David Lau: Taking High Commissions Out of Annuities
The DPL Financial Partners CEO discusses disentangling annuities and life insurance from their high-cost, high-commission roots—and why fixing long-term-care coverage could be next.
Our guest on the podcast today is David Lau, founder and CEO of DPL Financial Partners, which develops and distributes low-cost, commission-free insurance and annuity products. In addition, DPL Financial Partners provides tools and educational resources for registered investment advisors and individual investors. Prior to founding DPL, David was chief operating officer of Jefferson National and before that he was principal and co-founder of the Oysterhouse Group, a management consulting firm. He also served as chief marketing officer of E-Trade Bank and its predecessor TeleBank. David received his bachelor's degree in economics from the College of William and Mary.
“Kerry Pechter: How Annuities Fit Into the Retirement Income Puzzle,” The Long View podcast, morningstar.com, May 4, 2021.
“DPL Financial RIA Survey Shows Continued Uptick in Annuity Usage,” insurancenewsnet.com, Sept. 30, 2021.
“Another Reason Advisors Are Warming to Annuities,” by Bernice Napach, thinkadvisor.com, Sept. 30, 2021.
“Talk Your Book: Rethinking the 4% Rule,” Podcast With Wade Pfau and David Lau, dplfp.com, May 2, 2022.
“DPL Financial Partners Launches Commission-Free MYGA Marketplace for RIAs,” businesswire.com, Dec. 2, 2021.
“A Day at DPL With Wade Pfau | How to Use a Fixed Index Annuity,” by Wade Pfau, dplfp.com, Feb. 3, 2020.
“Too Much ‘Hocus Pocus,’ ” by Kerry Pechter, retirementincomejournal.com, June 4, 2021.
Taxes and Asset Location
“The Tax-Efficient Frontier: Improving the Efficient Frontier With the Power of Tax Deferral,” by David Lau, dplfp.com, Sept. 8, 2021.
“David Lau on Ways to Enhance the Tax Efficient Frontier at NAPFA Session,” by John Sullivan, thinkadvisor.com, May 19, 2011.
“Long-Term Care a Big Question in Pandemic,” by Emile Hellez, investmentnews.com, July 2, 2020.
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance and retirement planning for Morningstar.
Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Benz: Our guest on the podcast today is David Lau, founder and CEO of DPL Financial Partners, which develops and distributes low-cost, commission-free insurance and annuity products. In addition, DPL Financial Partners provides tools and educational resources for registered investment advisors and individual investors. Prior to founding DPL, David was chief operating officer of Jefferson National and before that he was principal and co-founder of the Oysterhouse Group, a management consulting firm. He also served as chief marketing officer of E-Trade Bank and its predecessor TeleBank. David received his bachelor's degree in economics from the College of William & Mary.
David, welcome to The Long View.
David Lau: Thanks, Christine and Jeff. Happy to be here. Thanks for having me on your podcast.
Benz: Well, we're happy to have you here. We wanted to start by doing a little bit of stage setting. Annuities are a broad and complicated basket, and it includes a lot of different product types. So, what are we talking about when we say annuity? Can you discuss some of the common characteristics?
Lau: When you think about an annuity, most people always just think about a SPIA generally. They think immediately about the SPIA, which is single premium immediate annuity, which is something that's where you turn over your assets to the insurance company and you generate an income stream. But actually, there's about six different types of annuities, as I think about them, depending on how you lump them together. But when you think about an annuity, basically I think about the structure. So, the fundamental structure of an annuity is an account or a policy that gives you tax deferral and some other benefits with the ability to annuitize, and that's where you do turn over your assets to the carrier.
Most people do not do that. But if you think about the annuity types, you have some that are super simple—fixed annuities or MYGAs—those are CD-like products giving you a fixed rate, and then, you have income annuities that, again, are those products that you're basically buying an income stream in exchange for your assets. But the most popular types of annuities are really the variable annuities, fixed-indexed annuities, and increasingly now what's known as buffered annuities or RILAs, registered index-linked annuities, and those are the most popular products in the marketplace.
When you're thinking about annuities, you have to ask yourself basically a couple of questions. They fall into a couple of different categories. Are you looking for something that's going to give you more like a fixed return, or are you looking for a variable return, participating in some different investment structure? And are you using it for accumulation and risk mitigation? Or are you going to use it for income? So, those are some of the very broad ways I think about annuities and what's available out there.
