Why The DoL Fiduciary Rule Won’t Kill Annuities, It Will Make Them Stronger!

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everybody! Welcome to "Office Hours" with Michael Kitces!

We're here today to talk a bit about annuities, and what I believe is a collision course that has been set up between annuities that have a lot of high-commission activity associated with them, and the new Department of Labor fiduciary rule that got announced just a week or two ago (which is going to be kicking in a year from now).

DoL Fiduciary And Annuity Commissions

Under the new rule, the Department of Labor didn't specifically say, "no commissions". They said: "Commissions are okay, but your products are subject to fiduciary scrutiny."

So what realistically happens when a broker tries to sell an annuity, particularly one with a high upfront commission, but the recommendation is subject to a fiduciary standard that asks questions like: "Did you receive reasonable compensation for your services?"

Are people who are selling high-commission products going to be able to justify that compensation?

The prevailing view, including from folks like me, is that, no, they probably will not. The fact that the DOL didn't ban commissions doesn't mean commissions won't eventually go away under a fiduciary rule. All the DOL said was:

"We're not going ban commissions outright. You people who say you can do commissions and still meet a fiduciary duty, knock yourselves out. But be ready to justify it in court when you get sued, because someone's going to challenge you about it at some point!"

So the DOL didn't really grant that commissions are fiduciary. They simply said:

"People who sell products for commissions, while trying to meet a fiduciary duty, will have their day in court and their chance to make the case."

And when that day in court comes, I suspect a lot of commissions will begin to come down (if they haven't already). The commissions will either get eliminated, or at least come down (as I can envision a world where maybe small upfront commissions are allowed and then an ongoing trail). Those big upfront commissions and no trail, which encourages a lot of annuity churning, are very unlikely to survive any extended period of fiduciary scrutiny.

The Future Of Annuities After DoL Fiduciary

So the question is: If most annuities that get sold today have commissions, and the commissions incentivize the sales, and the commissions get squeezed out, does that mean basically annuities are going to go away?

I've seen a number of annuity companies that have been starting to reach out, and are asking questions like: "We're trying to figure out what on Earth this means for our products. Are all of our products going to go out of existence if we can't distribute them with commissions to encourage their sale?"

But here's the key thing. I think ultimately, what you're going find when we look back on this in 5 or 10 years, is that this was not the beginning of the end of annuities. This was the beginning of annuities actually getting a lot better.

Why It's So Hard To Find A Good No-Load Annuity Today

So why is DoL fiduciary good for annuities? Well, here's the strange and sad reality of how annuity product design plays out today.

When you want to design a high-quality annuity, then similar to designing high-quality investments, it's pretty straightforward. You're going to have to manage the costs and the expenses, or the expenses are such a drag that you can't really have a product that has a good risk/return trade-off, and a good long-term value.

But the challenge in the marketplace, particularly for annuities, is that the best products with the lowest cost are often NOT the ones that actually get sold in practice.

To some extent, that's because many of us who operate as advisers have a chip on our shoulder about annuities, and view all of them as bad, when the truth is not all of them are bad. Sure, many of them are mediocre high-cost products, and a lot of us came from that world where we saw a lot of those mediocre products. So I understand why a lot of us who are fiduciaries today are wary about annuities.

But what that means when you're an insurance or annuity company, trying to design a product... Imagine this world. I can make the best product out there, but all the fee-only advisers just think annuities are bad and won't sell any, or I can make a crappy product with high commissions and a really nice profit margin for myself, and as long as I load it up with enough commissions, a bajillion insurance agents sell the heck out of it. So if you're running this company, do you want the high-quality product that produces no sales and puts you out of business? Or do you want the low-quality product that a ton of people sell, and it makes your business successful?

That's the sad, perverse reality of how the annuity product design landscape has played out. I've watched this even over the span of my career. I started 16 years ago in the business, and I remember some of the early variable annuities with living benefit riders, and I remember some of the early equity index annuities. They were good contracts. They had very reasonable costs. They were rather transparent. They were pretty straightforward. There was not a lot of questionable fine print. You didn't need a complex calculation engine just to figure out how how to project the crazy combinations of spreads and participation rates and monthly resets that exist today. They were actually quite decent, high-quality products. And they got squeezed out of the marketplace. It started on the equity-indexed annuity side, and then migrated to the variable annuities side over time as well, particularly after the financial crisis.

