Why Variable Annuities May No Longer Suck (Well, Some of Them at Least) – Observations from a Career Skeptic
By Brian Aberle, CFP®
Those of us that have ever heard of the insurance product called a variable annuity likely have strong opinions about them one way or another. Personally, and as the title may imply, I have never held them in high regard over my two-decade career as an investment advisor and financial planner. I've long found them to be complicated, bloated, and pricey amalgamations that use fancy buzz words to mask their inherent complexities. In addition, the compensation structure of variable annuities often had one question the motivations behind said products. The good news is that changes are slowly trickling into the world of variable annuities that have me feeling a tad more optimistic about the roles they may play for investors going forward.
In this blog, I explore how variable annuities work and how they've long been sold. I discuss changes that are underway that may clean up their image and make them a practical option for more investors in the future.
What is a Variable Annuity Anyways?
The easiest way to understand a Variable Annuity (I’ll use the acronym VA going forward) is to look at in the context of most other insurance. With insurance, companies offer to insure against a low probability yet high consequence event for a pre-determined expense structure. With home, life, and auto insurance, the assets and risks are reasonably definable.
VAs work similarly to that of most other forms of insurance but are often tied to the financial markets, hence the "variable" aspect of the name. A VA can potentially help someone better mitigate against retirement risk by "wrapping" an investment portfolio (the variable part) in an insurance blanket. For an agreed-upon annual expense, the insurance company will help provide safeguards against market-related longevity risk so long as certain conditions are met by the client. Example conditions would be not putting too much of a portfolio into high-risk investments or spending more than say 4.5% of the original value of the annuity in any given year. It seems like a pretty reasonable option, right? So, why don't more people have them? Complexity and greed are the first things that come to mind.
From my perspective as an advisor, the challenge was always with how VAs were sold. At some point, companies went beyond offering straightforward longevity and market protections to providing solutions that were riddled with unnecessary gimmicks, often called riders. These days, an annuity prospectus can be in the hundreds of pages long, and it's the role of the marketing teams to shrink that down to a few pages worth of buzz words and glossy print for clients.
Second, and with respect for my friends within the insurance profession, VAs have often been sold by the same folks who also sold one-and-done insurance, like life insurance. What this means is that the bulk of compensation was paid via upfront commissions. As a result of this commission structure, the management of the "variable" part of the equation, ie, the financial markets, had a tendency to be neglected at expense of the investor and, ultimately, the insurance company. It would be akin to buying an expensive “safe” car and then failing to swap out the bald tires over time, which, by the way, I see this often in the mountains of Colorado. Both investors and the insurance company ultimately pay for the lack of responsibility.
What is Changing?
Commissions are Going Away (for Some)
For Aberle Investment Management to call itself a fee-only investment advisory (RIA) practice, the regulations state that we cannot earn commissions by selling a product. It's as simple as that. Our practice is only compensated by our clients and nobody else via investment advisory, financial planning, or consulting fees.
More and more folks like us have left the big brokerage firms to either form a fee-only RIA practice or join an existing fee-only firm. As a result, several forward-thinking insurance companies have created new "RIA-friendly" VA products specifically suited for our clients. With these new solutions, the expensive upfront commissions go away, and the emphasis, as it should have been all along, focuses more on the longer-term investment advisory side. The insurance options are still there; however, we're getting back to basics, that being its an investment product with a "just in case" insurance wrapper around it. One could make the case that if an investor has a professional advisor at the helm of the variable/investments part, the probability of relying on insurance in time is also lower. If this proves out in time, I suspect we could see some reduction in the insurance costs as well.
Surrender Periods Go Away for RIA-Friendly Annuities
Surrender periods exist in the world of VAs so that companies can claw back the upfront commissions that were already paid to the agent if the clients don't own the annuity for enough time. Interestingly, these clawbacks aren't absorbed by the agent, but by the client.
A surrender period of 9 years or more is not unheard of, where each year often equates to a percent in commission paid upfront. So, to do the math, if one has a surrender period of 7 years, the agent arguably made 7% upfront. As an advisor that charges on average 1% annually to advise my clients, it seems foreign to think that someone can make an equivalent of 7 years' worth of our equivalent compensation upfront, but that is how the cookies have crumbled up to this point within the world of VAs.
