#382 | Protective Gets the Golden PLR

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The running joke on fee-based life insurance and annuity products is that they’ve been the “next big thing” for at least the past 20 years. Conceptually, fee-based products make all the sense in the world. Financial advisors are increasingly building businesses around asset-based compensation, regardless of what kind of licenses they hold or where they hang it. Purist fee-only RIAs are fewer in number than most people think. Instead, the predominant business model is a fee-based hybrid where the advisor charges fees but still collects commissions for insurance or other investment products. What’s the right commission structure? The one that best fits with the advisor’s practice.

As a result, both mutual funds and annuities have migrated towards a multi-share class structure where the advisor can choose to be paid a heaped commission, levelized commission or no commission at all. In annuity parlance, those commission structures are typically referred to as B-shares, C-shares and fee-based, respectively. Over time, more and more flows in mutual funds have moved towards share classes with lower commissions as more advisors have shifted towards business models based on assets under management rather than commissions. It seems like the whole world is moving that way, so why shouldn’t life insurance and annuities?

Over the past decade, we’ve seen several carriers create RIA-focused life insurance products without traditional street commissions. And yet, none of these companies have had much success. If the problem was commitment, Ameritas has been at it for over a decade. If the problem was performance, then Mutual of Omaha would be selling billions with its ultra-low cost Indexed UL. And if the problem was complexity and a cumbersome process, then Nationwide has solved both of those with Advisory VUL. What else is there left to solve?

Protective, it seems, has a different angle with its RIA-only Investors Benefit Advisory VUL – fees. Part of the secret sauce of modern investment management is the ability to deduct asset-based fees directly from the assets themselves. Imagine the shock that would happen if, suddenly, advisory clients had to stroke checks out of their own checking accounts to pay their advisors based on AUM. Instead, advisory clients sign the original wrap agreement and never talk about fees again. They don’t even see themselves paying the fees. They don’t get a report at the end of the year that shows how much they paid their advisor – they just see performance and trade confirmations in their email inbox that, if they looked closely enough, would mirror the AUM fee.

Ideally, an advisor selling a life insurance or annuity product without commission (so-called “fee based” products) would deduct the AUM fee directly from the product, but doing so had potential tax consequences. If the distribution to pay the fee is treated as a distribution to the policyholder who then pays it to the advisor, then there are potentially tax consequences. As a result, advisors typically charged asset-based fees for insurance to the client’s cash accounts. That can be really clunky, depending on the accounting software used by the advisor, the specific nature of the advisory agreement and the reporting functionality of the life insurer. It was not ideal and, theoretically, the complexity of charging fees on fee-based insurance products was keeping advisors away from them.

Back in 2019, several life insurers banded together to, hopefully, make deducting AUM fees out of fee-based annuities much easier. They each received a Private Letter Ruling stating that fees up to 1.5% can be deducted directly from the annuity without tax implications. This essentially allowing the wrap fee to be treated as a policy expense rather than a policyholder withdrawal. And, therefore, it doesn’t reduce the client’s basis or trigger income taxation. It was the golden PLR to usher in the new phase of fee-based annuity products.

Until last week, no life insurance company had received the same PLR to allow for advisory fees to be deducted directly from the policy cash values. Nationwide has a clever policy loan and repayment mechanism that can essentially pull the fee from the policy without tax consequences, but it’s a little bit tricky to understand. Protective, however, got the PLR. And as a result, its Investment Benefit Advisory VUL product stands alone in the industry as the only product that allows a fee to be taken directly from cash values in the same way it would work in a typical wrap account. The theory is that the PLRs for both annuities and now life insurance will fundamentally change the game and allow life insurers to tap into the massive AUM-based advisory market.

In the wake of the PLR in 2019, fee-based annuity sales absolutely skyrocketed, taking the industry by storm and almost immediately signaling an end to the old commission-based way of selling annuities – all while simultaneously cooling the planet, solving world hunger and landing a dog on Mars (RIP Fido). Just kidding. Fee-based products tallied up to around $6 billion in annuity deposits in 2022 against $312 billion in total annuity deposits. That number hasn’t changed much in the past few years. The reality is that for all of the time, energy and effort life insurers have poured into building more fee-based annuity offerings and making them easier to sell and administer, there isn’t much to show for it.

Why not? In my view, it comes down to product economics. As I’ve written before, fee-based products aren’t necessarily better for customers than commission based products and may actually be worse. MassMutual Ascend, for example, offers a 13% S&P 500 Cap on their fee-based Index Protector 7. On the comparable commissioned product, the Cap is 11.75%. That seems like a pretty big difference but, in terms of option pricing, it’s only about 50bps at today’s option prices. So which is the better product? Well, if the advisory fee is greater than 50bps, I’d argue that the commissioned product (American Legend) is actually the better choice in terms of pure economics for the consumer.

