Fiduciary VAs?

A traditional life insurance company has introduced a line of fee-only variable annuities for fiduciary advisors to consider.  This could be the start of a trend.

Lost in all the cross-talk about the on-again/off-again DOL Rule, fiduciary and transparency is the insurance industry, which has traditionally fit comfortably in the “none of the above” category.  This has not been an advantageous decision for the industry.  Back in 1975, when Fidelity and (lateLife-Salesr) a few other mutual funds started pulling the fund industry in the direction of no-commissions and full disclosure of fees and returns, the life and mutual fund industries held roughly comparable assets. 

Today, according to the Life Insurance Marketing and Research Association (LIMRA), life insurance asset growth appears to be stuck in neutral, with fewer than $18 billion in new premiums a year, and fewer policies sold today than in 1984.  (See chart)  Mutual funds, meanwhile, are playing at a whole different level.  They’ve routinely seen annual inflows of $100 billion to, in the boom year of 2007, more than $1 trillion in new assets.  (See chart)

Fund-Flows-New-ChartIt’s never too late to change.  Longtime life veterans have confided that most of the major insurance companies are taking a hard look at distribution options outside their traditional commission-compensated sales agents.  So I was very interested to see that Lincoln Financial has dipped a whole foot in the fiduciary water, by introducing a family of no-load annuities designed for the fee-only marketplace. 

“We recognize that the fee-only community is a different culture, and we prepared for that,” says Cooper Sinclair, Lincoln’s new AVP of RIA Strategy and Operations.  “The mandate that I was given when I came to Lincoln was to help determine a strategy and create a path to reach those advisors who work on a completely fee-only basis.”  The key features, he explains, includes transparency, liquidity from day one (another way of saying “no commissions”) and a wide selection of investments.

Lincoln had removed the commissions, but would its products fit into the fiduciary mindset in other ways?  Would the mortality and expense (M&E) fees be competitive?  Would the policies still offer what some would consider to be gimmick riders, with guaranteed living benefits that are calculated from a fictitious dollar amount that is different from the cash value?  Would they offer a broad range of fund choices that would include the funds and ETFs that fiduciary advisors are familiar with?  And if so, would the expense ratios be similar to what you pay if you invest in those funds directly?

No-Load Competition — Fees

VA-ChartAs I looked into the Lincoln Financial no-load VAs, I was surprised at how many other no-load annuities have quietly crept into the marketplace.  The chart (above) shows a partial list; all of these contracts feature zero commissions and surrender charges, and as you can see, they all fall into the same general ballpark in terms of overall costs.  The two most important are the M&E (basically paying the company to insure the risk that future actuarial tables might have to be drastically rewritten, as a result of much longer lifespans due to medical advances or other societal changes), and any fees paid back to the company out of the fund expense ratios.

The Jefferson National product stands out from the pack for having zero M&E charges, but the firm charges 12(b)-1 fees from the funds that your clients are invested in.  Look deep in the prospectus, and you find special provision that says that if your clients choose the lowest-cost options (the DFA and Vanguard funds are specifically listed) then they’ll be charged an additional 35 basis points a year.  What they giveth on M&E they taketh away on the 12(b)-1 side.

The TIAA-CREF Intelligent Annuity features an M&E that declines from 40 basis points down to 15 as the client puts more money into the contract, and the company says they don’t participate in the mutual fund fees that are offered to contract holders.  For others, it’s harder to tell, unless you compare the expense ratios, fund-by-fund, with their retail counterparts.

VA Issues

For most fiduciary financial planners, there are several issues to consider if you’re choosing from this or any VA list.  The contracts provide tax-free compounding, but, as you know, the returns are taxed at ordinary income rates (rather than capital gains rates) when money comes back out in retirement.  Plus: annuities operate under a last-in-first-out regime, so you get kind of the opposite effect of tax-loss harvesting.  With these tax inefficiencies on the back end, it would take a very long tax-free accumulation period (possibly forever, depending on returns and tax rates) to make up the difference, especially since you’re also adding an M&E or 12(b)-1 fee to the annual costs that would not be part of a taxable mutual fund portfolio. 