Ptak: And I think we want to explore some of those details further with you as the conversation goes on. But before we did that, we also wanted to talk about your motivations for starting DPL Financial Partners. And I'm going to read something from your website. It says, “We firmly believed—and still believe—it's not annuities that registered investment advisors dislike and mistrust. It's what they’ve become: complex, opaque, and expensive products that benefit the people who sell them more than those who buy them.”
Can you provide a bit of background on how it happened that insurance products, both life insurance and annuities, got so entangled with high commission?
Lau: That's a great question. To be fair to the insurance industry, it's more that that's where financial services really started. If you would go back a few decades, pretty much everything was commissioned and transactional and stuff like that. What's happened in insurance is, insurance hasn't evolved with the rest of the industry. So, while the rest of the industry has moved to no load, transparent, low-cost product, annuities and insurance really hasn't done that. So, they're basically working on an old business model that hasn't evolved. And if you ask why it hasn't evolved, I would tell you probably—and this is just my opinion—is that the commissions and the compensation are just too rich. It's hard to get away from when you've got an existing distribution methodology and paradigm where the people who are selling the products are getting compensated really well, whether it's the individual agent or broker or the wholesaler representing the products for the carrier. They are getting compensated well, and that's a tough thing to overcome.
Given the statement you read Jeff, the reason I really started DPL is because I've always been a consumer advocate for my entire financial-services career. I started in the early ‘90s. I was chief marketing officer at the first internet bank in the country, and the thesis behind that bank was not so much to let's be on the internet and let's be cool, because that's the thing that was hot at the time; it was about consumer value. It was, if we don't have to build branches to distribute commodity products, that eliminates a whole lot of overhead. So, can we then provide much better products to our customers? And so, with DPL, it's the same thesis with insurance, but rather than eliminating branches, you're eliminating commissions and you're changing distribution. And when you do that, you have a very meaningful impact on these products, which gets me to part of the second point of why I started it.
These are important product structures. Annuities are really beneficial products. They've got capabilities inherent in their structure that are really valuable to financial advisors for risk mitigation and financial planning. And the problem is that the commissions have just bastardized the products, so you lose sight of the intrinsic value of the structure because there's so much cost and complexity built in because of the commission. But when you eliminate the commission, you solve all of those problems.
Benz: You've set up DPL Financial in a way that addresses that. DPL provides a platform where registered investment advisors can compare and buy low-cost annuities. You use a membership model for that whereby RIAs pay a fee to be part of the DPL community. I saw on your website, for example, firms with under $100 million in AUM pay $1,000 a year and then the membership fee scales up from there for larger AUM levels. Why did you set it up that way, and can you talk about what firms get when they are members of DPL?
Lau: That was one of the things when you're an entrepreneur and you're starting a business, you're like, this is an interesting concept. This is an interesting idea. Let's bring this membership concept to the business. And the benefit is—and nobody really has a model like this that I'm aware of. So, we didn't have something to point to and say, “OK, let's look at how they do it.” We think this is a pretty unique model. But the reason we bring a membership component to it is, number one, we believe we provide a lot of value to the firms we work with, and we work with thousands of advisors across the industry at this point. And what we really are is a partner to help the firm grow. We're going to help them grow and serve their clients better with more holistic solutions than they had before.
So, part of, again, my motivation for starting the company was, I've always been somebody who has been attracted, because I am a consumer advocate, to the fiduciary model. And if you look at the way the advisory space has evolved, the fee-only advisor is now looking at without being able to provide insurance solutions and some other solutions at a competitive disadvantage. So, when I got in the industry 17 years ago, a fiduciary's differentiation was, I charge on fees, I don't accept commissions and I act as a fiduciary. Now, pretty much every advisor is saying that. They're managing money on fees; they're acting in a client's best interest. And while we do know there's a difference between that and fiduciary, for most clients, they don't understand that difference. And financial advisors have been broadening what they're delivering to their clients.
Now, many advisors are leading with planning. Asset management is just a component of what they're doing, and they're becoming financial planners and wealth managers. And so, if you're an RIA and you can't provide insurance solutions, you're really missing out on being able to holistically serve your client. And now, in order to fulfill the financial plans, you're going to have to send your client down the road to somebody who is now more and more competitive with you every day. That New York Life agent or that Northwestern Mutual agent is very much looking to be the same financial quarterback for that client as you are. So, that was another motivation. And that's why, again, tying it back to the membership, what we provide is a real value to the firm because we can help them fulfill their clients' financial plan, their insurance needs, and do it in a real fiduciary value-added way.