The same dynamic plays out in the life insurance space. The difference in performance between the commissioned product and the fee-based product has to be greater than or equal to the typical AUM advisory fee in order for the fee-based product to produce better long-term economics for the customer. In the case of Nationwide’s Advisory VUL – which I actually own and am a huge fan of – the difference in performance is less than 0.4%. That’s a pretty tight margin considering that most advisory AUM fees are 0.8% or higher.

For Protective Investors Benefit Advisory VUL, the margin is even tighter than in Nationwide Advisory VUL. Unlike Nationwide, which built an entirely new product chassis for Advisory VUL, Protective Investors Benefit Advisory (IBA) VUL is a near-clone of its street product, Protective Strategic Objectives II VUL (SOVUL). Both products have the same 0.2% M&E from years 1-10 that falls to 0.1% in year 11. Both products have the same Cost of Insurance rates, fixed 10-year policy charges and the same $8 per month administrative fee. Both products have a 0.25% asset-based Persistency Bonus starting in year 7. The difference is in the premium loads – 3.5% for the street product and 2% for the fee-based product – and the fact that Investors Benefit Advisory has no surrender charges.

Considering the fact that IBA has no commissions, these policy charge reductions are vanishingly slight. The structure is a bit of a mystery. Typically, reducing commissions results in a direct reduction in policy charges on the order of around $1.7 in charges over 10 years for every $1 of Target savings. Why doesn’t that happen for Protective? I think some of it may have to do with how Protective sees the internal distribution costs of the product. But I think the bigger factor is that Protective seems to have some surrender margin (as in, surrender charges are greater than compensation) in SOVUL. Dropping the surrender charge therefore removes a profit line item that partially offsets the benefit of eliminating street compensation.

Regardless of the exact rationale, Investors Benefit Advisory VUL looks surprisingly similar to Strategic Objectives II VUL in terms of actual policy performance. For the same 45 year old Preferred male funded at the maximum non-MEC premium, the difference in long-term IRRs is just 6bps. For any advisor that charges more than 6bps in fees – which is to say, all advisors – the economics for the consumer will be better in the street SOVUL than in IBA.

Why is the margin so tight? Because heaped commissions are actually pretty small relative to overall assets in the long-run, a point that seems completely lost on many financial advisors and consumers who bemoan “high” compensation in life insurance. You can easily see this playing out in life insurance policies that allow for blending. For example, switching from a full compensation ($21,987 Target) to minimum compensation ($4,397 Target) in Symetra Accumulator Ascent IUL 2.0 improves the age 100 IRR by a mere 12bps. Despite the narratives, heaped compensation is not the primary driver of product economics. And as a result, fee-based products don’t necessarily deliver better outcomes after a typical wrap fee is applied to the contract.

The pitch for fee-based products has to go beyond pure economics. For example, an advisor who charges an AUM advisory fee on assets in a life insurance policy has a greater incentive to service the policy than a stereotypical insurance agent who makes a commission and then moves on. Policy servicing is one of, if not the single biggest, determinant of success for a life insurance transaction – and yet the insurance industry generally doesn’t incentivize it. The good agents who dedicate themselves to policy servicing do it in spite of the immediate incentives rather than because of them. Fee-based commission may be much more expensive for the client in the long-run, but it may actually lead to better outcomes because policies receive regular maintenance and attention.

Fee-based products also allow for different types of conversations. Protective IBA, for example, doesn’t have a surrender charge. Year 1 policy cash values are spitting distance from the original deposit. Clients can buy IBA without having to be in it for the next 15 years, which is what’s required for a typical Whole Life policy to mature and really start delivering the goods. The barrier to entry with a fee-based product is lower. As a result, the sale should be easier – even if the long-term economics are worse once the fee is factored into the equation.

Because fee-based products are geared towards financial advisors, there also tends to be much more of a focus on the fund lineup. You can see this effect in Nationwide Advisory VUL’s slate of 140 funds, more than double the typical VUL product. Protective IBA also sports a slightly tweaked fund lineup from its retail SOVUL peer product. Fund expenses have been trimmed by a few basis points where Protective could do it and a few low-cost options have been added, such as a Schwab S&P 500 fund at 3bps. Yes, 3bps. The argument that VUL policies only have high-cost funds loaded up with unnecessary expenses is dead. The 3bps Schwab fund killed it.

This, I think, is the case for fee-based products. It’s not that they’re necessarily better for consumers because after accounting for advisory compensation, they probably aren’t. The case for fee-based products is that they are different. They’re hopefully going to be easier to sell because they (generally) don’t have surrender charges. They’re going to offer funds that align with how modern financial advisors manage money. Although they may actually cost more to the consumer than retail life insurance policies, they may actually be better managed and maintained over the long-run in a way that delivers better results to clients. And now, with Protective’s golden PLR, they’re going to be easier to wrap, too.