DOL fiduciary rule will transform the annuity industry

If the Labor Department has its way, say goodbye to the variable annuity industry as we know it. The department's pending fiduciary rule, if finalized in its proposed form, would have profound effects on variable annuities sold in retail retirement accounts, from sales to product development and adviser compensation. Namely, brokers selling VAs would likely operate more in a fee- rather than commission-based capacity, and insurers would pivot to develop product suites catering to this new demand. Further, there could be commission compression, more use of trailing rather than upfront commissions, a shift toward lower-fee share classes and increased adoption of fixed-indexed annuities. “I think it'll be a real test for the variable annuity industry,” said Bing Waldert, director at research firm Cerulli Associates Inc. The Labor Department's rule, a final version of which is expected as early as March, would raise investment advice standards for brokers working with retirement accounts such as IRAs and 401(k) plans. It would affect more than half of variable annuity sales; through midyear 2015, 61% of VA sales were in individual retirement accounts, according to Cerulli data. That's little changed from 62% during the prior two years. The one facet of the proposed fiduciary rule that would drive a sea change above all others is something called the Best Interest Contract Exemption (BICE). For advisers to receive variable compensation, such as a commission, for the sale of annuity securities, they would have to satisfy conditions laid out under the BICE. The BICE would require the insurance adviser and insurance company to enter into a contract with the IRA owner that would, among other things, acknowledge the adviser's fiduciary status, that the adviser will serve a client's best interests and that the adviser will receive reasonable compensation. It would also require additional financial disclosures. INCREASED LIABILITY The additional compliance steps and increased liability associated with the BICE would lead many advisers to steer clear of variable compensation, industry experts say. “I don't think broker-dealers will be comfortable with the environment in which they'll have to [operate] in order to do commissionable business,” said Judson Forner, director of investment marketing at ValMark Securities Inc., an independent broker-dealer. “It seems people will probably shy away from that.” Broker-dealers currently writing annuity business will likely figure out a way to continue doing annuity business, just not within the confines of the BICE, Mr. Forner said. American International Group Inc. chief executive Peter Hancock in January cited the DOL rule as a reason for the company's sale of AIG Advisor Group, a network of four broker-dealers. Advisers using products on a fee-only basis wouldn't need to comply with the stricter BICE standards given the lack of variable compensation associated with that model. “As drafted, the rule clearly provides a safe harbor for fee-based products, and those going outside that do so at their own peril,” said Lee Covington, senior vice president and general counsel at the Insured Retirement Institute. Based on his reading of the rule's text, Mr. Covington says it's not certain whether commission-based products would be permissible under the BICE at all. Fee-based variable-annuity sales only accounted for 4%, or $4 billion, of the $99 billion in total VA sales through the third quarter of 2015, according to Morningstar data. In full-year 2014, their share was 3.8% of a total $137.9 billion. Approximately 20 insurers sell these types of annuities through an I share class. The big difference between commission and fee-only annuities, other than their compensation structure, is that insurers haven't made living-benefit or guaranteed-income riders readily available through the fee-only products. Rather, they're mainly investment-focused annuities tapped by advisers for tax deferral in non-qualified accounts. “Advisory products today have not completely embraced these riders or have not built them out because most advisers looking for those features are using annuities in the commission space. It has not been a priority,” Mr. Forner said. Approximately 75% to 80% of ValMark's variable annuity sales in 2015 were in the guarantee space, through income, walk-away and death-benefit guarantees. Many believe insurers would build fee-only products for the advisers currently using commissionable products, or those with guarantees, as a sort of pivot product in the advisory space. IMPACT ON PRODUCTS “There would be a product development impact [due to the DOL rule] because I shares would be repurposed with living benefits attached,” said John McCarthy, senior product manager for wealth management products at Morningstar Inc. Jefferson National's VA business is entirely in the fee-based, non-qualified world, without the offer of riders or guarantees. The firm did around $800 million in VA sales in 2015. Jefferson National president Laurence Greenberg says the Labor Department rule could open up an opportunity for the firm to expand its VA business into the qualified market with riders and guarantees. “It's something we're looking at,” Mr. Greenberg said. The fee-only VA story would be playing out amid a backdrop of