Ptak: Following up on that, you mentioned how you cater to RIAs who want to provide their clients with low-cost annuities and life insurance and that setup can clearly be beneficial for their clients. But a related issue is, the advisors who charge their clients a percentage of their portfolios might still avoid annuities because it reduces the assets they can earn fees on. And so, how do you navigate that in practice? Is that a headwind for the advisors who might otherwise consider being members on the DPL platform?
Lau: It used to be, but that's one of the things we've solved for. I'd been the chief operating officer at an insurance carrier, Jefferson National, for over a decade, focusing on RIAs. And part of the change that we made in making annuities usable for fee-based, fee-only advisors, for people who are charging on AUMs, is we made them billable. So, now, these products are billable AUM assets. So, that objection has pretty much been eliminated. We serve at DPL kind of a two-sided marketplace. We're working with carriers to help them build products and processes and technology that supports the fee-only advisor so that they can bill their fee out of an annuity, and they can get data feeds, and they can get integrations into their desktop, so that these are just assets under management like anything else. Some advisors used to refer to that as “annuicide.” When they're managing money on AUM, if they recommend an annuity to a client, they're losing assets and therefore revenue. But that's not the case anymore, and I think in large part because of the work we do with carriers.
Over the last five years, you're seeing more and more carriers with more and more products coming to market that are billable AUM assets for the advisor. Think of it much in the way of the evolution of mutual funds, and this is part of my model for DPL is, Schwab created one source as kind of the first no-load mutual fund marketplace. We're creating the first no-load insurance marketplace. You're taking a different share class effectively. So, now, those old A shares and whatnot that you would never be able to bill a fee on—everyone is using iShares—we're taking annuities, getting rid of the commissions, and bringing out effectively a new share class, basically.
Benz: Are there any other examples you can share from these collaborations with insurance companies where you're aiming to help them create products that are a good fit for the RIA marketplace? Can you share examples of any of these collaborations that have come to fruition where you're obviously in touch with the RIAs and you've been able to say, “Hey, insurance companies, there's really an appetite for this type of product.”
Lau: It's really interesting the way that's evolved. At Jefferson National, we broke through in the RIA market by having what's known as an investment-only variable annuity. So, just a super low-cost variable annuity, no benefits, no guarantees, no riders. And it was just a tax-deferred investment vehicle, and that was very successful. So, a lot of carriers thought, OK, the way to get into the RIA market is create these products. And it was too much; what they really needed to be doing was creating the products that they're good at.
When we have gone to the carriers, I've got basically one guiding principle for the carriers as we look at product development and product design is we want to bring products to market that can be used and not sold. And it's a little bit for them to get their head around what exactly that means because they've been in such their own mindset for so long that we really aren't looking for the product that's got 27 different riders on it. We're looking for a product that you can simply use as an advisor to solve problems within the portfolio or provide solutions within the financial plan. And if you've got a highly complex product that's got all kinds of different features, that's not really what an RIA is looking for. So, when we work with carriers, we're looking at simplifying products and making them more clear and transparent, because again, these are valuable structures, and one of the best ways advisors bring value to their clients is by leveraging the structures that are available to them to get the best results for the client, and an annuity is a very valuable structure.
Ptak: Can you give an illustration of how DPL might work in practice? What an investor might pay in fees for the same annuity purchased with the help of their RIA on DPL's platform versus going through a commission salesperson?
Lau: That's a great question because when we talk about what we do and making no-load, commission-free products, everybody is immediately like, “Yeah, of course, that's a good idea.” And then when you see the impact, you're like, “Oh wow, that's a really good idea.” Because the distribution expenses typically built into a commission product are very hefty. You could be looking at an 8% commission, you've got paying internal wholesalers and marketing costs, and paying for steak dinners and ball games and all the stuff that carriers traditionally do. That's all built into the pricing of the commission product. Well, in our products, we can eliminate those things. And when you eliminate those things, you're taking the price down of the product 80% to 85%.
So, to bring it to real numbers, the average variable annuity, just the product costs, what's known as the M&E, is about 140 basis points on the commission side. Our variable annuity products are 20 to 30 basis points. So, very, very much cheaper. And then, within other products like fixed annuities or fixed-index annuities, what you see, how that manifests—because those products often don't have distinct product costs, they're spread products—you see better rates. So, instead of a product that might pay 2%, ours might pay 3%, that kind of thing, within the fixed products.
