The ‘Clunky’ Details of Fee-based Annuities

Regulators have pushed insurers to develop fee-based annuities, but financial advisors and brokers who sell them say these types of 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 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.

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 under 59.5, 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 to a mutual fund every year 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 annually, 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.”

M&E Charges

Mortality and expense (M&E) charges are paid by the investor out of the fee-based annuity to the insurer and insurance company marketers often tout the lower M&E charges on fee-based annuities compared to M&E charges on commission 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 commission annuity.

But that’s a misnomer as insurers don’t count the advisory fee coming to the advisor out of the SMA, advisors say.

Transparency is a big issue, especially among registered investment advisors (RIAs), said David Lau, CEO of DPL Financial Partners, a firm which helps insurers develop products for RIAs.

Fees are hard to dig out of the documentation and it's not easy to sift out which fees - M&E charges, rider fees, mutual fund fees - are baked into what.

"A lot of insurance product winds up getting very complicated," he said.

Products become complicated and can do so quickly.

Suppose the client decides to replace his or her 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 his or her 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 for managing the annuity account from the investor, 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 can take over the annuity, but not without a selling agreement with the variable annuity company, financial advisors said.

So fee-based chassis are 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 into the variable annuity, then the commission-based route is a better option and insurers and advisors intend to continue with commission-based annuities for that very reason, advisors say.

A traditional $100,000 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 commission annuities don’t come with the SMA.

While 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].

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