Navigating the ever-evolving landscape of retirement planning can feel overwhelming. With over 200 years of market history offering a complex mix of opportunities and risks, then add in inflation and hidden costs gnawing away at potential returns, making informed decisions about your retirement future can be overwhelming.
Then to make matters worse, enter annuities, a type of retirement vehicle with a wide array of options and containing complex contractual agreements. While offering valuable features such as guaranteed income for life, some annuities come with commission structures that can significantly inflate fees, impacting long-term investment growth. These are complex insurance products with sales literature and prospectus that can baffle even a seasoned investment advisor. This article delves into one of the major cost levers that affect the fees and ultimately the investment returns of an investor-advisor compensation. There are two primary fee models for annuities: fee-based and commission-based. We’ll explore their unique characteristics, potential advantages, and disadvantages for both advisors and clients and the ongoing debate surrounding their use.
ANNUITY COMPENSATION MODELS
Fee-Based Financial Advisors
Fee-based advisors are compensated by an annual fee, typically a percentage of the assets they manage for their clients. This fee is usually set at a fixed percentage rate, such as 1% or 2% of the client’s total assets under management. The fee pays for the advisor’s ongoing management services and typically includes investment advice and portfolio management (and also includes the firm’s overhead and profit). This form of advice compensation has been steadily growing over the past two decades due to regulatory changes, technological advancements, and the development of new investment categories such as ETFs, structured notes, and more.
Advantages of Fee-Based Models
Fee-based models are often lauded for their fee transparency and alignment with clients’ interests. A fee-based advisor will disclose the fees and charges that may be hidden within an annuity under other compensation methods. Since advisors earn a percentage of the client’s asset value, they, too, benefit if the client’s assets grow, thus aligning the advisor’s interests with the clients. In other words, if the client’s investment portfolio declines in value, the advisor’s compensation also declines.
Furthermore, since the advisor is not paid an upfront commission, there is a financial incentive to continue to provide a certain level of client service and investment performance to maintain the ongoing investment management fee. Should the client become dissatisfied with either the investment performance of the client service, the client may be able to either switch advisors and/or investments (fees may apply).
Commission-Based Financial Advisors
Commission-based advisors earn their income through commissions paid by the insurance companies whose annuities they sell. The commission is usually calculated as a percentage of the premium(s) the client pays for the annuity. In this compensation model, the advisor’s income is tied directly to the sale of specific products, which can vary significantly in terms of their commission rates. The commission may be paid entirely or partially to the advisor at the time of the sale, or as a “trailing” commission that is paid out over the following years. However, once the advisor has received their upfront commission, the financial incentive to maintain a minimum level of client service and investment performance has been removed.
Advantages of Commission-Based Models
Commission-based models may result in lower visible costs for the client, in the case of some transactions such as annuity purchases. Since the commission is factored into the product’s cost, clients do not pay product fees directly to the advisor. This model may also be more accessible for clients with lower asset levels who might not be able to afford potential out-of-pocket fees associated with some fee-based advisors.
EXAMPLE 1: COMPARING FEE STRUCTURES
If you think about the commission issue at a high level, the investor will always ultimately pay the advisor’s commission, the insurance company’s overhead, and profit. After all, the insurance company is in business to make money, to make a profit. Therefore, the investor must determine:
- What are the exact fees (in real dollars) being paid?
- What is the advisor/insurance company doing to add value to justify the fees?
In other words, how is the advisor earning their keep? In this section, we will provide you with some simple guidelines that will allow you to do calculations to determine the true cost of the value you are receiving from the annuity and your advisor.
To provide a fair analysis, we will compare a commission-based annuity with its fee-based product “twin”. We will use the commissioned-based Lincoln Level Advantage® B-Share Individual Variable and Indexed Linked Annuity, and the fee-based Lincoln Level Advantage® Advisory Individual Variable and Indexed Linked Annuity.
The two investment products under comparison offer fundamentally the same features and benefits, the primary difference between the two are the method of compensation and the fees charged.
| Commissioned | Fee-Based | |
|---|---|---|
| Account Value Death Benefit | 1.10% | 0.10% |
| Guarantee of Principal Death Benefit | 1.30% | 0.30% |
| Advisor Fee | 0%* | 0.50%** |
| Total Fees to this point | 2.40% | 0.90% |
* The advisor was paid a commission by Lincoln Financial Group.
** TruWealth Advisors charges an annuity management fee of .50% on this annuity product at the time this article was written.
Before we look further into the fees, let’s pause and review what we have learned to this point. As you can see the commissioned-based product costs for both the Account Value Death Benefit and the Guarantee of Principal Death Benefit are 100 basis points higher (100 basis points equals 1%) respectively. Therefore, for the two product features (providing the same benefits) the investor would pay an additional 200 basis points or 2%. One of the driving factors in the difference in the fees is the compensation model. Not only does an advisor have to be paid, but there will be an entire sales division, marketing materials, compensation department, regulatory administration, and more that must be paid through the fee proceeds of the product. The difference in regulatory agencies that provide oversight is significant, with commissioned-based products falling under FINRA (Financial Industry Regulatory Authority) and fee-based annuities falling under the SEC (Securities and Exchange Commission). The regulatory differences are beyond the scope of this article, but suffice it to say, FINRA regulations are broad, and lengthy and add significant costs to the companies they oversee.