Benz: I wanted to talk about the life insurance perspective on this. I'm curious, has it been an uphill battle to get insurance companies to work in this way versus how they've been doing it for so many years? Because it does seem like they might think, well, this sounds good, but do we risk cannibalizing this whole commissioned piece that has been our bread and butter for so long?
Lau: So it is interesting. Life insurance is a little bit different than annuities, and that has been a little bit more of an uphill battle. And ironically, it's one of those things where regulation that's come into play in order to try to protect consumers actually kind of backfires. So, when we work with carriers, when you take the commission out of a permanent life insurance product—term is different; term is a highly competitive marketplace. There's so many comparison engines and things like that; that's a price-competitive market. Permanent life insurance is not.
But when you take that commission out, you're radically changing the product. So, many permanent life products, it might pay the insurance agent 100% of the first-year premium, maybe 80% of the first-year premium. Meaning, if you were putting $10,000 into the policy, maybe $8,000 of it's going to the agent and only $2,000 is actually going to the policy. When you take that commission out and all of the premiums go into the policy, you wind up with a radically better product. And so, the regulations that really hinder the creation of permanent life policies have to do with requiring agents to use the companies that they're selling the best product, their best-priced product. And so, you wind up with carriers who don't, to your point, Christine, don't want to cannibalize existing distribution. If they create these products, and then they're available to their traditional distribution channels, that would create problems for those agents. You don't have the same issues with annuities.
Benz: I wanted to ask about annuity providers. Has it been an uphill battle to get them to participate in this marketplace?
Lau: Actually, quite the opposite. When I started the company, number one, I started calling some carriers before I actually launched and said, “I'm thinking about building this platform. Would you be interested in participating?” And universally, they answered “Yes, 100%,” for a number of reasons. One is, the RIA market, the fee-only market, is a market that is growing enormously as we all know and a market in which they've never participated in any material way. So, they see it as, one, we can open up this new market; and then number two, when you're working with the carrier at the CEO level, which is typically what we're doing, is they see the future. Financial services, as I was talking about earlier, has largely moved away from this commission structure. They see it that if they want to continue working with financial advisors, they really need to figure out how to deliver products on a fee basis rather than a commission basis. And that has implications not only in the product design, but in the technology that they build, and compliance, and all kinds of things like that. We hear from pretty much everybody. We're working with 14 of the top 20 annuity providers right now, and we're in discussions with a few others. And generally, almost without exception, they're calling us rather than us calling them.
Ptak: Wanted to shift and talk a little bit about another dimension of the process by which one would assess the appropriateness of an annuity or an insurance product, which is insurance company financial strength. In some annuity, critics point to insurance company risk as another potential risk factor for annuities. How legitimate is it to be concerned about an insurance company running into financial problems, in your opinion?
Lau: You can never say anything is risk-free, right? But I mean, relative to other things you're going to invest in, investing in annuities or insurance products through an insurance carrier is a very safe thing to do. There's tremendous oversight and regulation of insurance carriers so that the failure rates of insurance carriers are exceptionally low, particularly at a national level. When you do hear about a carrier that got into some trouble, they're probably a small, regional, more local carrier. But the big carriers, they're extremely well-regulated, they've got lots of cash reserves against their guarantees, and there's state guaranty associations, and they're being regulated by several entities, state regulators, SEC, Finra. It could be all kinds of people overseeing the carrier. But in in general, compared to most things you could invest in, an insurance product is going to be very safe.
Benz: How healthy are those state guaranty associations? I think there have been some questions about that, whether they truly would be there as a backstop, especially in perhaps certain states? We live in Illinois, for example. How do you think about that?
Lau: To be clear, the state guarantees are not FDIC. This is not the federal government standing behind banks. This is state guarantee associations. And the way that those work, just at a very simple high level is, that carriers who sell products in those states have to allocate based on their percentage of sales in those states, resources to provide a backstop to any company that's doing business in that state that might have problems. But generally, what happens is when a carrier is running into financial trouble, there's many steps taken by regulators before it ever gets to state guaranty association. So, as soon as a carrier might start having trouble, the regulators might stop them from issuing new policies. They're going to put companies up for sale or blocks of business up for sale. They're going to step in and mitigate some of that potential risk long before it gets to, call it, a catastrophic level.
