Tuesday, September 29, 2015

Variable Annuities under the DOL's Proposed Fiduciary Requirements: Is Your Due Diligence Sufficient?

As a professor teaching undergraduate classes in both insurance and investments, I have often reviewed variable annuity contracts with my students. Different contracts often use different terminology for the same concepts. The array of available riders and choices inside a variable annuity also contribute to their complexity. As a result, much time is spent analyzing different variable annuity contracts, in order to secure for the students an appropriate foundation for the analyses they will undertake in the future.
What I have also seen is the sale of variable annuities by many insurance 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. This is broken down as follows, for the series of the variable annuity which does not possess an up-front and substantial commission (paid via a deferred contingent sales charge, or DCSC):
   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. 
   0.2% 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 estimate 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 asset allocation dictated by the insurance company if the spousal lifetime benefit rider is chosen, it is likely that the gross returns (before any fees and expenses) 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% (or lower) over the long term, and may be much less. However, for the first ten years of the annuity contract, it offers a “roll-up rate” of 5% (compounded) for the “protected value” – the value if annuitization takes place; 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. 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 additional limitation on 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, the higher protected value, as to some of the percentage fees charged).
It is the obligation of the fiduciary investment adviser to understand the product he or she is selling, and to fully explain all material aspects of the contract to the client. Hence, I suggest that the U.S. Department of Labor, in its issuing release, remind investment advisers of their fiduciary obligation of due care when dealing with variable annuities. The investment 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 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.

Monday, September 28, 2015

Should the DOL's "Education Exemption" Sunset?

Broker-Dealers' Proposal to Expand the Carve-Out for Investment Education to Include Recommendations of Specific Investment Alternatives Impermissibly Creates a Loophole, and Would Not Meet ERISA’s Standards for the Grant of Exemptive Relief.

Advice, whether it is provided to one person, to a small group, or to a large group, is advice.
Advice is advice. It does matter if it is given in-person, over the phone, in a one-on-one conversation, in a group setting, by e-mail, by facsimile, by computer program, by video, or by any other means.
Under ERISA, the provision of advice is a fiduciary act.
Under the DOL’s Conflict of Interest rule proposal and PTE proposals, the use of asset allocation models that identify specific investment products (i.e., funds) would not be treated as non-fiduciary investment education. This appears entirely proper. Advice is advice, even when delivered in group “educational” settings. Substance trumps form.
Yet, some of the comment letters submitted by broker-dealer firms seek a grand expansion of the education advice exemption, even to situations in which very specific recommendations on investment products is provided.
Given the extension of the definition of “fiduciary” under the DOL’s proposed “Conflicts of Interest” rule, there appears to be no need to any exemption for investment education. Education should be provided by fiduciaries.
The “education exemption” was initiated to provide for consumer education at a time when most “retirement plan consultants” were not fiduciaries. The purpose of the exemption was to encourage education of a general nature.
Yet, with the DOL’s extension of the definition of fiduciary to encompass nearly all who provide advice to plan sponsors and plan participants, one must ask - why is there a need for the education exemption at all? Why wouldn’t you hold a fiduciary to a plan sponsor responsible for education provided to plan participants, especially if that advice touches on important subjects such as asset allocation?
I would urge the DOL to sunset the education exemption, perhaps after a period of one year.
It is simply no longer necessary.
Recommendations of specific securities clearly are investment advice. Any ability by a non-fiduciary advisor to undertake specific security recommendations would create a giant loophole, which over time would swallow up ERISA’s important fiduciary protections.
Should the DOL amend its proposed PTE to provide that specific investment recommendations could be made to plan participants on specific investments, in group educational sessions, the result will be the delivery of investment advice by brokers and insurance agents almost exclusively under this arrangement.
The non-application of fiduciary standards to the delivery of specific investment recommendations is, simply put, nonsensical - which the DOL has recognized in its most recent proposals.
Accordingly, any expansion of the education exemption would not be protective of plan beneficiaries, nor in their interests, and hence would fail to satisfy the requirements for the grant of exemptive relief.
Substantial abuse which could take place if specific investment advice, including specific advice on which investment products to choose to implement a client’s investment plan, were permitted to occur in group “educational” sessions.

There is no longer any need for the education exemption. Those who provide education to plan participants, including advice on asset allocation (perhaps the most important decision an individual faces in terms of designing an investment policy), should be held to a fiduciary standard with respect to such advice.

