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IRS alleviates suffering of RIAs who use fee-based annuities by ending the need for an excruciating tax conversation that brought their own fees into focus

RIA clients practically needed a CPA to understand the tax and the compassion of a mystic to accept it with aplomb; the Internal Revenue Service took pity

Tuesday, September 3, 2019 – 9:59 PM by By Lisa Shidler
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Craig Hawley says RIAs will buy more fee-based annuities under more pain-free conditions.

Brooke's Note: It hardly seemed fair. Not only were commission-based annuities the ones deserving of more scrutiny. But they received less than their fee-based brethren -- thanks to the IRS. The federal tax extractor asked RIAs that use fee-based annuities to (all but) collect a tax for them -- and explain it on their behalf, too. The IRS demand made a fee-based product into one that called for a very decided sale be made -- of accepting its tax. Now the IRS is doing what it never does -- forgoing revenue. It's a good outcome. It's a particularly good outcome for the fast-growing fee-based annuity cottage industry.

RIAs who use fee-based annuities to round out portfolios are doing cartwheels after the IRS removed a convoluted tax that was hard to understand, harder to explain and annoying for the client to grasp - if they ever did.

It was never so much about the money; it was the agony associated with having to explain it to clients, which usually meant a painful discussion as well about an advisor's own fees.

The pain was inflicted when advisory fees were pulled from annuity accounts. Under the IRS rule, the move was "deemed a taxable distribution,” says Craig Hawley, head of Nationwide Advisory Solutions.

Previously, money withdrawn from an account to pay the advisory fee was treated as income to the client, making it taxable, even though the client never actually pocketed the money.  

But the IRS finally put an end to the unpleasantness in ruling Aug. 7 delivered in a private letter to Lincoln Financial Group and Nationwide Insurance. It stated an advisor could vacuum out as much as 1.5% of the annuity's value as a fee without requiring clients to report it as income. 

"[It's] the most consistent friction point around the use of annuities," says Hawley. 

Fresh look

Annuities have historically been loaded with fees, and this additional tax was one more reason RIAs hated them. In fact, the tax seemed to single out RIAs because it was levied solely on fee-based annuities.  See: LPL Financial tries to solve two 'digital' problems with one new hire; the broker-dealer admits high 'friction' with clients for onboarding and matching them to the right annuity

Del Campbell
Del Campbell says he’s thrilled clients won't be taxed on their advisory fees anymore.

Right now, fee-based  variable annuities (VA) are still a tiny fish in the giant annuity ocean; they make up only 3% of all annuity sales. But the insurance industry argues the fee-based annuity market is growing rapidly. For instance, $3.2 billion in 2018 sales were up 42% from 2017.

Now that this hurdle is pushed aside, it's possible RIAs may give fee-based annuities a fresh look, says Del Campbell, vice president of annuity product development at Lincoln.

 “There are a lot of advisors who haven’t embraced annuities. Part of it has been operational challenges of what an annuity has presented. This is a big operational challenge that's been removed. It’s a huge one.” See: A perfect storm of factors -- including 'code' and 'annuities' -- made Jud Bergman pay Bob Curtis $500 million for MoneyGuidePro, plus $30 million to keep the MGP crew around a few more years

The fee was not trivial. 

For example, a couple over age 60 that owned a $400,000 fee-based annuity that charged a 1% fee would have to report $4,000 in phantom income as a taxable distribution on their tax return.  

The couple would have had to pay an additional $880, assuming they were in a 22% tax bracket. 

The insurance industry argues that costs could be much higher depending on the fee and the age of the annuity holder. 

For instance, if the couple is under 59 1/2, they would have to pay an additional 10% penalty. And, if the advisor charges 1.5% fee, then the taxable amount would rise to $6,000, adding nearly $2,000 to their tax bill, providing they're in the same 22% bracket. 

But the IRS has always allowed an advisors’ fee to be taken out of annuities in the qualified (401(k) plans without being taxed, but outside of a 401(k), the fee had been considered a distribution and was taxed. 

In the spotlight

Boston-based Cerulli analyst Scott Smith says the insurance industry's moans and groans about the tax should be taken with a grain of salt.

After all, an advisor could pull the fee from a traditional advisory account – where it wouldn’t be an annuity distribution and wouldn’t face a tax.