Ptak: How should investors proceed if they're putting an amount in excess of the coverage limits into an annuity? Is that an argument for buying multiple annuities from multiple carriers? Or do you think it's just a nonissue given some of the mitigants that you mentioned before?
Lau: You don't see it happening as much. The equivalent, I guess, would be like a bond ladder or a CD ladder, and you're putting assets across different institutions. You see that a little bit when people are using fixed annuities or something like that. But generally, you don't see a lot of it where people are splitting benefits between different carriers when they're looking at income guarantees or something like that. So, I wouldn't say it's an imprudent thing to do. It probably does make some sense to do it. But generally, you haven't seen that in the past, because again, you're looking at point solutions that have been sold by an individual salesperson selling an annuity to a particular person, and they're more of that salesperson than the traditional asset manager or financial advisor. So, from that point of view, there could be some sense to it. But generally, you don't see a lot of it.
Benz: We wanted to dig into some different annuity types to pick your brain a little bit. Many advisors, many RIAs, financial planners are willing to take a look at the very basic income annuities that you referenced earlier, the SPIAs or single premium immediate annuities, and maybe deferred income annuities as well. Does the DPL platform include those products or are advisors who are inclined toward them better off going straight to the insurance company if they're looking at products like that?
Lau: We definitely have those types of products. We've got every type of annuity product. And you're generally going to get the best available products through DPL. So, what we see is, while many advisors think of those products, the immediate annuities or deferred income, and people talk about them, but they're pretty much wildly unpopular products. They're a tiny part of the annuity marketplace. It's something like 3% or 4% of annual sales in immediate annuities or deferred annuities. So, most advisors are looking toward variable annuities, or fixed, or fixed-indexed annuities. And now, these buffer annuities that are relatively new to the marketplace, been around maybe seven, eight years.
And the reason most advisors think of SPIAs and DIAs is, one, those have always been the lowest-commissioned products, so there's better value in those, but also because they have a very limited point of view on how you would use an annuity or why you would use an annuity. And mostly, in that case, you're just thinking, OK, I'm trying to use the annuity to protect longevity risk within a financial plan. And therefore, most advisors will say, “I don't use annuities all that much because I'm only thinking about them for clients who could potentially run out of money or outlive their assets.” But actually, the best use cases for annuities are really for risk management and just general income.
So, when you look at the academic study around annuities and academics universally, and you can't say that about many things, universally in support of using annuities and financial plans for retirement income. The reason is because they generate the income more efficiently than traditional fixed income does. When we talk to advisors, we're educating on those use cases. One, let's look at income. If your client is going to take income from their portfolio, it's likely that the annuity can generate that income far more efficiently than your fixed income. So, let's look at allocating some portion of your fixed income to an annuity when the client is getting near retirement. And the other is risk management. Particularly in markets like this, and you look at historic strategies for risk management for advisors who are only using investments, it's really diversification; diversification of asset classes and geographies and other things to create risk management within the portfolio. But there's so much more correlation today than there used to be between all those different asset classes that when stocks are going down, so are bonds and now, so are crypto. Some people talk about using crypto as a diversifier. Crypto is going down, too, with the market. So, insurance is a way to truly bring risk management into the portfolio and have assets that are protected from downsides regardless of what's going on in the market. Those are really the two big use cases we talk to advisors about.
Ptak: You used the term “efficient” before and how annuities boast greater efficiency than bonds in certain circumstances. Can you just talk about what you mean by efficiency in that context?
Lau: The annuity has, again, some structural advantages, and an annuity is a product that when you're using an annuity that's designed for income, that is a product particularly and specifically designed for income. And so, the annuity is going to enjoy the benefit of risk-pooling with the carrier, pooling the risk of many, many lives and adding that benefit of risk pooling on top of effectively the interest rate that is available through investments. So, Wade Pfau, who is a well-known retirement researcher, he has got a chart that shows in historic interest-rate times where the 10-year is yielding 5.2%—or whatever the average is, something like that. An annuity is going to generate about 22% more income, meaning 22% more efficient in that kind of interest-rate environment. That's the benefit of that risk-pooling. In low-interest-rate environments like we're in today, even though rates have been rising, you're looking at more like a 40% benefit. So, we've got a tool, and this is one of the things our members get access to, is our technology. We've got a tool that will allow you to compare your fixed income strategy to an annuity.
