Now that the Department of Labor fiduciary rule hassurvived the budget process, virtually assuring itspath to adoption in 2016, it is time to give some thought as towhat this rule will likely mean for the future design of annuityproducts.

To predict how annuity products may change going forward, wemust first understand that under the proposed DOL fiduciary rule,advisors will have two options for providing individual retirementaccount (IRA) recommendations.

2 options for providing IRA recommendations

Option #1: Advisor serves as a fiduciary underERISA without conflicts.

This option eliminates all conflicts of interest between theclient and advisor. For example, commissions will no longer be anacceptable means of compensation. Advisors serving as a fiduciaryunder ERISA must either charge an hourly rate, a flat fee or a flatpercentage of assets under management regardless of the assetclass.

Read: Go to our DOL fiduciary rule page

It is important to note here that an ERISA fiduciary differsgreatly from a fiduciary under the Investment Company Act of 1940(’40 Act). Since I am not an ERISA attorney, I won't attempt toexplain the differences between the two in their entirety.Ultimately, the key distinction is that the ERISA fiduciary cannothave any conflicts of interest, while a ’40 Act fiduciary has to“pledge” to disclose and manage the conflicts.

Option #2: Advisor serves as an ERISAfiduciary with conflicts under the Best Interests ContractExemption.

Under this option, the advisor can make IRA recommendationsunder BICE. This exemption is the DOL’s attempt to allow for acompensation model similar to the majority that exist today.

The BICE essentially allows for conflicted forms of compensation(i.e., commissions and revenue sharing) as long as the compensationis “reasonable,” adequately disclosed and does not lead to biasedrecommendations in any way.

The BICE also requires a laundry list of disclosures aroundcompensation and costs. In short, advisors will be required todisclose how much they and their firm will make on each specificrecommendation along with the annual costs, in dollars, that willbe incurred by the client.

Oh, and one other small detail--the advisor will have to executea contract with each client, attesting to the fact that anyrecommendations will not be biased in any way.

Any violation of this contract or omission of disclosurerequirements of the BICE could lead to a breach of contract claimagainst the advisor and the firm.

Let's consider how advisors may respond to these newrequirements. The DOL's most common soundbite regarding this ruleis “If your doctor and lawyer must put your best interests first,shouldn't your financial advisor?”

I’ll save my thoughts as to whether or not doctors and lawyersserve as fiduciaries in a manner proposed by the DOL for anothercolumn, but here is what I will say: Just as doctors order tests toreduce their potential liability, advisors will consider potentialliability when making recommendations.

While serving as an ERISA fiduciary is the more restrictive ofthe two options, it is also the clearest as to what is allowed andwhat is not. I predict that many advisors will take this moreconservative route.

The BICE, while allowing advisors to make relatively minimalchanges to their existing business model, comes with manyuncertainties. Questions such as what is “reasonable” compensation,what fees must be disclosed and how, and what other forms ofpayment must be disclosed will be debated by every financialinstitution.

I suspect many of the answers to these questions will not beknown until the lawsuits are filed after the next bear market.

New contracts

Now that I have discussed how I see advisors responding to theproposed new DOL rule, let's turn to the treatment of annuitycontracts by advisors in reaction to the rule.

Given the relatively long duration an annuity could and shouldbe held, I could make an argument that a 7 percent upfrontcommission is reasonable. After all, if the policyholder owns theannuity for 10 years or more, that essentially equates to 0.70percent per year or less.

Over the long run, even a commission of this size could be thecheapest option for the policyholder.

However, each financial institution, and selling advisor, willhave to ask themselves whether or not they want to potentiallydefend such a commission.

Advisors and their firms will quickly conclude that it will beeasier to defend a 6 percent upfront commission than a 7 percentupfront commission. It will be far easier still to defend a 2–3percent commission, even if it comes with an annual trail.

Putting it all together, a few conclusions regarding futureannuity product designs come to mind.

First, there will be a need for annuities that pay zerocommissions and can be sold in a fee-based account. For thoseadvisors that take the ERISA fiduciary route, this will be theironly option for selling annuities. Many advisors that decide toutilize the BICE will also likely choose to reduce their potentialliability by recommending annuities that do not paycommissions.

There is no language in the BICE suggesting that you cannotutilize a fee-based account structure as a means to comply with itsrequirements. Rather than worry about whether or not a commissionis reasonable, especially when commissions differ from product toproduct, many advisors will likely turn to a fee-based accountstructure and eliminate that particular uncertainty altogether.

Second, while I’m not predicting an end to commission-basedannuities, I do believe that the commission structure will change.I think the days of 5 percent-plus upfront commission options willsoon be behind us. These will likely be replaced by commissionoptions of 1–3 percent upfront with an annual trail. In otherwords, a commission structure that looks a lot like a fee-basedaccount charge.

The commission compression will also lead to changes in thesurrender charge schedules. Once the larger upfront commissionoptions are eliminated, there is no longer a need for initialsurrender charges of 7–10 percent, nor do they need to last aslong. Annuity companies will likely introduce three differentannuity designs:

• A low-cost option that pays zero commissions with no surrendercharges designed for fee-based accounts under both ERISA and theBICE.

• A low-cost option that pays zero commissions and has lowsurrender charges for a limited amount of time designed foraccounts under ERISA and BICE. The addition of a minimal surrendercharge will allow for better consumer pricing, and would thereforebe positioned as an option for policyholders who are willing toaccept this minimal potential charge.

• A slightly higher-cost option that pays some commission and hasa low, but longer, surrender charge period that is designed to beused only with the BICE.

If I’m correct, this could also be a welcoming end to multiplevariable annuity share classes that each sit on a unique productchassis.

Up to this point, the industry has had little success gettingadvisors to offer annuities in fee-based accounts. While many havetried, few would consider those efforts a success.

Jefferson National, with its $20 per month design, has had themost success and it took them eight years to achieve $2 billion intotal sales through advisors.

The industry is understandably concerned about what might happento sales should my predictions become reality.

At the same time, all of the no-load or low-load annuitiesintroduced to date have had to compete with a commissionablealternative to the same product. Take away that alternative andfee-based options will have more success.

Still, I suspect the industry will see at least a 50 percentdrop in sales while advisors adjust to the new model.

Easing compliance

Many advisors will say that the higher commission is necessaryto compensate for the time taken to work through the significantamount of compliance paperwork and regulation that exists atfinancial institutions.

However, I would argue that the majority of this paperwork is adirect result of the current commission structure.

FINRA is so focused on ensuring the annuity is not beingrecommended because of the commissions that they have forced firmsto create a seemingly endless stream of hurdles for virtually everysale.

My expectation is that in a world where the new product designsI have proposed exist, most of the current suitability paperworkwould become unnecessary.

In this world, annuities should not attract any more complianceoversight than any other product. Hopefully, FINRA shares myview.

If not, we could very well experience a decline in sales inexcess of even the 50 percent I previously contemplated.

Given the great need for guaranteed lifetime income, I wouldthink this would be a situation the DOL hopes to avoid.