At the minimum, any BD's proposal to expand the proposed PTE to encompass the recommendation of specific products would create a giant loophole, into which non-fiduciaries would jump wholeheartedly. And, the plan participants would, unfortunately, follow them into this non-fiduciary black hole of conflicted advice delivered under the meaningless (from the standpoint of consumer protections) standard of suitability.

Sunday, September 27, 2015

DOL Conflicts of Interest Rule: Great for Small Investors ... and the U.S. Economy!

The Landscape Today
    Today, most small investors' primary retirement savings are undertaken in defined contribution (DC) accounts.
    Most small investors don't seek out investment advice, because they don't trust financial advisors.
    Most small investors receive educational presentations from non-fiduciary DC plan "consultants" - but because providing specific investment recommendations would trigger fiduciary status they leave such presentations with two thoughts: "I really don't understand what was said" and "what do I do now."
    Most small investors do not receive investment advice from non-fiduciaries currently they either do not meet the non-fiduciaries minimum investment requirements, or they are steered into the highest commission or highest fee products (good for the seller, not for the investor).
    When smaller investors do receive investment advice, which is most commonly associated at the time of a rollover to an IRA, current pitfalls include:
  Such advice does not address whether an IRA rollover is appropriate (versus staying in the DC plan, which could be more appropriate due to differences in conditions for early withdrawals, loan features, better investment options, etc.).
  Is usually limited to which investments to buy, and does not address many of the tax considerations present (such as planning options around company stock, Roth IRA conversions, tax-efficient portfolio design and/or drawdown strategies, coordination with decisions on when to take social security retirement benefits, annuitization of all or a portion of plan assets, etc.). In fact, most brokers, insurance agents and dual registrants disclaim the provision of this all-important financial and tax advice, often leading to irreparable harm.
  Most of the larger Wall Street broker-dealer firms don't serve small investors - they don't compensate registered representatives on any clients who possess less than $100,000 - $250,000 of investment assets.
  20% to 40% of the returns of the capital markets are diverted through costly intermediation - the sale of highly expensive products. The academic research is clear: higher fees and costs result in lower returns.
  Most Americans are sold produces, and dont receive objective investment advice. As a result, most Americans don't invest well, thereby accumulating far less than they need for a secure and comfortable retirement.
  Excessive financialization of the U.S. economy results in decrease of U.S. GDP by 2% per year (Wall Street is a macro-economic problem of the first order. (Forbes, 5/31/2015, citing NY Times article IMF Staff Discussion Note: Rethinking Financial Deepening, May 2015).
  Lower GDP growth and individuals ill-prepared for retirement increases burdens on federal, state and local governments to provide for needs of the elderly.

How the DOL Rule Will Change the Landscape
    DC plan advisors, as fiduciaries, can innovate and provide what plan participants need and want: cost-effective, specific investment recommendations in group presentations.
    DC plan participants receive objective, comprehensive, expert advice regarding the IRA rollover decision.
    The movement toward fiduciary investment advice and away from product sales accelerates, following trends already seen in the marketplace over the last decade or longer.
   Increased competition among fiduciary advisors occurs, placing further downward pressure on fees for investment advice.
   Low-cost, fiduciary financial and investment advice, already available to small investors through independent fee-only advisors, becomes far more widespread.
    As more fiduciary advisors act as purchaser's representatives, more asset management firms (who provide mutual funds, ETFs, REITs, annuities, and other investments at far less cost. Controlling investors fees and costs is part of their fiduciary duty.
   Total fees and costs relating to financial and investment advice fall dramatically.
    Increased use of technology leads to innovation in advisory firms and better, and low-fee solutions for all individual investors.
    As majority of advisers become "trustworthy'" the demand for financial advice soars - leading to much better individual decisions on saving, smart expenditure planning, taking advantage of tax-saving opportunities, and better investment advice.
    Americans save, plan and invest far better for retirement and other needs.
    Far greater capital accumulation provide the fuel for innovations to be developed and deployed, super-charging U.S. economic growth - and enabling federal debt to be addressed quicker and better (leading to lower future interest rates, even better economic growth).
    As many more Americans become prosperous, government funding of needs declines, leading to lower income tax rates and less pressure to cut benefits.
    An increased number of college graduates entering into the financial services profession results - these grads desire to provide expert advice, not sell products.

    Plan sponsors (employers both large and small), who currently are often sued for being steered into choosing high-cost investments in their DC plans, in reliance on recommendations from non-fiduciary retirement plan consultants operating behind the low "suitability" shield, receive far better advice from fiduciary advisers who now share responsibility for plan menu choices.