In this kind of marketplace, what that 40% more efficiency means, if you have somebody who you're looking to fund income in retirement—say, you want to fund $50,000 a year for 30 years, that's your retirement. If you want to fund that through fixed income at, like, 3%, that's going to take about $1.2 million, $1.3 million in your fixed-income allocation. You can fund it with an annuity for $750,000. So, you're looking at a massive difference in efficiency in funding that income need. And then, what that creates—and again, this goes back to the academic research and the academic recommendation on how to think about annuities—is now you have a surplus. So, you have a gap of $400,000 or $500,000 that you didn't need to allocate toward that income goal, which you can now invest for legacy or discretionary spending. So, you get so much more efficiency and true liquidity within the portfolio.
Benz: I'm hoping we can talk a little bit about specifics for each of those use cases that you mentioned. So, you're just talking a little bit about income production and how an annuity could fit there, and I want to also talk about risk mitigation. But let's talk about specific annuity types. If an advisor is saying or an individual investor is saying, I am not going to earn much from my traditional bond allocation, and we're also seeing a lot of volatility in the bond market, what's the annuity prescription in that instance?
Lau: If you're looking at your accumulation phase, you look at products that can provide a bondlike return. And for us, that's MYGAs—multi-year guaranteed annuities—those are basically just a fancy name for fixed annuities that the rate is guaranteed for more than one year. Those products right now, we have four-year products paying 4%. So, you're getting a really good interest rate and you're getting it tax-deferred, which is again the advantage of the annuity when you're talking about fixed income. Because one of the common concerns advisors have about annuities is the taxable nature of them, which is that they're taxed at ordinary income rates when you take withdrawals or get payments out. But for fixed income, that's always also taxed at ordinary income. So, when you can tax-defer ordinary income, that's a smart thing to do.
We see the use of fixed annuities and MYGAs and then fixed-indexed annuities, which are, again, fixed products that you have downside protection. So, for the individual or the client, they can't lose assets in the policy due to the market. And within those products, you basically have two investment options. You've got the fixed account, and again, our fixed accounts in those products are paying 3% to 3.5%, I believe, right now. And then you have indexes that you can invest in, so like the S&P 500 index. You can get a diversified source of return for your fixed income. So, if you allocate to that index, you're going to get a cap, but you're also getting that floor, so you can't lose money in that regardless of the performance of the index. But you could get a cap up to 6%, or I think even 9% are some of our higher ones right now. So, you can get a return in fixed income if you're going to the fixed account of 3%, 3.5%. Or you can put it in the index where you're going to get, call it, a 0% to 9% return. And so, those are really great risk-mitigation products in a portfolio because they're truly uncorrelated to the market.
Ptak: One issue with annuities, especially fixed-index annuities, is that it seems that there's the potential for insurance companies to change up the features and benefits of the new products they're offering based on market environment in a way that's beneficial for them. If the insurer is pessimistic about what the equity and bond markets might offer over the next couple of decades, for example, it's going to create annuities where the insurance company won't get into trouble by offering features that are too rich, so the thinking goes. Is that a fair way to look at it? Or do you think that's a little bit too pessimistic?
Lau: I don't know if pessimistic is the right word. But I wouldn't look at it that way. Because if you think about the insurance carrier, what is an insurance carrier at its heart? It's a risk-mitigation company. So, they're all about risk mitigation. They're not in the business of forecasting markets or what's going to go on. When you look at a fixed-indexed annuity, the indexes are basically a collar option strategy. They're not making bets in the market. They're just creating a collar option strategy with zero floors and whatever cap they can purchase in the options market. So, they're not really looking to have forecasts on which way the market is going to perform.
For them, they want to be neutral in that regard. That's not how they're looking to make money. They want to provide a neutral benefit within that index, and they want to price it as perfectly as they can. In those products, they're simply making a spread, just like bonds or CDs or any other fixed instrument. They're really just working off the spread. They're not trying to take any risk relative to which direction the market might go.
Benz: I know DPL does provide advisors with feedback on annuities that their clients may bring to them where the advisor is looking to do his or her due diligence on the annuity that's in the portfolio, or that is part of the clients' assets. So, does it ever happen that when DPL is doing these reviews that the product that the investor has is actually a really great one that the person should hang onto? Can you provide some feedback on that?