With new RIA-friendly VAs, these surrender periods go away. That is because there are no commissions to claw back from the client in the first place. What this also means is that the client has much more flexibility to utilize a different VA structure in time should their situation change with little to no repercussions. They can switch companies, or just switch products.
More Investment Options, More Integrations
Within our practice, we have long utilized lower cost, index-linked instruments as core building blocks for our client portfolios. Yet, within the world of VAs, we often found ourselves reverse engineering our approach to accommodate the more expensive and proprietary instruments mandated by insurance companies. This, too, seems to be changing, with more companies offering up quality 3rd party and index solutions.
Several annuity companies are also integrating with 3rd party reporting providers like the ones we use. This allows us to view our client portfolios in their entirety, rather than in isolation. This is particularly helpful in light of the current low interest rate environment we find ourselves in. The prospects exist to help clients construct an alternative strategy where growth can be emphasized versus low bond yields, thanks to the insurance blanket. We can also create model portfolios, much like we do on the advisory side, and rebalance for multiple clients at a time.
Dueling Interests for Insurance Companies, For Now
Insurance companies have found themselves in a bit of a conundrum in offering up new fee-only, RIA-friendly annuities. This is because many often still offer commission-based annuities through their traditional channels. The instruments could be quite similar, except that one has commissions and surrender charges attached while the other does not. Often, a financial advisor that maintains insurance and that works for a large brokerage firm may only be able to offer the commission version, through no fault of their own. Thus, one side often can't see what the other side can offer, and as a result, this creates a conflict. Regulators have picked up on it.
As an example to above, the State of New York recently passed a law indicating that insurance companies offering both fee-only and commission-based annuities would need to provide clients with a cost comparison of the two products. You can read about this law here. As a result, two prominent insurance companies backed out of selling the fee-only annuities until "clarification" could be provided. They've since brought them back online.
What these decisions by several companies convinced me of was that traditional, commission-based VAs still, unfortunately, rule the day. To provide a cost comparison risks putting a stick in the spokes of conventional business models. Furthermore, several states, as well as institutions like the CFP® (Certified Financial Planner) board, are toughening their rules on what it means to be a fiduciary. This again places a bullseye on the responsibilities around the "variable" part of a variable annuity. Said another way, advisors in time will be faced with a choice; either sell products and earn a commission or serve as a fiduciary. But you can't have it both ways.
What to Do If You Currently Own a Variable Annuity
If you have a legacy VA, chances are that you have an opportunity to look at new options that can be quite competitive on features, cost, and flexibility. You are not stuck. I would encourage you to consider the following items:
Know what you are paying. – If you don't, it's understandable. VA documentation can be quite complex. We can help you understand your current costs at no obligation. You might also be surprised to learn that some of the bonus features you signed up for have long since expired, yet you are still paying for them. It seems strange, doesn't it? Happens all the time.
Have you adjusted your VAs investment allocation since purchased? Talk to your current advisor/agent about this. Perhaps there is a good reason for the non-change, but there needs to be some reason. VAs often can be lifetime vehicles. With that in mind, one cannot simply apply a "set it and forget it" investment strategy because markets are ever-changing, whether they have an insurance wrapper or not. Someone has been/is being paid to be your advisor. If they aren't doing their job, you need a new advisor.
Have you heard from your insurance agent/advisor/salesperson since purchasing? This borrows from the first point, but did your agent become a ghost post-sale? If they call you every 6 years or so to "check-in," then it's ok to be skeptical and ask, "has my surrender period lapsed?". It may create a mildly audible squirm over the phone from the other side.
Understand that VAs are transferable. Current tax laws often permit owners of variable annuities to transfer them to a new variable annuity without tax consequence. This is called a 1035 exchange. If you have an old instrument that no longer suits your needs, we can help.
Conclusion
At their core, variable annuities in their most basic structure offer a compelling instrument that can potentially help clients mitigate against outliving their money. But they've earned a well-deserved bad rap over the years for being bloated, hard to understand, and overpriced consolidations of crud, where the insurance bells and whistles dominated the narrative while the investment aspect was shoved to the background and often ignored for years. Though improvements are welcome, we still have a ways to go. Just prior to wrapping this blog, I received a phone call from an insurance rep pitching me all of the buzz words I've come to despise over the years. Sigh.
Thanks for reading,
Brian Aberle, CFP®
President, Aberle Investment Management
Aberle Investment Management LLC, is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.