a surrender charge period of ten years or less, and a surrender charge of ten percent or less, although some products possess surrender charges of 16% or even higher.

In essence, from the standpoint of a fiduciary, EIAs are a good concept, but one that has to date been poorly executed. In fact, I have yet to meet a fee-only investment adviser who has recommended an EIA to her or his client.

Still, hope remains that better EIA products will emerge, as they do appear to provide an alternative to other fixed income investments, especially in a rising interest rate environment (should such occur) in which significant interest rate risk is present.

(*If you know of a no-load EIA from a financially strong insurer, please drop me a line. There have been recent predictions of the emergence of no-load EIAs, but I have yet to see them from a high-quality insurer.)

Understanding the Fundamentals of EIAs

I recommend several resources to advisers to gain a fundamental understanding of EIAs.

Craig McCann, PhD and Dengpan Luo, PhD, An Overview of Equity-Indexed Annuities (concluding, in part: “Equity-indexed annuities are complicated investments sold to unsophisticated investors without the regulatory safeguards afforded to purchasers of similar investments. If brokers and agents told investors of the effect equity-indexed annuities’ shaving of index returns and extraordinary costs the market for these products would dry up.”

Michael Kitces, The Myth Of “Free” No-Expense Fixed Or EquityIndexed Annuities – Interest Rate Spread Is Still A Cost! (March 18, 2015).

Michael Kitces, Building YourOwn Low-Cost Equity-Indexed Annuity Or Structured Note (June 10, 2015)

Examining “Real-World” Returns of EIAs

Given that EIAs have been in the marketplace since 1995 (i.e., for up to two decades, as of the writing of this post), increased analysis has occurred of the returns of EIAs in the “real world.”

Babbel, David F. and VanderPal, Geoffrey and Marrion, Jack, Real World Index Annuity Returns (December 27, 2010) (The authors note that their analysis is subject to several limitations, including that the historical are derived from 15 carriers that chose to participate and that chose the products for which they reported returns.) Their study was criticized by Robert Huebsher in his article at Advisor Perspectives, “Fantasy-world Returns for Equity Indexed Annuities” (May 31, 2011). Larry Swedroe also discussed the 2010 study, noting: “The fact is that, after analyzing these products, there’s almost always a more efficient way to accomplish an investor’s objective of reducing the risk of large losses. If you’re a risk-averse investor looking to protect yourself against black swans, a more efficient way to do so is through the use of what can be referred to as a low-beta and high-tilt strategy.” Larry Swedroe, Swedroe: Looking Under theAnnuity Hood (Sept. 17, 2014).

Dr. John R. Brock, Equity-Indexed Annuities – Look Before You Leap (2014). (“Using a hypothetical EIA that included representative-to-generous contract provisions, my analysis showed that equity‐indexed annuities do appear to offer the promised reduction in volatility compared with stocks. The real question for potential buyers of these products seems to be whether the reduction in volatility is worth the corresponding price paid in lower returns … As one analyst put it, ‘The upside to an equity-indexed annuity is that there is no downside. The downside to an equity-indexed annuity is that there is very limited upside.”)

A recent article addressing adherence to an insurance agent’s suitability obligations under state insurance regulation, as well as a broker’s suitability obligations under FINRA rules, is:

Lazaro, Christine and Edwards, Benjamin P., Suitability Obligations Applicable to Securities andAnnuities (May 11, 2015), Practicing Law Institute Securities Arbitration, 2015; St. John's Legal Studies Research Paper No. 15-0024. The foregoing article provides a good discussion of the adviser’s obligations under the suitability doctrine (which the SEC has said forms a small part of a fiduciary’s obligations).

Ensuring Client Understanding.

However, I have observed that most purchasers of EIAs gain little understanding of many of the material facts surrounding these products. A fiduciary advisor possessing a conflict of interest relating to the sale of an equity indexed annuity must not only disclose material facts to the client, but must also ensure client understanding of them. These facts might include (but are not limited to) the following:

1) That the EIA imposes a penalty, similar to a surrender charge, for early withdrawals from the annuity, whether any portion of the funds can be withdrawn from the EIA each year without a penalty, the amount of the surrender charge and when it disappears, and that withdrawals from the EIA are best undertaken at particular points during each contract year.