Lau: Sometimes you run into—like there was an old, commissioned product that was sold that had rich benefits that the client shouldn't get rid of. So, in general, the answer is yes. We absolutely look at what's best for the client. And again, we've got technology that does that. That's one of the remarkable pieces of technology. I think it's the only comparison tool like it for financial advisors or even consumers who own an annuity. How do you compare them or understand what you have? We built a tool that models over 2,500 annuities and 25,000 riders and 400,000 price points. So, you can look up the existing annuity, tell us a little bit about it— what's the account balance, what's the benefit base, and so on, and a little bit about the client— and then, we'll tell you if we have something that would improve that situation. And most of the time we do. But if whatever the product happened to be super rich, or right now the market is down, the benefit that the client may have built up in the product may not make sense to lose, we'll definitely point that out for the advisor along with advice on how to use the product. So, oftentimes, the advisor or the client don't even know what they have. Where we might tell them, you're in a good situation here but turn on the income rider. People forget maybe you have to do that. So, we try to provide, again, whatever advice is in the best interest of the consumer.
Ptak: Wanted to shift and talk about taxes and asset location, if we could. Annuity critics sometimes lament the tax treatment of annuity income, saying that annuity purchasers turn assets that would otherwise be eligible for the long-term capital gains or dividend tax rates into assets that are taxed at ordinary income-tax rates. Do you think that's a fair way to look at it? Or do you think it's over-simplistic?
Lau: Just like any other investment, you have to understand what the characteristics of it are. Fifteen years ago, I wrote a white paper on this, basically how to use an annuity for asset location. So, I'm not the hugest fan of using variable annuities for income. But what variable annuities are really good for is asset location. So, if you can get a really cheap variable annuity, like I was mentioning, maybe 20 basis points for high-income earners or people who are in high tax brackets or maxing out their 401(k) or IRA, and then, you've got a really cheap investment vehicle like a no-load variable annuity, locating the right assets, regardless of the tax treatment, can be a really smart thing to do to enhance portfolio performance really without increasing risk. Meaning, if you're going to be investing in fixed income, generally that makes sense, as we were talking about earlier, to tax the first—so locate some of your fixed income within the annuity. If you are investing in funds that have active management and there's high turnover rates, that can generate a lot of short-term capital gains. That could make sense to tax-defer. Or REITs or other things that generate ordinary income. It can be a really smart thing to do to put into a variable annuity. But to your point, Jeff, if you're looking at an S&P 500 index fund, that makes almost no sense to tax defer. So, there's really no great tax benefit of putting that into an annuity in particular.
Benz: David, you referenced RILAs earlier in the conversation and noted that these are really hot products today. These are registered index-linked annuities. Can you walk us through how they work and what the attraction is for advisors today?
Lau: They are. And the insurance world always does such a great job of naming products— registered index-linked annuity. They're colloquially called buffered annuities. And basically, these are like structured note products. And for us, they were introduced maybe eight years ago. I think it was AXA, now Equitable, who introduced the first product. And the way they work is sort of like that fixed-index annuity. But instead of that zero floor that the fixed index has, there is a buffer of loss that the carrier will absorb and price those options at. So, for the fixed-indexed annuity, say, you invest in the S&P Index, like I was talking about, you have a zero floor; you can't lose money in the strategy. And then maybe you've got 6%, 7%, 8%, 9% cap that you can earn. And so, we look at that as more of a fixed-income type replacement within a portfolio.
For the buffered annuity, or the RILA, what you're going to get instead of that zero floor might be a 10% floor, meaning a 10% loss. So, they're going to cover the carrier and it can work in either direction. Some absorb the first loss. Some take the tail risk. The carrier will absorb in the products I like personally a little better, the first 10% of loss. So, if you're invested in the S&P Index and the index goes down 8%, the client loses or the individual loses nothing, because it's got that buffer of protection. If the index goes down 12%, then the client or the individual is losing 2%, because they've got that 10% of protection. And the advantage of using a product like that over the fixed-index product is you're going to get cap rates, which are much higher because you don't have that zero-floor protection. So, the cap rates on those products in an S&P is more like 15% to 18%.
The reason they're so popular, as you can imagine, is, OK, I can get some S&P exposure here while having a really good downside protection that can buffer some of the losses that could happen in a volatile year. And so, those are newly popular on our platform. In the first three years of our existence, we sold very few of those. And then, as you can imagine, this year, advisors have been more like, “OK, now that buffered product you guys were educating us about, let's hear about that again.” We're starting to see the value, which is, in large part what we're seeing across the board—advisors attracted to products with true risk-mitigation capabilities. Because people honestly just got complacent. We had a very long bull market run and portfolios were getting heavier and heavier overweight to equities. And a lot of that risk was masked up until this year really. And so, now, you're having advisors really look at alternatives to fixed income and products that can deliver true risk mitigation.
