Annuities tend to have a bad reputation; too expensive, too opaque, too cumbersome. For the better part of my 31 years advising clients that are approaching retirement or who are recently retired (or semi-retired), I have typically advised against annuities, sharing the concerns of the general public. But recent inquiries from very smart people, followed by an article in Barrons, and a paper written by industry legend Roger Ibbotson along with a podcast interviewing Ibbotson on the subject caught my attention. Keeping an open mind, I set out on a broad due diligence review of the new annuity market. I was surprised by what I learned.
About 10,000 people turn 65 every single day in America. We are coming off a ~30-year bull market in bonds and a ~10-year unprecedented bull market in equities – and rates are rising. This unique combination of events along with rapid innovation in annuity offerings lends itself to considering the allocation of a portion of an overall retirement portfolio to annuities, at least for some. The type of annuity that caught most of my attention in the due diligence were: commission-free annuities.
There are different types of commission-free annuities, but this article will focus on the most common offering: the fixed indexed version. Under this approach, the retired or semi-retired investor earns credit based on a fixed guaranteed rate or based on the change in the price of an index such as the S&P 500, subject to a floor and a cap. The appeal of a fixed rate as well as a floor and cap option is obvious for those approaching retirement or those who are recently retired. Certain commission-free fixed indexed annuities will also offer riders that contractually guarantee a certain amount of lifetime income from the account value.
A problem in the past, it seems, has been that the traditional commission offerings have paid low rates with poor floors and caps. In large part that’s because the product manufacture pays out hefty commissions to brokers, bankers, insurance agents as well as overrides to their managers etc. In some case, an upfront commission of 7% or more. The commissions may be a drag on the outcome for the retired or semi-retired investor.
Here is where commission-free annuities enter the scene. The annuity provider strips out all compensation to the advisor or intermediary facilitating the transaction, resulting in noticeable better rates, floors, and caps. You must be wondering at this point, how the advisor gets paid for facilitating the arrangement? That occurs through a negotiated fee. This fee is arranged in several possible ways; drawn from the annuity account directly, drawn from another account or simply invoiced from the advisor to the client. Commission-free annuities gained traction as the fiduciary rule was debated by policymakers and industry pundits. When the regulation was rolled back by the Trump administration, the idea stalled a bit, but it’s coming back now because, regardless of what occurs in Washington, it’s what many people want. The appeal of commission-free annuities transcends the fiduciary debate for at least three reasons:
- In the commission-free version, the investor is paying the fee directly to the advisor. And advisors – or any businessperson, tend to represent the interest of the person or entity that is paying them, which is what an investor naturally would want.
- When the fee is paid directly from the investor to the advisor, it’s transparent; everyone knows how much is going to the advisor.
- The fee can be appropriately negotiated based on relevant factors. With the commission version, the compensation is set by the product vendor. But how does the product vendor know how much work the advisor is doing for the investor and the extent of the relationship? Personally, if I earned a 7% commission from an annuity transaction, in most cases, that amount would be inappropriately high resulting in a less favorable outcome for the investor. In the end, aren’t the client and advisor best positioned to work out the compensation?
A commission-free annuity may turn out to just be a better deal for the investor. If an investor is paying the advisor adequately for other services, they may be able to negotiate the annuity transaction with the advisor as an accommodation. In other scenarios, the advisor may be able to bill the investor for the annuity work from a different account, perhaps an IRA where the fee is paid with pre-tax dollars.
Traditional commission based annuities still have a place and should also be considered when evaluating annuities. If the rates are close, it just may be easier for the investor and advisor alike, to set it up with a commission arrangement. While each approach has its pros and cons, the time has come to at least consider the commission-free version if you are evaluating annuities for retirement income.