So now when we look at the products that are in the marketplace today, they are higher cost, more complex, and more difficult to even vet. And a lot of us on the Periscope here know what happens when you take a product that's extremely opaque and complex out of the insurance industry. It tends to get loaded up with a lot of fees and expenses on the back end that no one can see because the thing is too darn opaque and complex to evaluate. The good products get squished out of existence.

I've spoken with a number of product designers at annuity companies over the years. And when I ask them why they can't make a product that is better, that's cleaner, that fiduciaries like us could feel more comfortable selling and sleep well at night, the refrain I always hear back is:

"Look, at the end of the day we've tried to design these products over time. We roll them out. Hardly anyone buys them. Hardly any advisors recommend them. The high commission stuff gets sold.  And that's what keeps our company moving forward."

God Bless Capitalism. It's doing its thing. The companies have gone where the products are getting bought. But that's not necessarily where the best products are out there.

So we've been stuck in this trap where the high commission - or I should say the expensive products that give companies really fat margins - are the ones that give the annuity companies so much money they can incentivize with really high commissions which gets people who are attracted to the high commissions to sell them. While the high quality products with little marketing dollars  don't get sold because there's no money to market them and no one's getting paid a commission to be incentivized.

And when we multiply that forward year after year, the good products have atrophied, the worse products got sold, and the marketplace has shifted. And I think that really is the environment we've seen over about the past 15 years or so, in both the equity-indexed annuity and the variable annuity space.

How DoL Fiduciary Changes Annuity Product Design

So here's what changes when DOL fiduciary comes about. Now suddenly, annuity companies can't rely on commissions alone to distribute their products. They have to come up with some other means, such as actually making a product that's good and then marketing it to fiduciary advisers! Because anybody who's advising on a retirement account going forward is going to be a fiduciary adviser. That's the scope of the DOL regulations.

So commissions will either get reigned in or eliminated completely. Companies won't just drive their sales based on the highest commission product. They'll have to actually make a good one, and then they'll actually have to figure out how to sell it, which means market it, educate advisers, show them why the product is actually good, and make the honest case for it. Because that's the only way that's going to be left to incentivize advisors to use the product, since commissions won't be much of an option anymore.

In other words, I think we've failed to appreciate in the industry how dramatically the incentives, not just for salespeople but for the product manufacturers themselves, are going to change after DOL fiduciary. The companies that create the products will suddenly have to change how they build and distribute products in a fiduciary world, where commissions are no longer the primary driver of sales. It has to actually be quality product design with bona fide marketing.

How Annuity Products Will Change After DoL Fiduciary

I think what you're going to see in the coming years... it will take a while for this to play out, but first you're going to start seeing annuity costs come down. You'll also start seeing the benefits get less gimmicky, because if you're a fiduciary, you don't want a gimmicky kind of product! You risk getting sued for misleading and false advertising!

And remember that sadly, the standard for getting sued for false advertising under suitability standards is really low. You can always say, "Well, on page 37 of the disclosure documents, it was disclosed that this thing might not do what I projected it to do." But You can't use that cop-out when you're a fiduciary! You have to actually demonstrate you did your due diligence and that another prudent expert would have recommended the same thing in the same client situation, and that your compensation was reasonable. There's no incentive to sell a gimmicky product in that environment. You sell the one that's actually good, and the one that's going to cover your own backside, too.

So I think we'll see annuity products start to become less gimmicky. Product illustrations will become more realistic, because no broker/dealer is going to want to encourage an annuity on their platform with all their brokers using aggressive or unrealistic sales illustrations that over-project the returns. Because the broker/dealer opens themselves up to a class action lawsuit for misleading sales projections if they allow aggressive sales illustrations! And transparency will start getting better on all the products, because the disclosure requirements associated with DOL fiduciary are going to drive at least some additional transparency.

