DOL May Encourage Move To Wrap Variable Annuity Fee Structure

Proposed Department of Labor rules may encourage insurance carriers to adopt a more fee-based structure and that could favor the “wrap” variable annuity structure, a market research analyst said.

A wrap structure would mean no surrender charges and very low expenses, but the remuneration to pay the financial advisor may have to come out of a pool of money set up between the financial advisor and client, said Steve D. McDonnell, president of Soleares Research in Astoria, N.Y.

“I’m not clear myself from the where the source of funds would come from,” said McDonnell, in an interview with InsuranceNewsNet.

Like thousands of other variable annuity specialists around the country, McDonnell is keeping close tabs on carrier earnings calls and the latest developments around the DOL’s pending fiduciary regulation. The final version of the rule is expected to be released in the coming weeks.

Several life insurance and annuity executives have spoken in vague terms about restructuring variable annuity products to accommodate fee-based models. What that eventually means in terms of “take-home” pay for financial advisors, the market will have to wait and see.

With a nonqualified variable annuity, an advisory fee deducted from the variable annuity is considered a taxable distribution. That is why the advisor doesn't draw such a fee directly from the variable annuity, to save the client from the tax bite.

Instead, the fee is drawn from a separate pool of money set up between the advisor and the carrier, he said.

Fee-based advisors generally don't sell variable annuities and part of that has to do with overcoming ingrained objections.

“A lot of it has to do with the advisor’s perceived value-added activities, for instance a variable annuity with a living benefit might have a limited set of investment options, whereas most registered investment advisors (RIAs) want the ability to invest client money relatively freely, sometimes even at their discretion, on behalf of their clients,” McDonnell said.

Fee-based compensation models have been around for years, but many advisors feel hamstrung by the perceived high fees and limited investment options that come with variable annuities.

Those have been some of the criticisms of variable annuities compared with mutual funds, he said.

Wrap variable annuities with no surrender charges are variable annuities sold to fee-based advisors. A wrap variable annuity looks like a C-share variable annuity but the core contract administrative and mortality charges are lower because the insurance carrier isn't paying the commission as it is with other contract classes, McDonnell said.

Wrap variable annuity mortality and expense charges, on the order of 45 or 50 basis points onto the base chassis, are low compared with C share variable annuities that charge expenses of 155 or 160 basis points.

C shares typically have the highest expense and mortality fees but are more liquid than other variable annuity share classes. C shares, however, are often used as a replacement of an older contract when the client doesn't want to incur fresh surrender charges, McDonnell said.

Some regulators have even urged broker-dealers not to allow L shares and C shares in connection with guaranteed benefits, he said. Variable annuity L shares typically have surrender periods of three to five years.

“I don't know if that many clients buy C shares for their first variable annuity,” he said. “Usually, the ones buying C shares are the ones moving from older variable annuity products into newer ones via a 1035 exchange.”

Many advisors historically have liked the variable annuity for the upfront commission structure and the trail commission options.

Advisors can get paid their 100 percent of their 7 percent commission upfront on the variable annuity sale, or they can split the total commission between a 6 percent upfront commission and a 1 percent trailing commission, or a 5 percent upfront commission and a 2 percent trailing commission, and so on.

“It's tempting for financial advisors to say they'll take option A with the entire commission upfront,” he said.

Variable annuity experts like John McCarthy, senior product manager with Morningstar, said variable annuity B shares would likely be affected by the DOL rule. Advisors and independent broker-dealers would be forced to display the impact of living benefits fees on the investment portfolio and the impact of fees on retirement income.

B shares, which typically come with seven-year surrender charges, are the dominant share class with 75.3 percent of all variable annuity sales in the third quarter of last year, according to Morningstar’s data.

The top carriers with B share sales in the third quarter were Jackson National, American International Group, Lincoln Financial, AXA Equitable and Prudential Financial.

New sales of variable annuities in the third quarter dropped 9.9 percent to $31.2 billion compared with the year-ago period due to low interest rates and shrinking supply as carriers pulled back on variable annuity exposures.

Low rates have made it difficult for annuity carriers to offer particularly attractive living benefits or to design variable annuities with radically different step ups and lifetime guarantees, McCarthy said.

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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Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. He can be reached at [email protected].