The tax disadvantages are mitigated somewhat if the client decides to annuitize at or after retirement.  When the contract is annuitized, the company calculates an “exclusion ratio;” the ratio between the money put in by your client and the current contract value, so the client isn’t paying taxes twice on the original investment.  A percentage of each annuity payment, for life, is considered a tax-free return of principal—and if the client lives a long life, then more money will come out tax-free than was invested. 

But it’s helpful to recognize that few VA contract holders actually DO annuitize, perhaps (I’m speculating here) because the person who sold them the contract for a commission is long gone, so there is nobody to help them understand their options.  Is it possible that, as companies increasingly market VAs through a fee-only channel, that the annuitization rate will go up dramatically, changing the pricing on these products?

Second, you can’t charge AUM fees out of the annuity assets.  Well, you CAN, but each distribution is a taxable event, with a 10% surcharge if the money is coming out before the client’s age 59 1/2.  For advisors who charge based on a client’s AUM, the fees will have to come out of another account, making the arrangement somewhat messy. 

Also: chances are the annuity doesn’t hook into your asset management software to let you provide neat performance statements.  This could change.  Sinclair says that Lincoln has begun an integration process with Orion and Black Diamond, and also hopes to have an integration with eMoney this year.

Finally, there’s a trust issue if you decide to annuitize.  Will your client be offered the same rate that the same company offers to buyers of immediate annuities?

For all these reasons, I suspect that, initially at least, most readers of this newsletter will consider the list of no-load annuities mostly as vehicles they can execute a tax-free 1035 exchange from the legacy contract that was sold to a new client some years back by his brother-in-law.  As time goes on, if the insurance industry gets more comfortable with the fiduciary culture, then insuring against longevity might become a more interesting option.

Resources

I asked the Inside Information community for analytical help, and was introduced to a diversity of consultants that you might want to put on your resource list, including Joe Maczuga of Fee Advisors Network (www.feeadvisorsnetwork.com); Scott Witt of Witt Actuarial Services (www.wittactuarialservices.com); John Ryan at Ryan Insurance Strategy Consultants (www.ryan-insurance.net); Jerry Skapyak of Low-Load Insurance Services (https://llis.com/); Brian Fechtel of Breadwinners’ Insurance (www.breadwinnersinsurance.com); Martha Gallagher of AdvisorAdit (www.advisoradit.com); Deborah Castellani of Akros Fiduciary Management (www.thefiresystem.com); James Mergens at Corporate Life Brokers (www.corporatelifebrokers.com); Vince Micciche (www.vincentmicciche.com); and Stephen Mallery of Mallery Financial (www.malleryfinancial.com). 

VA Structures

Most of the competing no-load annuities are pure accumulation vehicles that are designed to provide low-cost tax deferral.  Lincoln Investor Advantage and Lincoln Investment Solutions fit this profile except that Investment Solutions also offers a death benefit rider and guaranteed income riders.  Witt notes with approval the 35 basis point combined admin. and M&E charges on the accumulation portion.  “I would put this annuity in the upper echelon of vanilla variable annuities,” he says.  But then he adds: “I don’t see anything that leads me to believe I would select a Lincoln contract over Vanguard or Jefferson National.”

On the investment side, Maczuga notes that “a fairly large portion of the portfolio in both the Solutions and the Advantage products are represented by proprietary Lincoln National Money Managers, which would bother fiduciary fee advisors.”  He recommends using the independent money manager options.

Mallery points out that while there are no clearly-disclosed 12(b)-1 fees in the Lincoln National products, there could easily be other shelf space payments from funds back to the company, and there are hints of this in the expense ratios of the fund offerings.  Witt makes the same point, noting that an S&P 500 index fund is available for 21 basis points, but otherwise, in a broad range of investment options, the low-cost index funds are scarce to nonexistent.  “In most instances, the combined investment expenses may be on the high side compared with an indexer,” he says.

