Curtis Cloke didn’t need the Department of Labor to tell him to focus on his clients’ needs. Two pilots laughing during a terrifying plane trip made it all too real.
Cloke, a retirement income advisor and well-known sales trainer, has always been thinking about how to distill the complicated world of finance and insurance down to the essentials. But it was severe turbulence that shook some palpable empathy into him.
He was aboard an 18-passenger, single-propeller plane that took off into a 40-mph ground wind on a rainy, misty day from his tiny home airport in Burlington, Iowa, three years ago. Although Cloke flew weekly, this trip stood out.
“I was the only passenger in this plane, and I’m just focused on keeping my stomach in check and not getting sick. I couldn’t even see out the windows,” Cloke recalled. “And all of a sudden I heard this laughter. I looked up and while on autopilot, these pilots had their phones up and beamed at each other for some game, and one had yelped out a happy moment.”
But “happy” was not how Cloke would have described the moment for himself. “I yelled at the cockpit, ‘Hey, what are you doing up there?’ The pilot looked back, looked at his co-pilot, and they laughed. He said, ‘Relax. We have five gauges on this dashboard right here that are telling us that nothing’s flying into us and we aren’t flying into anybody else. So just sit back, relax and do your best to enjoy the ride.’”
The pilot’s smug demeanor didn’t help Cloke enjoy the rest of the flight, but he was at least reassured that they weren’t going to crash. Back on the ground, during his third drink to steady his nerves for the plane ride back through the same rough conditions, Cloke had an epiphany.
“This is exactly what our clients are experiencing as they face retirement,” Cloke said. “They hate the ride. They can’t see out the windows, and they just want somebody to tell them if it’s safe or not. They want to know, ‘Am I going to make it?’”
Armed with that insight, Cloke went back to the office and instructed his team to figure out a better way to present information to clients. They needed to start with a dashboard that showed a bigger picture that clients and the advisor could adjust and readjust, rather than columns of numbers that clients couldn’t relate to.
Although this was Cloke’s journey to better client service, the DOL has spent 2016 pushing advisors in a similar direction: toward more clarity with holistic care, and less persuasion with product-selling.
The conflict of interest fiduciary rule goes into effect on April 10, 2017, but 2016 alone has brought a wave of surprises.
First was the inclusion of fixed indexed annuities (FIAs) in the best interest contract exemption (BICE). The BICE requires not only that the client’s best interest be protected but also that a financial institution must sign a contract with the client promising to uphold that standard.
Variable annuities were already under that standard in the rule’s original version released in April 2015. FIAs were under the prohibited transactions exemption (PTE) 84-24, which featured different requirements. After several months of hearings and comments, the DOL released a final version that moved FIAs into the BICE. The final rule was not subject to comment or hearings.
A key effect was that FIAs, one of the fastest-growing insurance products, now needed a financial institution to sign the contract with clients and assume liability for the advisor’s conduct. Simply put, the financial institution could be looking at a class-action lawsuit at any time after the sale.
Another surprise was the amount of documentation advisors would need to show that they made the recommendation without the influence of a commission and in the best interest of the client. And also show that their compensation was reasonable, which has not been defined.
Pressure on the industry is also increasing from other sources. Insurance companies themselves are turning away from commission-based sales. And a potential rule from the Securities and Exchange Commission would widen the scope of who falls under the fiduciary duty standard.
Advising by Gauges
Cloke and his team came up with a dashboard similar to the selection of gauges Cloke saw in the plane’s cockpit during his flight from hell. They came up with 12 gauges, but that seemed too complex. So they cut it to four.
The gauges are simple, but the methodology behind the numbers is not. Even taking the first one, which indicates a safe withdrawal rate, requires several bits of data. “We talk about this in the context of traditional asset management,” Cloke said.
“We talk about this in reference to Monte Carlo simulation. But we had never quantified it from the day of retirement to the end. I put in inflation for their nonmedical flows. I put a higher inflation in for all their medical flows to cover health insurance premiums, Medicare Part B, et cetera. I put in their pretax dollars that are taxed one way. I put in their Roth dollars taxed another. I put all the analytics in that I can ascertain.”
The program puts together a dynamic tax estimate. Cloke described it as an automatic 1040 for each year based on flows.
Editor’s note: The quadrant chart in this article was printed with an incorrect caption. The correct version appears below.
“I don’t have to think about it. I just have to know that it’s under the hood,” Cloke said. “When we get to the withdrawal rate column, it immediately tells the consumer for every single year from the day of retirement until the day we project the last spouse passing away what the withdrawal rate requirement is, based upon all that dynamic math.”
Quite often, that withdrawal rate is around the typically advised 3 percent. The next gauge is income — what percentage of that income do clients not want to risk?
“You’re asking a very emotional question,” Cloke said. “And whether they have $100 million or they have $500,000, somewhere between 70 and 80 percent is the consistent answer.