broker-dealers encouraging advisers to move to fee-based business, meaning they derive the majority of their business from charging clients an annual fee on assets under management. Around 33% of Jefferson National's business is expected to come from B-Ds this year, up from about 5% to 10% a decade ago, Mr. Greenberg said. Variable annuity commissions historically have been front-loaded, with brokers being paid a commission upfront for a sale, according to Chris Joline, partner in PwC's Financial Services Regulatory practice. However, the need to disclose that commission to clients as part of BICE compliance might lead to greater use of trailing commissions that pay out the same amount, but over a longer period of time. “That longer trail might be, from an optics and sales perspective, a better presentation,” Mr. Joline said. Overall commissions, which the insurer pays to the broker, may compress as a result of the rule in order to satisfy the perception of what's deemed to be reasonable and fair compensation, he added. Some argue that the high compensation offered by some VAs is justified because they are more complex products than, say, mutual funds, and require additional paperwork, all of which contributes to more work and a longer sales process. If a broker does a cost-benefit analysis and feels a lower commission wouldn't be worth that additional work, VA sales could suffer, some say. 'THAT'S ECONOMICS' “If the incentive-based compensation is too low, product sales are going to go down,” said Austin Frye, president and founder of Frye Financial Center and an adviser with LPL Financial. “That's economics.” Further, brokers could find themselves in the situation of not being able to recommend a variable annuity for a client at all, if no annuities available over their broker-dealer's platform are deemed to be in a client's best interest, according to Amy Lynch, president and founder of Frontline Compliance. “Under a fiduciary standard, [brokers] can't make the sale, period, if nothing fits for a particular client,” Ms. Lynch said. On the commission side of the house, there would likely be a continued trend toward a B share class and away from an L class because of the greater sensitivity about fees the fiduciary rule would create, Morningstar's McCarthy said. The base contract expense of a B-share variable annuity averages 126 basis points, compared to 163 basis points for an L share, according to Morningstar data. Year-to-date through the third quarter of 2015, 75.3% of all VA sales flows were going to a B share, up from 63.6% over the same period in 2012. That shift in part reflects a Financial Industry Regulatory Authority Inc. announcement in early 2015 that it would target VA sales practices in its regulatory and exam priorities, particularly practices relating to L shares given their higher costs and shorter surrender periods. Following the announcement, Voya Financial Advisors said its brokers could no longer sell L shares if the variable annuity contract included a rider. B shares are most consistent with a long-term investor because their surrender periods are longer than those of a typical L share, and hence they are the share class in which living-benefit riders usually make the most sense for clients, Mr. McCarthy said. Fixed-indexed annuities could also get a shot in the arm from the DOL rule, with some discussing the possibility of switching to FIAs where they might have previously sold VAs, according to Fred Reish, a partner in Drinker Biddle & Reath's employee benefits and executive compensation practice group. “There's definitely conversation out there around that,” Mr. Reish said. Compliance with the BICE only pertains to securities products under the DOL's proposal, and fixed-indexed annuities don't fall into that category, he explained. Regardless, sale of the products would still be beholden to a fiduciary standard in qualified accounts. FIA SALES RISING Although variable annuity sales are almost triple those of fixed indexed annuities, FIA sales have been gathering steam the last few years at the same time that VA sales have floundered. Because annuities in the non-qualified market will not be affected by the Labor Department's proposal, some industry experts believe brokers will sell more variable annuities in this market. “I think they'll sell more outside the ERISA purview,” Ms. Lynch said. Shunning the qualified market would mean missing out on the huge pot of rollover money into IRAs, though. New money from rollovers contributed $377 billion to overall IRA assets in 2014, according to Cerulli data. However, this point is moot if the Securities and Exchange Commission follows the Labor Department with a fiduciary rulemaking endeavor of its own, which would affect all securities products, Ms. Lynch said. The SEC isn't expected to propose its rule until late this year. Of course, there's one caveat — the aforementioned items are scenarios that could play out under the proposed version of the DOL rule. What the final rule will look like is a mystery to all but a handful of Washington policymakers. However, the timing of the rule's arrival at the Office of Management and Budget, which must sign off on it before the DOL makes it public, indicates that it will likely undergo a few tweaks, rather than an overhaul. “We don't expect wholesale changes,” Mr. Joline said.