In turn, this means we're going to get better clarity about how the annuity products are working under the hood, because that's what anybody doing fiduciary due diligence is going to be looking for. And that's what any attorney is going to be looking for when they say to an advisor they're suing "Justify to me how you knew this thing was the best if you didn't even understand how it worked under the hood?" Not being able to do due diligence on annuity products is going to get you sued, and you're going to lose, as a fiduciary, if you can't even do your own due diligence because the products aren't transparent.

Then you'll see surrender charges mostly vanish, because the truth of a surrender charge is it's nothing more than the penalty that the company looms over the client in order to recover the commissions that were paid upfront to the agent. It's no coincidence that contracts often have things like 7% surrender charges when they have 7% commissions. It's because literally, the annuity company pays the 7% commission upfront and then it recovers the 7% commission out of the expenses at 1% a year to make their money back, and the surrender charge ensures they can recover the rest if the client leaves early. That's why there's a seven-year, 7% surrender charge that steps down by 1%/year.

So at a point that you're not paying commissions upfront, you don't need the surrender charges either. They're basically built together. They go hand-in-hand. Or conversely, you might actually see a few products that have surrender charges, but the purpose of the surrender charge won't be to recover the commissions. The surrender charge will be a good trade-off for clients. For instance, a future annuity product might say "If you're willing to buy the version that has the five-year surrender charge, we'll give you a better yield. We'll give you a lower cost. We'll give you a better feature or benefit." Because it actually makes sense from the annuity company's perspective. If they can apply a surrender charge, and they know the money is going to stick around a little longer, they can invest it differently. It changes their time horizon.

For instance, imagine what you would do for clients, if they agree to a five-year lock-up to invest with you, versus the client that could fire you at any day. In many ways, we can actually invest a little bit more prudently and aggressively for clients when we know they're going to stick around for a period of time. And annuity companies, functionally, can do the same thing, particularly for the cost of how some guaranteed products come together, where low persistency, high turnover of the products are expensive for the annuity company too, and it drags it down the results for everyone. So surrender charges can actually be a good trade-off that you consider in the future, not something we try to avoid today.

Overall, I think what we're going to see is a huge wave of innovation for annuities when companies say, "Oh, crap. We can't compete on just the best-sounding gimmick paired with a high commission. We actually have to compete with the best feature, and then have it be something that's clear enough that we can teach fiduciaries what it is, how it works, why they should recommend it to their clients, and that they can do all the due diligence, so that they won't get sued as the intermediary for making a bad recommendation."

So the pressure now is on annuity companies. They must try to design an actually good annuity, and see what they can do. And that's just such a monumental shift in the annuity marketplace. That's why I titled this broadcast that DOL fiduciary isn't going to kill annuities. It can actually make them stronger.

This is the change in the incentive system that we needed for annuities. To actually allow them to function in something that's closer to a meritocracy. The good ones will be able to rise to the top, not the highest commission ones with the best payouts to the agent but not the best payout to the client!

So recognize the shift that's about to get underway. If you're a fiduciary right now that hasn't done annuities in the past, stay tuned. I think you're going to find that the products get a lot more interesting. Not right away. It's gonna take them probably two or three years for the dust to settle on all of this. Starting maybe some time in 2018 or 2019, you're going to see this shift really begin, and the new products to begin rolling out, not laden with opaque, low-transparency, high-commission stuff. Actual creative value that would be useful for our clients, that we can integrate in with the rest of their portfolio and holistic financial picture. Not to mention the opportunity to do a 1035 exchange out of existing higher-cost products, either while the client is alive, or even for the beneficiaries after death of the original annuity owner!

DoL Fiduciary For Qualified Vs Non-Qualified Annuities

Now the one warning, the one caveat, the one challenge of this shift in the annuity landscape that I think is going come over the next couple of years, is that the DOL's scope is only for IRAs. It's not for non-qualified taxable accounts. It's not for anyone that sells a non-qualified annuity. And the problem you're going to see is that while annuity products will start getting some better options for all those that operate as fiduciaries and sell into IRAs, there's also a temptation for some annuity companies to still keep producing the high-commission, low-quality, mediocre products and pump them to annuity agents that sell outside of IRAs. Because those who sell into non-qualified accounts, that sell non-qualified annuities, are not subject to any of this fiduciary scrutiny.

