Regulators have pushed insurers to develop fee-based annuities, but financial advisors and brokers who sell them say these annuities remain clunky and aren’t as “clean” as commission-based annuities when the time comes to close a sale.
Despite the onslaught of new fee-based annuities in the market over the past 18 months, sales of these products remain a fraction of the overall variable annuity and fixed indexed annuity market.
In the third quarter, sales of fee-based variable annuities amounted to only 2.5 percent of the $21.8 billion in VA sales, LIMRA Secure Retirement Institute reported.
Fee-based indexed annuities represented even less — 0.4 percent — of $13.7 billion worth of indexed sales in the third quarter, LIMRA said.
Exploring the difference in fee structures between fee-based variable annuities and commission-based variable annuities helps explain why financial advisors have shied away from fee-based annuities for so long. Here’s how it all begins.
Fee-Based Burdens of SMAs
Taking a fee out of the annuity doesn’t make economic sense because of the tax consequences to the investor and the penalty incurred for an early withdrawal for clients younger than 59.5 years of age, according to financial advisors.
Instead, clients need to write their advisor a check every year for their services or receive a fee from an outside advisory account, which many people find onerous.
Advisors compare that to writing a check every year to a mutual fund for managing a 401(k).
The more popular option is for advisors to open an account separate from the annuity. Those accounts are known as separately managed accounts (SMA), or “sidecars,” from which to draw the fee.
Under a fee-based model, an investor with, say, $100,000 wouldn’t lock the entire $100,000 into the annuity.
Instead, following the counsel of the advisor, the investor might devote $60,000 to the annuity, for example.
The remaining $40,000 would sit in an SMA, and the advisor would receive an advisory fee for managing the annuity and SMA.
But the fee would come out of the SMA, since there’s no upfront compensation on a fee-based annuity.
A 0.5 percent trail, or other agreed-upon trailing fee paid every year to the advisor based on the aggregate account balance of $100,000, which fluctuates every year, would come out of the SMA value of $40,000.
“It can get a bit more clunky, and it’s definitely not as clean as a commission-based variable annuity,” said Jessica Rorar, a senior planner with ValMark Investment Group in Ohio. “It’s a clunky mechanism on a fee-based chassis.”
Mortality and expense (M&E) charges are paid by the investor to the insurer out of the fee-based annuity. Insurance company marketers often tout the lower M&E charges on fee-based annuities compared with M&E charges on commissionable annuities.
Strictly speaking, insurance companies are right. The M&E charge, sometimes referred to as a contract fee, on a fee-based annuity typically comes to 0.35 percent of the account value, compared with the 1.3 percent M&E charge typically levied by a commissionable annuity.
But that’s a misnomer, as insurers don’t count the advisory fee coming to the advisor out of the SMA, according to advisors.
And fee-based models can get more complicated quickly.
Suppose the client decides to replace the advisor on the separate account because a new advisor promises to charge a lower fee on the $40,000 in the SMA. What then?
The original advisor, who has no more assets on which to charge a fee, is left high and dry, since the fee can’t come out of the annuity without tax consequences to the investor.
Sure, the advisor could ask for an annual fee from the investor for managing the annuity account, but that leaves the clients paying a fee to the original advisor and another fee to the new advisor, which is more expensive for the client.
A fee-based annuity without a corresponding account out of which to pay the advisor results in an orphaned annuity account, or a “house account.”
Another advisor could take over the annuity, but not without a selling agreement with the variable annuity company, financial advisors said.
So a fee-based chassis is far from ideal, but as insurers refine fee-based annuities over time, more and more advisors can expect to see their fees come out of the annuity, not out of a separate account, Rorar said.
The Cleaner, Commission-Based Sale
Contrast the fee-based model with a traditional commission-based annuity sale, which has been the preferred option for decades.
If the client insists on placing the entire $100,000 in the variable annuity, then the commission-based route is a better option. Insurers and advisors intend to continue with commission-based annuities for that very reason, advisors say.
A $100,000 commissionable variable annuity, which would generate a commission of 4.5 percent, or $4,500 upfront, would be paid by the insurer to the agent through the M&E charge and not out of the $100,000 account value.
In addition to the 4.5 percent commission, a 0.5 percent trail, or whatever agreed upon trailing compensation starting in the second year and thereafter, would also come out of the M&E fee.
Many variable annuity companies charge 1.3 percent of the account value as an M&E contract fee, but commissionable annuities don’t come with the SMA.
Although the investor sees an M&E fee come out of the commission-based variable annuity, it isn’t labeled a commission fee.
Commission-based products, particularly those with longer durations, are often less expensive than fee-based contracts and in the best, or better, interest of the client, insurance executives and some financial advisors said.
Advisors are also free to set up a compensation structure in which they generate 2 percent in upfront commission with a 1 percent trail, an agreement that varies from one broker/dealer to the next, advisors said.
With a commission-based model, the SMA upon which the advisor relies for compensation isn’t an issue.
An investor looking to sink $100,000 into a commission-based variable annuity finds that with every quarterly statement, the principal — and more or less as the account value rises and falls with market cycles — is all there.
InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected]