DOL fiduciary rule hastening death of L-share variable annuities

Insurers are speeding up their closures of L-share products as regulators crack down, but are quickly introducing new fee-based contracts

Jan 11, 2017 @ 1:34 pm

By Greg Iacurci

The specter of the Department of Labor's fiduciary rule is accelerating the demise of L-share variable annuities.

Variable annuities sold in an L-share class had already been reeling prior to the DOL issuing the final version of its conflict-of-interest rule last year, due to a crackdown on L-share sales by brokerage regulators.

But insurance companies in 2016 hastened the shuttering of such variable annuity products as demand for their distribution dried up and their future continued to look bleak.

“Certainly with the DOL fiduciary rule now in play, they just won't stand the test of time,” Bernard Gacona, senior vice president and director of annuities at Wells Fargo Advisors, said.

L shares carry higher contract fees than other types of variable annuities, such as those sold in a B share. The cost spread between the two is roughly 40 basis points, when considering base contract expenses, Mr. Gacona said.

They also have shorter surrender periods — around four years, compared with seven for a B share. Some feel that clashes with the purpose of owning a policy purchased with an income rider, which is by nature a long-term investment because it guarantees a lifelong income stream.

'MIXED MESSAGE'

“It's sort of sending a mixed message to the client,” said Steven McDonnell, president at Soleares Research, a market research firm.

Net new variable annuity filings, by share class

Sales of L shares have dropped dramatically over the past several years. They represented just 3.4% of overall variable annuity sales in the third quarter last year, a dramatic drop from roughly 27% at the end of 2009, according to Morningstar.

At the same time, sales of B shares have swelled, to 82% of overall sales from 50.5% over the same time period.

That's partly due to recent efforts by the Financial Industry Regulatory Authority Inc., the brokerage regulator, to scrutinize new sales and exchanges of L-share products because of the fear that their attractive commissions can incent abusive sales practices.

But the DOL's fiduciary rule, which dictates investment advice for a fee in retirement accounts must be in clients' best interests, creates a much higher bar for sales than currently exists. That's led to speculation that broker-dealers will shy away from L shares toward lower-cost commission products such as B shares when the rule's implementation period begins in April.

“It was the perfect storm,” Mr. Gacona said, in reference to Finra audits and the impending fiduciary rule. “Everyone saw the writing on the wall.”

The regulatory atmosphere led Commonwealth Financial Network to ditch L shares last year, and Voya Financial Advisors the year prior.

Insurers such as Prudential and Jackson National, two of the largest variable-annuity companies, ceased some L-share sales last year.

“As fewer and fewer are being sold, carriers are responding, saying let's stop even creating these contracts,” according to Kevin Loffredi, senior product manager of annuity solutions at Morningstar.

As a result, in 2016 insurers sped up net L-share contract closures threefold.

I SHARES

At the same time, however, insurers significantly sped up I-share product development for variable annuities, also known as an advisory share class.

“All the carriers are trying to build out the advisory-type approach for a post-DOL environment,” said Zachary Parker, first vice president of income distribution and product strategy at Securities America Inc., an independent broker-dealer.

Such annuities cater to advisers doing business in a fee-only, rather than commission, model, whereby they may charge a flat, annual 1% fee on a client's assets under management. The DOL fiduciary rule makes it less risky and cumbersome for firms to provide advice for a fee rather than a commission.

Insurers have developed new fee-based VA products within the last few years as the overall advice industry has shifted more toward the advisory model. Advisory VAs accounted for more than half of new variable annuity filings in 2016, Mr. McDonnell said.

However, of the advisory VAs developed in 2016, the majority came with the option for investors to purchase an income rider, Mr. McDonnell said, which is a feature that historically hasn't been offered on such annuities.

Many expect demand for advisory variable annuities with income riders to increase at least a bit, as brokers transitioning from a commission to an AUM model due to the fiduciary rule seek out products similar to those in the commission space.

L-SHARE TRANSITION

Of course, some argue clients may benefit from an L share's shorter surrender period because it provides the option to switch more quickly into a better product, if one comes along, thereby justifying the higher fee.

Firms are finding ways to accommodate such an inclination in a more cost-conscious way than a traditional L share.

Wells Fargo, for example, which eliminated L shares from its platform around 2011, now offers variable annuities with a “liquidity rider,” which carries a similar cost to an L share for the first four years of the contract, but then automatically drops to B-share pricing afterward if an investor doesn't exchange the annuity for a new one, Mr. Gacona said.

Securities America is considering a similar approach to help comply with the DOL rule, Mr. Parker said. Such a feature would prevent clients from paying a higher ongoing cost if they were to decide to remain in the annuity, he said.

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