2) That investments in an EIA are not meant for funds that are likely to be utilized by the client to address short-term financial needs.

3) That the dollar value of the annuity shown on the client’s statement is not the “market value” of the annuity as it relates to the client, but rather the “surrender value” (unless these are separately stated and appropriately marked on each statement).

4) That the amount of the credit provided to the client during any period for index returns during each period does not include dividends which would have been received by an index fund tied to that index and which would otherwise have been be reinvested in that index; how the dividend rates for the index have fluctuated over time; the current dividend rate for the index; and if in the future dividend payout rates are higher due to changes in U.S. federal income tax policy, or due to other factors (such as shareholder demand for payment of dividends, versus retention thereof), the percentage of index total returns the client receives could be significantly impaired by the fact of the exclusion of dividends.

5) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by a cap on the index returns; that this cap limits the amount of interest credited to the client’s annuity contract; the current cap and the cap in recent years; whether the insurance company has lowered the cap since the inception of the annuity contract (for any purchaser thereof) and when; and that the insurance company reserves the right to lower such caps, which would negatively affect the client’s returns;

6) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by the participation rate; the current level of the participation rate; the past levels of the participation rate; and that the insurance company reserves the right to lower the participation rate, which would negatively affect the client’s returns.

7) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by is further limited by market value adjustments, which should be able to be described with particularity, and that such market value adjustments may negatively affect the client’s returns;

8) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by is further limited by the imposition (annually) of “administrative charges,” whether the insurance company reserves the right to increase the administrative charges; whether such administrative returns are capped; the current level and historical level of the administrative charges, and that such administrative charges negatively impact the client’s returns;

9) That the funds placed with the insurance company are part of the insurer’s general account and subject to the general claims of the insurance company’s creditors; unlike a mutual fund or variable annuity sub-account your annuity funds are not segregated and therefore the client’s funds are not protected in the event of insolvency of the insurance company; the financial strength ratings of the insurance company including its Comdex score; whether any state guaranty funds exist to safeguard investors and the extent of such guarantees; whether such state guaranty funds would apply should the client’s state of residence be changed; and the fact that state guaranty funds exist at this discretion of the states’ legislatures.

10) The default rate, over the past 10, 20, 30, 40 and 50 years or more, of insurance companies, based upon their initial financial strength rating;

11) That various legislative (tax) and regulatory (fiduciary rule-making by DOL and SEC) proposals exist which, if they were to be enacted, could adversely affect the commercial viability of many life insurance and annuity products, which in turn could significantly impair the ability of many insurance companies to meet their obligations to their present insurance policy holders and annuity contract owners;

12) That for nonqualified EIAs any withdrawals from the annuity of gains within the annuity will be taxed at the client’s ordinary income tax rates, that gains are distributed prior to the return of principal (unless annuitization occurs); that the client will not receive the more favorable long-term capital gain treatment that would have been available through a tax-efficient or tax-managed stock mutual fund; and that no stepped-up basis exists upon the death of the annuitant (and the consequences of same, to heirs);

13) That for EIAs held in IRA accounts, tax deferral is already provided by the IRA account possessed, and hence is not a benefit of this annuity contract; similarly, for EIAs held in Roth IRA accounts, tax-free growth of principal is a feature of the account and not of the annuity contract.

14) That (hypothetical) returns shown for the past 10 years, or 25 years (or some other range, as required by some state laws/regulations) reflect interest rates over that time span. There is no assurance that fixed income yields will be the same in the years ahead. If fixed income yields are lower, the amount of interest available within an equity indexed annuity product to purchase options on indexes would be less, which would likely lower future returns.

One might opine, from reading the foregoing list of facts that a purchasing client should understand, that many clients might be unable to achieve such an understanding of these relatively complex products. In that case, a fiduciary adviser who possess a conflict of interest in connection with the proposed sale would be unable to proceed with its sale, given the requirement of not just disclosure, but also of client understanding. A client who does not understand the product, and the ramifications of the (often multiple) conflicts of interest present in connection with the sale of an EIA, is therefore unable to provide "informed" consent. (Even then, the proposed transaction must remain substantively fair to the client.)

Compensation Practices: Trips, Economic Incentives.

