Fee-based annuities still require caution, despite IRS olive branch

The agency may have fixed a big tax problem for RIAs, but issues remain with many fee-based products.

Financial advisers who use fee-based annuities are likely celebrating after the Internal Revenue Service extended an olive branch last week, ruling favorably on how advisers can charge for annuity advice.

But registered investment advisers should hit pause before the party becomes an all-out kegger — there are still traps for unwary advisers that can hurt a client’s financial plan.

Within the past week or so, the IRS issued private letter rulings to several insurers saying that financial advisers using the insurers’ nonqualified fee-based annuities can withdraw an advisory fee straight from the annuity contract without causing adverse tax implications for clients.

The insurers included Allianz Life Insurance Co. of North America, Great American Insurance Group, Jackson National Life Insurance Co., Nationwide, Pacific Life Insurance Co. and Prudential Financial Inc. Experts saw the tax issue as a primary roadblock to using fee-based products and expect interest in them to increase as a result of the IRS rulings.

But pulling an advisory fee from a fee-based annuity contract can still cause problems. That’s especially true for advisers whose clients’ annuities have a living-benefit rider.

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These riders are an additional feature popular on variable and indexed annuities. They offer clients a minimum income guarantee — a 5% annual withdrawal rate for life, for example — with the potential for the income base to grow over time as a result of market performance and the presence of special features like bonuses. When a client draws income from the annuity in the future, the income payments are calculated from this “benefit base,” which may be larger than the account value underpinning the contract.

These riders come with stringent rules. Withdrawing too much money from a contract in a certain year, for example, could adversely affect a client’s income benefit.

Here’s the rub for advisers: Many insurers’ products are structured in such a way that pulling an advisory fee from the annuity contract is treated as a withdrawal that may dilute a client’s income. A typical repercussion, depending on the annuity, could be that the insurer reduces the client’s benefit base by the amount of the withdrawal or won’t allow the benefit base to grow during the year of withdrawal, said Jacob Soinski, an annuity planner at ValMark Financial Group.

Joe Maringer, vice president of national annuity sales for Great American Insurance Group, said that would be akin to “imploding” a living-benefit rider.

Sixteen insurance companies offer three dozen fee-based deferred annuity products with a living- or death-benefit rider, according to data from market research firm Wink Inc. as of Aug. 14. Insurers launched a slew of products in 2016 and 2017, around the time that the Department of Labor fiduciary rule, now defunct, looked as if it would push more clients into fee-based arrangements.

The majority of fee-based indexed annuities either don’t allow advisers to pull a fee from the annuity contract at all, or if they do allow it, “negative contract implications can occur,” Mr. Maringer said.

This isn’t true of all annuity products, though. For example, pulling an advisory fee from Nationwide’s Advisory Retirement Income Annuity, a fee-based variable annuity, wouldn’t harm its income rider.

Given the IRS’ recent private letter rulings, most insurers are likely working to structure their products more favorably so that an adviser withdrawing a fee wouldn’t upset a client’s living benefits, Mr. Soinski said.

Great American is an example of a company that’s doing so, Mr. Maringer said, and “hopes to have these updates sooner than later.”

Del Campbell, vice president of annuity product development at Lincoln, said the company similarly is “working on developing a fee corridor that would allow advisers to take a fee from the annuity without impacting the contract benefits.”