If we look at the Total Fees to this point, we see a difference of 150 basis points, which amounts to a savings of 1.5% per year on the entire account balance.
Next, we will review the mutual fund expenses fees of both products. As seen below, there is no difference between the commission-based and the fee-based mutual fund expense fees because both products utilize the same mutual fund options.
| Commissioned | Fee-Based | |
|---|---|---|
| Expenses before reimbursements | ||
| Minimum | 0.48% | 0.48% |
| Maximum | 1.27% | 1.27% |
| Expenses after reimbursements | ||
| Minimum | 0.48% | 0.48% |
| Maximum | 1.20% | 1.20% |
Assume a $100,000 annuity with zero growth for one year:
| Total Fees Paid | Commissioned | Fee-Based |
|---|---|---|
| $2,400 | $900 |
Revisiting Our Two Questions
Earlier we stated that the investor should ask two questions: 1. What is the exact fee in real dollars being paid? 2. What is the advisor doing to add value to justify the fee? In this apples-to-apples case, we see above that the commission-based annuity will cost $1,500 a year more than the fee-based annuity for the exact same product. Now we must ask ourselves, “What is the advisor (and the advisor’s company) doing to add value to justify the fee?” Unless the advisor is providing superior service and investment selection, then the commissioned-based annuity probably would not make sense for many investors.
EXAMPLE 2: COMPARING FEE STRUCTURES
We will now compare a RiverSource RAVA Advantage 5 to a Security Benefit Elite Designs Variable Annuity and a Midland National Capital Income Fixed Indexed Annuity. For full disclosure, a true apples-to-apples comparison of the RAVA Advantage 5 is the Security Benefit Elite Designs because both vehicles are variable annuities. We included the Midland National product in our analysis due to the popularity of fixed-indexed annuities.
| RAVA Advantage | Security Benefit | Midland National | |
|---|---|---|---|
| Product Cost | 0.96% | 0.45% | 0% |
| Rider | 1.5% | 0.35% | 1% |
| Inv. Fees | 0.38% | 0% | 0% |
| Advisor Fee | 0%* | 0.5% | 0.5% (3 yrs. then 0%)** |
| Total Fees | 2.84% | 1.30% | 1.5% (3 yrs. then 1%) |
* The advisor was paid a commission by RiverSource Insurance Company.
** This fee is based on the fee structure offered by TruWealth Advisors on this annuity product at the time this article was written.
Assume a $100,000 annuity with zero growth for one year:
| RAVA Advantage | Security Benefit | Midland National | |
|---|---|---|---|
| Total $ Paid | $2,840 | $1,300 | $1,500 (3 yrs. then $1,000) |
Is Cheaper Necessarily Better?
In the comparison above, all three annuities are top-rated and are widely held by the public. Each of these annuities has features and benefits that slightly differentiate them from one another. The question an investor must ask themselves, “Is the annual difference in fees worth the value I am receiving?”
The associated costs for annuity riders, indexing, and mutual funds may warrant a higher fee. Riders such as a Guaranteed Death Benefit may be valid for one investor and not valid for another. The same can be said for the use of an indexed annuity rider, the validity of the fee is dependent on the goals and needs of the client. Due to the complexity of annuities, it is critical that a client meet with a fee-based advisor to review what is in the client’s best interest.
WORDS OF WISDOM
When buying an annuity, you should also ask your advisor:
- Why do I need to buy the additional rider?
- What does the cost of the rider equate to in real dollars each year for my portfolio?
- Is there a less expensive alternative product that will achieve the same goals?
- How long is the surrender period? And what does it cost each year if I surrender either the entire annuity or a portion of the annuity?
- Please provide me with research or data showing the average return on investment after fees for this particular annuity product.
Before you make any investment, here are some essential questions you should ask yourself:
- What are my specific goals for this investment?
- How much do I need and when do I need it?
- What is my risk tolerance?
- What is the associated rate of return for your risk tolerance?
- Does that associated rate of return achieve your goal?
- If not, you will have to adjust the goal or your risk tolerance.
- How important is the preservation of the principal?
Before you make any investment, here are some essential questions you should ask your advisor:
- How does the investment help me reach my goal?
- What is the risk profile of this investment?
- What are the specific fees for this investment?
- What does that equate to in real dollars each year for my portfolio?
- Are you paid an upfront commission or an ongoing management fee?
- What is your specific commission in real dollars on this investment?
- What does that cost me in real dollars each year on my portfolio?
UNDERSTANDING THE BEST MODEL FOR YOU
Ultimately, the choice between fee-based and commission-based models depends on the individual client’s needs, preferences, and financial situation. Both models have their merits, and both can offer value under the right circumstances. It’s crucial for clients to understand how their advisors are compensated and to have open conversations about fees, commissions, and potential conflicts of interest. Doing so can help ensure that you make informed decisions that align with your financial goals and values.
Disclosures
TruWealth Advisors, LLC is an SEC registered investment adviser located in Louisiana. Registration does not imply a certain level of skill or training. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should consult your own tax, legal and financial professionals before engaging in any transaction. Past performance does not guarantee future results. Additional information about TruWealth Advisors, including our registration status, fees, and services is available on the SEC’s website at https://adviserinfo.sec.gov/firm/summary/306876.
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