As I have stated in past articles in this "Who Moved My Cheese?" series of articles, fees and costs matter. The higher the fees and costs, the lower the return for investors, on average, for the same products.

The usually-high commissions paid on sales of equity-indexed annuities quickly result in "unreasonable compensation" for larger amounts. For example, a 10% commission on a $50,000 EIA contract, resulting in a $5,000 commission, would likely be considered "unreasonable compensation" in most instances, given the presence of alternative (non-EIA) investment products that pay far lower commissions (such as fixed annuities) and given the time involved in providing service to the client. (As I have stated previously, the receipt of compensation should be timed to the delivery of services; products should not be sold for an up-front commission for an understanding that advice will be provided over several years.)

Allianz Life Insurance Company of North America, which appears to dominate the EIA marketplace with about a 25% market share (in 2014), provides a 6.5% commission on first-year premium contributions to annuities for purchasers age 75 or less on two of its products (as of Jan. 15, 2016). Other EIA products, from other insurers, were available for 3% to 10% commissions, from one insurance broker's listing of available products (as of Jan. 15, 2016). Such EIA products had surrender charges imposed (generally, on a declining scale year-over-year, from 9% to 20% initial year surrender fees), with the surrender period lasting from 5 to 16 years. There exists is substantial economic incentive for an insurance agent to recommend a higher-commission (and higher-surrender fee, generally) EIA over a lower-commission EIA.

Others have observed surrender fees as high as 25%. See, e.g. Lazaro, Christine and Edwards, Benjamin P., The Fragmented Regulation of Investment Advice: A Call for Harmonization (March 3, 2015). Michigan Business and Entrepreneurial Law Review, Vol. 4, No. 1, 2015, at page 129.

Unfortunately, rebating of commissions back to the client remains illegal under state law in every state except California and under certain conditions in Florida. Even in those states, if an insurance agent rebates a commission and he insurance carrier finds out about it, the insurance agent can pretty much count on losing his contract with that carrier.

Many insurance brokers or carriers continue to offer agents trips to industry conferences, such as those held in the Bahamas or near Disney World, if a certain amount of annuity sales are achieved (usually with a particular product or insurer). (See, e.g., Allan S. Roth, The seamy side of annuity sales, MarketWatch, Dec. 22, 2015, available at http://www.marketwatch.com/story/the-seamy-side-of-annuity-sales-2015-12-22.) The receipt of such additional compensation should be prohibited under a fiduciary standard, as an avoidable conflict of interest.

Again, I am hopeful that far better EIA products will be offered in the future. And that state laws against rebating of commissions might be repealed, over time, in reaction to the fiduciary standard's requirement of reasonable compensation, and the need for fiduciaries to agree with the client to such a reasonable amount prior to the making of specific product recommendations.

But, for now, it does not appear than any equity indexed annuity product out there would likely meet the due diligence required of a fiduciary advisor, in this author's view.

NEXT POST: Part 9 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. He has previously taught courses (at another college) in Insurance and Risk Management, Advanced Investments, Employee Benefits Planning, Business Law I and II, and Money & Banking.

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:

• Feb. 24-25, 2016: FPA of Oregon and S.W. Washington Midwinter Conference 2016, where Ron will discuss: "The DOL's Transformational Conflict of Interest Rule"
• Feb. 26, 2016: FPA of Puget Sound's 2016 Annual Symposium, where Ron will discuss: "Reducing Your Risks in the New Fiduciary Era"

Connect with Ron on LinkedIn.

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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.

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.]

THE SCENARIO: RECOMMENDATION OF A VARIABLE ANNUITY WITH NO BREAKPOINT DISCOUNTS

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)
60	3.4%	4.0% to 4.4%	3.9% to 4.2% (depending on age of older spouse)
65	4.4%	4.3% to 4.8%	4.2% to 4.5%
70	4.4%	5.0% to 5.4%	4.6% to 4.9%
75	4.4%	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:

• Feb. 24-25, 2016: FPA of Oregon and S.W. Washington Midwinter Conference 2016, where Ron will discuss: "The DOL's Transformational Conflict of Interest Rule"
• Feb. 26, 2016: FPA of Puget Sound's 2016 Annual Symposium, where Ron will discuss: "Reducing Your Risks in the New Fiduciary Era"

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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.