In either event, the benefits of the contract may not vary based on investment experience of a separate account maintained by the issuing carrier, or based upon the investment.

3. How does the Department of Labor fiduciary standard impact advisors who sell or provide advice with respect to deferred annuity products?

As is the case with fixed rate immediate annuity products, fixed rate deferred annuity products continue to be covered by prohibited transaction exemption PTE 84-24 after the implementation of the Department of Labor’s final fiduciary rule.

In order to be excluded from the heightened fiduciary standard, the benefits of the contract may not vary based on investment experience of a separate account maintained by the issuing carrier, or based upon the investment experience of an index or investment model.

4. How does the Department of Labor fiduciary standard impact advisors who sell or provide advice with respect to proprietary products, including annuities?

While many in the industry expected that the rule would contain a prohibition on in-house (or proprietary) financial products, which can be more expensive than other products and present a greater risk of self-dealing, the final rule does not contain this prohibition. Instead, advisors who limit recommendations to proprietary products may continue to do so, provided that they satisfy the requirements of the best interest contract exemption

The client must be clearly notified in writing that the firm offers proprietary products or receives third-party payments with respect to the recommended investment product. The client must also be informed of any limitations that the advisor is subject to in the ability to only recommend a specific group of products (the extent of these limitations must also be disclosed).

Similarly, conflicts of interest must be disclosed, including any services that will be provided to the client. The firm itself must have determined that the limitations upon its advisors’ ability to recommend products will not cause receipt of compensation in excess of reasonable compensation, and will not cause imprudent recommendations to be made.  Relatedly, the firm may not rely on quotas, appraisals, special awards or other incentives that might cause its advisors to make imprudent recommendations.

Essentially, an advisor who recommends proprietary products must continue to satisfy the fiduciary standards that otherwise apply. The feasibility of satisfying the best interest contract exemption requirements will depend upon the specific firm or advisor’s clients, and the fees and characteristics associated with the proprietary product itself.

5. What factors should be considered when determining whether the purchase of an annuity product is in a client’s best interests?

When a sale or recommendation regarding an annuity product cause an advisor to fall within the Department of Labor’s enlarged definition of “fiduciary,” the advisor will be required to determine whether the product or transaction is in the client’s best interests. The advisor will be required to look to the client’s individual circumstances and conduct an investigation to determine whether any given annuity product is in the client’s best interests.

Fees are not the only factor to be considered in determining whether a product is in a client’s best interests. The advisor will be required to understand various aspects of the annuity product itself, including (1) surrender charges and fees, (2) the index or indices to which an indexed product is linked, (3) any participation caps, (4) the product’s investment risk, (5) how the interest credited to the product is calculated, (6) any riders that may be added to the product, including those providing for guaranteed income, (7) the insurance carrier’s ability to revise the terms of the product, and (8) additional fees and expenses.

Advisors will need to understand how a client’s participation in investment gains from the index to which the annuity is linked may be limited by spreads or participation caps, as well as other fees. This also includes knowledge of how changes in the relevant index impact the client’s individual account — i.e., how interest is credited to the account value. The method that is in the client’s best interests will depend upon the individual client’s tolerance for risk.

For example, the annual point-to-point method is often popular because of its simplicity. The beginning index value is compared to the ending index value on the contract's (annual) anniversary date, and the percentage of change is calculated. If the ending value is higher, the client generally receives interest, and if it is lower, no interest will be credited. While this method seems simple on the surface, the addition of caps and spreads can complicate matters.

A cap effectively limits the client's credited interest at the cap amount (if the index gained 10 percent and the cap is 6 percent, 6 percent will be credited, but if the gain was 1 percent, the client would receive the 1 percent credit because it is less than the cap amount). A spread is subtracted from the value of the gain — so if the index gained 10 percent and the spread was 5 percent, the account would be credited with 5 percent interest. If the index gained only 1 percent, no interest would be credited because the spread is greater than the gain. If annual point-to-point with a spread is used, the interest credited can be reduced to zero even if the percentage of change in index value is positive.

“Monthly averaging” and “monthly sum” are additional interest crediting methods that may be used. Monthly averaging can be more complex than annual point-to-point, because it measures the index value at the end of each month for a year, combines the 12 values and divides by 12 to determine an average. This average is then compared to the initial index value to determine the final value (after which a cap or spread may apply to reduce the amount of interest that will be credited).

Monthly sum requires comparison of the index value on the contract anniversary each month to the prior month’s value and calculating the change. The increases (or decreases) in index value are combined at the end of the year (and can also be subject to a cap or spread) to determine the interest credited. The monthly sum method is the interest crediting method that is most likely to suffer from market swings — if the index performs poorly for a few months, the amount of interest credited can decrease dramatically. 

For many clients, the best solution will be combining several of the interest crediting strategies in order to find a balance.  In these cases, the client may not be able to fully take advantage of large market gains, but will be able to generate more consistent returns across the board. Historical performance may help advisors to better understand the potential impact of any given interest crediting method.