The refrain I'm worried we're gonna start hearing a couple of years from now are annuity agents saying, "Why would you contribute to an IRA at all when you can get tax-deferral and buy my non-qualified annuity with all these neat features and benefits?" Which will really be code for, "Don't put your money in an IRA where I can't sell this mediocre product. Buy it over here where I'm subject to a lower standard, and I can actually sell it to you without getting in trouble."

So I have to admit that while I think DoL fiduciary is going be a good thing for annuity landscape overall, because once we unleash the forces of better product design, it going to compound towards creating better and better products, you're also going to see two roads diverge in the coming years. The products in IRAs will get better and better, and get some really creative features and benefits, because if you're an annuity company, and you want to be sold in an IRA, you need a relevant retirement income guarantee or some other guarantee and benefit that has merit beyond just the tax-deferral wrapper.

But while we're going to see better products on the IRA side, we may continue to see the same product mediocrity we have today from a number of companies on the non-qualified side. And they're going to get further and further apart over the next maybe five years or so. Now eventually, I think that's going to drive regulators to act. We already have this weird untenable environment where, if you're working for a broker/dealer, you actually have a different legal standard for the client's IRA than the client's brokerage account, for the same client selling the same products and giving the same advice. Because one is subject to the DOL, and one is subject to FINRA, and the SEC is ultimately the overseer of FINRA and likely to push that. So at some point, I think we'll see a blending of the fiduciary standard across all types of accounts and all types of advisers. But even then, state insurance departments exist outside that regulatory screen. Fixed annuity agents, including those selling equity indexed annuities, exist outside of that environment as well. So unfortunately, I think there will continue to be a dark side for non-qualified annuities for many years to come. It's going to take a long time for our advisory regulatory environment to move out and capture all annuity agent sales practices.

Nonetheless, the contracts to be held in IRAs are going start getting good. I think they're gonna start getting really interesting. I think you're gonna see an explosion of options for annuities for fee-only advisers, because the push from the Department of Labor is that we all become level-fee fiduciaries, and that's where the product designers are going to have to go, if they want to capture or keep the IRA marketplace.

DoL Fiduciary Has Changed The Incentives For Annuity Companies

So stay tuned for this. I think it's one of the untold stories of DoL fiduciary, that not only is it changing maybe how advisers are compensated and regulated. It has changed the incentives for the companies that provide products to us. That's actually a very profound force that's going to take years to play out, but it means we might finally see some improvements in products because the incentives have changed. It's going to be more of a meritocracy and less of a, "What's the best commission we can load in this product? And how opaque and mediocre can we make it so we can scrape more money out, so that we can pay a bigger commission over to the agent?" Watch for this, going forward.

So I'm curious. Does anyone have any questions? Any thoughts about this from your end? Any of you actually operating as fiduciaries and doing annuity contracts right now? I don't see a lot of them out there these days, but there are a few, companies like Jefferson National, that have been doing investment-only variable annuities for a while. A nice option for a tax-deferral wrapper for a high-income client that doesn't have enough tax shelter dollars elsewhere, and needs a little bit of asset location. So we do see a couple products out there that are much lower cost and just function as annuity wrappers that adviser can use for tax deferral, and there are a couple that have retirement income guarantees as well, though not many. Again, the incentives to the companies haven't really been there, unfortunately.

All right. Well, I see no other questions then, so we'll go ahead and wrap up.

Thank you for joining us, "Office Hours," Michael Kitces, 1:00PM East Coast time every Tuesday. Hope this has been helpful, and we'll see you all next week. Take care!

So what do you think? Are you a fiduciary who recommends annuity products to clients today? Why or why not? Do you think DoL fiduciary has changed the incentives for annuity companies and their product designers in a meaningful way? Please share your thoughts in the comments below!