Easier said than done, says Hawley, because it suddenly shines a spotlight on both the fees and the IRS tax on those fees - whereas fees and commissions are traditionally not disclosed. 

“There was tremendous friction of how an annuity could be used as payment for advisory fees. We suggested advisors pull their fee from another cash account. But if they did that, the customers were confused and advisors didn’t want to deal with all of this friction,” Hawley says.

Expansion eyed

Nationwide has a major stake in the fee-based annuity business.

Thomas Fink of Ameritas says RIAs need to start looking at annuities differently.

More than $1 billion is coming into the channel annually for its popular Monument Advisor product sold through Nationwide Advisory Solutions. The product makes up one-third of the industry’s $3.2 billion in total sales of fee-based VAs, according to insurance trade association LIMRA. 

Both Lincoln and Nationwide are looking to expand their fee-based annuity product line.

Nationwide gained a jump start in the fee-based business when it purchased Jefferson National more than two years ago. It's had the Monument Advisor product for years. See: Nationwide buys Jefferson National under purported DOL duress but 'good private equity' and good planning may rule the day

Now, taking away the tax hurdle could be a real solution – even if it’s more of a mental barrier. But changing the minds of RIAs requires more than just a tax change, Smith says.

 “This ruling could help convince some advisors on the margin. But I don’t think tax-treatment of advisory fees was holding too many advisors back on using annuities.

"Seems like the equivalent of a new bourbon approved for sale in Utah – yes, you increased your addressable market, but there isn’t much in the way of unmet demand,” he explains

A bad taste

RIAs still have prejudice against annuities, Smith says. See: Decades-old stench of annuity sales and deception hangs heavy, but very 2018 efforts by DPL, Nationwide, Allianz and others offer whiff of hope of cracking the RIA market

Scott Smith: The insurance industry's moans and groans about the tax should be taken with a grain of salt.

“It’s almost a religious argument,” he says. “They look at something that charges 200 basis points and feel like it doesn’t even do a good job.”

To curtail that problem, the IRS will only let advisors charge a 1.5% fee.

This might help RIAs to justify a fee-based annuity, says Thomas Fink, vice president of RIA business development at Ameritas.

“This removes a barrier of entry of why advisors couldn’t use these annuities,” Fink says. “Advisors have a bad taste in their minds because of commissions.”

David Lau, founder & CEO of DPL Financial Partners, says RIAs shouldn’t be so critical of insurance products because they may be missing out. See: LPL Financial's $28 million cash purchase of AdvisoryWorld solves one big problem: Now it can make sure the proposal software includes annuities in its proposals

“RIAs that do not offer insurance are in danger because their other two value propositions — managing assets for fees and being a fiduciary — are no longer differentiated.”

“Most every advisor can claim they act in a client’s best interest and manage assets on fees, but RIAs are the only advisors that don’t provide insurance solutions," he says. 

On the table

Chuck DiVencenzo, spokesman for the National Association of Fixed Annuities, says annuities belong at the table. 

Chuck DiVencenzo
Chuck DiVencenzo: 'Both fixed annuities and fixed variable annuities will have a purpose in the financial plan.'

“What is important as we go forward is both fixed annuities and fixed variable annuities will have a purpose in the financial plan,” he says.

Right now, the demand for annuities actually hails from most individuals and not necessarily from RIAs, Fink says.

“There is more and more demand, not from the RIA perspective, but more carriers are getting more requests for this. More than five years ago there weren’t many no-load products. It was a sheer request in volume. More people are asking for it," Fink says.

Campbell, with Lincoln, says the tax change, will help make a dent in annuities.

“It’s only going to bring in people to consider annuities. I think it’ll help the industry to continue to reduce barriers. I think it’s one more thing that will continue to foster growth.”

Fink agrees: “It’ll make a big difference in the industry primarily because advisors want to manage someone’s wealth, they have assets elsewhere that are in old commissioned products that can be converted to investment only annuities.”


Related Moves

LPL Financial tries to solve two 'digital' problems with one new hire; the broker-dealer admits high 'friction' with clients for onboarding and matching them to the right annuity

Ashish Braganza puts LPL in to the data game but critics wonder whether the belated hire comes with too small a budget and team

July 25, 2019 – 6:18 PM



September 14, 2019 — 8:47 PM
Mr. Lau doesn’t argue that annuities are better for the client he argues that adviser are missing out on higher fees.

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