Ptak: You've talked about bringing other insurance products to the DPL platform, specifically long-term-care life and disability products. How far along are you in that process and how big a deal are fees and commissions in those marketplaces?
Lau: I'll start with the end of that question: The fees and commissions are a big deal in terms of the pricing. They're still heavily commissioned products. You wind up with, call it, a 25% to 40% pricing advantage in those type of products. They're a little different than annuities where you really want to make them billable assets for the advisor. Those are more true insurance policies where the benefit is not that you can increase AUM for the advisor, but that you're just going to get a better product to the end consumer. So, each of those is a little bit of a different challenge. Long-term care is the one I've been wanting to solve for a while, and it's just difficult. The traditional long-term-care products where you're paying a premium in order to get coverage for long-term care have become pretty challenging in, number one, they've gotten more expensive than they have been historically, and I think that's because carriers mispriced them originally, and there's been a lot of news about increasing costs of long-term care insurance. So, if you have a policy, the cost has been going up. Then the other thing is, for new issues, they're underwriting much more stringently. So, the big problem companies like Genworth got into was because they viewed these policies very much like disability, and that the usage would be very much like disability products. Turns out that's not true at all. So, if you own a long-term-care product, you're probably going to use it is what they learned.
The challenge in long-term care, as we all know, is typically with clients or people who have Alzheimer's. So, today in traditional long-term care insurance, if you've got any family history of Alzheimer's, you're going to have a really difficult time finding a policy, because those are the kind of long-term-care stays that can be financially devastating and go on 10, 15 years. So, that's a really challenging product to solve for.
So, what we did, we designed a hybrid product that is based on an annuity as its fundamental product. And the reason we did is basically said, we can't necessarily solve all the problems of long-term care, but what we can do is try to address the financial problem and the financial problem being basically, as a retiree, your costs just went up. What we designed was a fixed-indexed product that provides you with a very safe product with no underwriting, importantly, that will provide you with a really good income stream throughout your retirement. And then should you need long-term care, you qualify for two of the six—you can't perform two of six ADLs, activities of daily living, your income will double for five years. So, we think it's not a perfect solution, but it's a pretty good one. And we're looking at some other products on the long-term-care side. Then disability, we've got a couple of different relationships we're working on, on disability and getting pricing out on disability products. But I would say, in the next six months, we should be able to come to market.
Benz: To follow up on that long-term-care question, it seems like when you talk to individuals and advisors about the type of product they'd like to see in that market, it would be the kind with maybe a longer elimination period where the person would self-fund for perhaps a couple of years and then the insurance would kick in to cover them in case of that catastrophic 10-year, 15-year long-term-care event. What's the viability of such products? Are they simply not going to fly with state insurance regulators? That's what I've heard in the past, but I'm not sure if that's true.
Lau: It is true, unfortunately. Again, this is like an unintended consequence, because I agree, like that's the product, particularly for the market we serve with financial advisors, that's what they would love to cover: the tail risk. And for clients who have a lot of wealth, you want to be able to protect that. But again, this is kind of unintended consequence of regulation. And one of the reasons I always say the root of all evil—I should probably say most evil—in insurance is the commission. In long-term care that elimination period is limited to a pretty short period of time because the regulators have tried to make sure carriers aren't trying to sell you something that you're not going to get coverage for. So, if you have like a three-year elimination period—and for people who aren't familiar with the products, that means you go three years in long-term care before you get a benefit. They're worried about commissioned agents selling that product to people not for the purpose of taking care of that tail risk but selling them the product as this is a long-term-care product. Mostly, the regulators want to see those products built and designed so that if you're paying for this insurance, when you get into a long-term-care facility, your elimination period is going to be very short. So, let's have the benefits start kicking in as soon as possible so they really prohibit anything. I think most states it's more than a year or maybe two on the outside in terms of the elimination period. It's one of those ideas that I think is a really strong idea, but there's got to be some championing at the state level in order to get them to be products that can be approved.
Benz: Got it. Well, David, this has been such an illuminating conversation. I know Jeff and I have learned a lot during this discussion. So, thank you so much for taking time out of your schedule to be with us today.
Lau: Oh, I appreciate it. I enjoyed the conversation. Thanks Christine and thanks Jeff. Great questions, and again, really appreciate you having me on the podcast.
Ptak: Well, thank you.
Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Ptak: And @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)