“But when all the data is entered, often the withdrawal rate is closer to 7 percent, and they are living on 20 to 40 percent reliability of income.”
Cloke and his team do not have to tell clients that their plan does not match their reality. The gauges do.
Gauge No. 3 sharpens the picture for people who thought they were relatively well off. For example, say a couple has agreed to the guidance of a 3 percent withdrawal and needs $90,000 a year to maintain their income. The $1 million they have between them in retirement accounts will yield $30,000 annually with a 3 percent withdrawal. Then they have $30,000 in pension and $30,000 in Social Security — $90,000 altogether. Gauge No. 3 shows discretionary liquidity.
The hypothetical couple has an allocation liquidity with stocks and bonds that can move from one place to another. But they don’t have any discretionary liquidity — that gauge is zero.
“So, now I help them understand the difference between investment allocation liquidity and discretionary spending liquidity,” Cloke said. “And you know what liquidity they care about? Discretionary, every time.”
If they wanted to travel or spend money on some other activity or purchase, they wouldn’t have room to do it. Cloke said this is when an annuity makes sense for a dependable income that they don’t have to worry about outliving.
To get to the extra 3 percent withdrawal that clients may want for discretionary income, half of the $1 million in retirement funds would get the extra $30,000, Cloke said. The $500,000 is no longer a hostage to produce the $30,000 annually.
The fourth gauge is net worth. Clients can see how adjusting one gauge affects the others. It is not always a given that the purchase of an annuity reduces net worth more than other strategies would.
As a financial and insurance advisor, Cloke sells a range of products. So his process is not a sales technique to sell annuities alone.
“When clients see their baseline with those four things, they want those gauges fixed,” Cloke said. “Sometimes they can get the income that they said they wanted if they’ll just allow me to use all the tools in my toolbox — mutual funds, stocks, bonds, notes, life insurance and annuities of all different types and size.”
Cloke said he believes his model is something the DOL wants to see — more focus on client goals and less on a particular product. Although his system sells annuities, they are in only one group of products his company sells.
“DOL regulations are going to require us to stop being product-specific, and be product-agnostic,” Cloke said. “We need to start focusing on what the clients want, not what we want.”
Because clients are in control of making decisions, Cloke is not worried about defending against a lawsuit under the BICE.
“We can go back and say, ‘This is the discovery of what the client wanted and what they needed,’” he said. “‘Here are the holes that were defined in the quantitative results. Here are the 18 things that we tested, and this clearly won hands down.’ Nobody is going to be able to attack that.”
Companies Still Assessing
Cloke’s new process seems to align with the DOL. But many advisors and companies are still trying to find that direction, even though the rule was long in coming and the effective date is only months away.
In October, LIMRA CEO Robert Kerzner said companies were still at a stage where it was difficult to see a general model or direction for the industry.
“We’re still in the assessment state, and very few have made very specific broad exhortations of what they’re going to do,” Kerzner said. “I still think we’re very much in the chaos stage.”
One trend that has been clear is the move by some companies, brokers in particular, to drop commission sales. But as companies move toward fee sales, they move away from the lower end of the consumer market.
That is what happened in the U.K. after commission sales were banned in 2013.
“There are some recent studies from the U.K. government that reaffirm that there has been a reduction in advice to the middle market,” Kerzner said. “We have certainly predicted that that’s what will happen in the U.S. This is not the time to be removing choice.”
That means many people who have fewer assets and are younger will be left behind. Or, more accurately, they will be left with robo-advisors, which about 80 percent of Americans don’t even know about, Kerzner said. Consumers have said they want people and not robos to advise them.
“There is some new research that suggests people want a combination of robo and human advice,” Kerzner said. “When one looks at the data of how millennials want to buy life insurance, mid-40 percent still say, ‘I want it face-to-face.’ That doesn’t mean they mean face-to-face over a kitchen table, but we need ways to leverage technology where a combination of technology and some form of human interaction can reassure people.”
But it is going to become critical very quickly because consumers need the push to take action on securing their future. “It could be with some type of tool with a millennial. That may be a gamification approach to help them learn budgeting better, and working on some basics.”
Even though Kerzner has been talking for years about gamification and other ways of reaching consumers, few companies have done it.
On the bright side, Kerzner said he saw some good fundamentals for the industry. Despite the headwinds, demographics are working in the annuity industry’s favor.
“It’s hard to escape the fact that nearly 59 percent of the retail market is in IRAs,” he said of annuities. “The products provide what that older demographic needs and is worried about — they don’t want to outlive their income. We have a product that can help with that.”
Despite low interest rates, even traditional fixed-rate products, such as single-premium immediate annuities, have been selling well. Usually, sales plummet when interest rates drop.
But sustaining that growth will require some innovation, Kerzner said.
“The product is going to have to be different,” Kerzner said, “and we’ll see how innovative we can be.”
It will be in a different market environment, though. Mergers and acquisitions are changing the players in the business, from smaller marketing organizations that won’t be able to absorb the changes to large corporations that can’t afford another couple of bad quarters.