Riders

In addition to the accumulation features, the Lincoln products offer two features that have proven to be very attractive to commission-based advisors.  One is the variable annuitization in the i4Life rider.  Instead of a fixed amount each year based on the size of the account on the day the client decides to annuitize, the i4Life income income payment is calculated based on the shifting values of the account. 

Why is this attractive?  Since the arc of a 60/40 portfolio is generally upward over longer periods of time, this provides a way for the income to grow with (or perhaps faster than) inflation—plus you get the tax benefits of an exclusion ratio.  TIAA-CREF is the only other company I know of that offers this kind of feature, but only on its single premium contract.

The second difference between the Lincoln contracts and the other no-load VAs is the guaranteed income riders.  All of the insurance consultants told me that these are typically very difficult to evaluate, but in general they create a “contract value” that is different from the actual account value, and the contract value grows at some minimum guaranteed rate even when a bear market takes the account value down.  Alternatively, the contract value can be set and reset at high watermarks of the account value, and locked into that value. 

At some point, the client can start taking payments of 5% to 7% of this fictitious amount each year, with a guarantee that this payment will be made even if the account value itself goes down to zero.

The actuaries I talked with generally had a dismissive attitude toward these riders, in part because their annual cost generally exceeds their value.  One of the actuaries laughingly confessed: “I’m torn between what I know is the pricing behind it and what the customer perceives.” 

They also noted that, regardless of pricing, very few clients actually ever turn on these living benefits, meaning there is virtually no risk to the insurer. 

And unlike true annuitization, the living benefits checks are taxed at ordinary income rates.

“In most cases, living benefit riders are just more expensive ways to buy the immediate annuity equivalent, but the company hides that fact through complexity,” explains David Jacobs, of Pathfinder Financial Services in Kailua, Hawai’i.  He was the only member of my audience who was able to deconstruct the riders for me.  For example, with the Market Select rider, a 65-year-old male has a choice of either a 6.26% payout on the initial cash value or a 5% payout that grows as the cash account grows.

How likely is it that the account will grow?  Jacobs starts with the 5% annual withdrawal, a 0.4% annual M&E fee, a 1.25% rider fee and the fund fees themselves.  The portfolio is restricted to a 60/40 asset mix.  How likely is it, given sequence-of-return risk, that the portfolio’s long-term return will overcome 7.15% in total outflows a year?

The conclusion?  “In most cases, the living benefit riders are more expensive than their immediate annuity alternatives,” says Jacobs.  “So during the accumulation phase, a person is better off just using the lowest-cost variable annuity she can find.  And then, when she wants to start receiving payments, she can exchange into the immediate annuity of her choice.”

Jacobs was more positive about the Lincoln Financial’s Core Income Benefit annuity, which, unlike the others, only offers low-cost iShares for the investment components.  More interestingly, the contract guarantees that the income payout, whenever it is taken, will basically follow the Bengen distribution rate that every fee-only advisor is familiar with.  The client will get 4% of the initial amount when he or she starts taking distributions, plus at least a 2% inflation increase compounded each year, regardless of what the markets do.  Think of it as guaranteeing the 4% safemax withdrawal rate with inflation protection.

“I like that they let you choose a 70/30 portfolio, which I would generally recommend with this kind of product,” Jacobs says.  “For a 65 year old couple that is risk averse and would normally have trouble owning significant equities, this could be a great answer for them. It allows them to have the much more aggressive portfolio knowing that no matter what, their 4% distribution is guaranteed.”

The main negatives, he adds, are the ordinary income tax treatment of most withdrawals (until you start hitting principal), the highish fees (just under 2% all in) and potential problems if hyper inflation shows up.

I think the best conclusion I can draw is that Lincoln Financial is a canary in the coal mine.  The company has put considerable effort into matching the rather frugal competition in the fee-only space, and Sinclair seems to “get” the issues that are important to the non-sales community—the people who have never before recommended variable annuities to their clients.  The reception these products get will help other insurance companies decide if they want to follow Lincoln’s lead, or conclude their commission-fueled distribution network isn’t so bad after all.