The mergers are not helping with recruiting and retaining advisors, even though the trend toward a fee-based business would seem to appeal to younger workers.
“The optimist would ask, ‘When we’re in a more fee-based business, might the millennials actually rather be in a noncommission, giving-advice kind of profession?’” Kerzner said.
But companies are having trouble recruiting and retaining even with that sales model, he said.
“There’s no question we are going to have to find new ways to provide advice and new models of how we can bring people into the business to provide help and guidance to prospective customers,” Kerzner said. “Because, remember my basic premise — robo-advice alone is not going to do it.”
The problem is that companies have pushed aside projects and development to react to the immediate crisis caused by the DOL rule.
“It just sucks the air out of the room,” Kerzner said. “Any ability to think about innovating is now being directed toward the DOL. It’s a huge resource drain, especially on IT. Companies, instead of building that product of the future, are going to spend the next two years redesigning every one of their annuity products.”
Necessity may be birthing innovation, though. As an American College instructor, Jamie Hopkins sees how the DOL rule has divided students into two camps.
“Millennials as a whole — even though some of them are primarily in the insurance world — actually view the DOL more as a positive,” Hopkins said. “They would like to see a move away from commissions and more to salaried employees at some point, like other professions. That is very different than if I talk to the CLU life insurance agent who’s 56 years old and who thinks that the DOL is a terrible thing and companies are still trying to figure out what we can do on commissions.”
The commission system is scary for someone just getting started, with student loans and a growing family.
“It’s exactly like our retirees — all of a sudden they have all these fixed expenses, and what do they want? Well, they want guaranteed income at that point,” Hopkins said. “Most people aren’t willing to take on that risk.”
The DOL push for reasonable and level compensation might spur creativity not only in how advisors get paid but also in how products can attract a wider audience of advisors. Perhaps including some who would not have considered annuities.
Already, some companies are suggesting strategies using annuities as assets.
“You can still have variable compensation that isn’t commission-driven,” Hopkins said. “The asset under management (AUM) model is in a lot of ways a commission-type model. It’s how many assets you bring in and you get paid.”
Another approach is with assets under advisement (AUA), which are owned by the client and are not actively managed like assets under management would be.
Hopkins isn’t under any illusions that investment advisors are going to flock to insurance products, though.
“Obviously, a large portion of the RIA world is just traditional for-fee planners,” Hopkins said. “They don’t have an incentive to look at insurance products. I do believe that’s changing a little bit as their clients are starting to move into the retirement phase. They do recommend things like long-term care insurance, and they’re realizing the most efficient way to generate this person’s retirement income is going to be partial annuitization.”
There is another element to the reluctance.
“There used to be a term — annuicide — which means if you’re asset under management and you annuitize everything, you don’t get paid anymore,” Hopkins said. “That’s a clear incentive not to do that, but you’ve seen a little bit of a change there where people will put assets under advisory and you can include the annuity there.”
Already this year, companies have introduced several no-load annuities for fee-based planners.
States Get Into Retirement Game
Another area where the industry is going to see more government involvement is in state-run retirement plans. Those are automatic-enrollment IRA programs that several states have been developing with the support of the federal government.
Some have criticized the programs as government intervention that is attempting to supplant an industry, but Hopkins is enthusiastic.
“All of a sudden we’re going to have all of these people who are not in retirement plans automatically enrolled into a state-run IRA program,” he said. “They can opt out if they don’t want to be in it, but we know from watching 401(k) automatic enrollment that it works really well.”
As far as the programs taking business from advisors and the financial sector, Hopkins didn’t see that happening.
“These people are not saving today, and they don’t have advisors,” he said. “I know some advisors say they might not be part of the process, but most of the advisors I talk to think this is good because it opens the possibility in 10 to 15 years of actually having people who did save and now can do something the advisor can help with.”
The fact remains that the current employer-based retirement-saving system has not worked that well over the past 40-odd years despite many attempts at changing the incentives. Hopkins said one of the unintended consequences of the state-based system could be another nudge out the door for the employer-based system. Rather than assume liability with their program, the employer could drop the program and default to the state system.
The state system might help with retirement funds, but it would not solve the problem of getting people properly insured, which has been a struggle even in better times.
“People aren’t going to put insurance first,” Hopkins said. “Insurance is planning for the what-ifs, which is incredibly important. But people have never been good at that. We’d much rather take the instant gratification as opposed to putting money away in case something bad happens.”
Hopkins said he understands the argument against the conflict of interest with commissions. He even sees the argument’s good intentions. But that conflict of interest does not mean that the sales are inherently evil.
“We’re trying to get people to get more consumers insured so they have the right protection for their families and their assets,” Hopkins said. “We’re not selling bad things to people; we’re incentivizing people to go out and do good things for them. Yes, there’s conflict, but we’re still doing good things for people. If we take that away, does the incentive to do good things for people diminish, too?”