Why Doesn’t my Financial Advisor like Cash Value Life Insurance?

I’ll be very up front about the fact that I’m stereotyping badly with today’s post regarding financial advisors and cash value life insurance. I realize there’s a lot of liberal interpretation regarding what it means to be a “financial advisor.” But for today’s purposes, we’ll refer to financial advisors as those who primarily focus on gathering assets to manage.

Ignorance

Before I put on the tin foil hat and call out a possible motivation for your typical financial advisor’s aversion to cash value life insurance, let me also point out that at least some degree of this aversion is likely ignorance. And in many cases, ignorance can be bliss.

Compensation

In order to understand the motivation behind life insurance aversion among the financial advisor crowd, it’s important to understand the way in which financial advisors get paid. Please understand that I don’t intend to bring this up as way to deride the model. I’m not labeling it as wrong, merely highlighting where the incentives exist. And as Steven Levitt and Stephen Dubner pointed out in their best selling book Freakonomics, incentives matter.

Financial advisors, again keeping in mind that we’re talking about those who primarily make their money off asset management fees, are compensated based on the amount of assets they have under management. They traditionally place a client’s money inside an account colloquially referred to as a “wrap” account and their role is to manage the investments inside the account. And for this, they collect an ongoing management fee that ranges generally between .5% and 1.5% of the account balance.

For those who are less focused on the managed wrap account approach, or for those who have yet to obtain their FINRA series 65 or 66, the compensation comes by load fee and ongoing “maintenance” fees associated with the mutual funds they sell. Technically these people cannot refer to themselves as financial advisors, but a lot of them ignore the rules and do it anyway.

The mutual fund load fee is fairly explicit and explained in the funds prospectus (that War and Peace sized book they hand you before you buy in). The maintenance fees (officially called 12b-1 fees) are also defined in the prospectus. Load fees vary depending on the size of your investment and the share class you buy into. 12-1 fees vary only by the share class (size of investment does not effect them).

Regardless to the method of being compensated, the earnings from your incoming investment generate something called Gross Dealer Concessions (GDC) that go directly to the advisor’s Broker/Dealer or Registered Investment Advisor. The advisor is then compensated based on a percentage payout of the GDC (unless the advisor owns his or her own independent Broker/Dealer or Registered Investment Advisor, at which point he or she receives 100% of the GDC).

Trails

If you poke around for information regarding investment sales compensation you’ll no doubt run into the notion of “trails.” Trails are simply industry lingo for residual income somewhat akin to insurance “renewals.” The trail is simply the advisory investment management fee or the 12b-1 fee. It is realized as GDC and paid out accordingly.

The Big Difference Between Insurance and Investments

Now that we’ve laid the foundation, here’s the important puzzle piece to gaining insight to the relatively little mention of life insurance among “financial advisors.” Compensation for insurance sales is primarily made off the incoming money. There’s a commission paid by the insurance company to the agent for his or her work in wedding the insurance company to the client.

Investment sales can have a compensatory function for incoming money, but long term success is focused on residual fees collected on the size of the investment (ask an advisor what his or her assets under management are, and almost all know the number). And this subtle nuance can be a huge difference with respect to take home pay.

An Example to Drive the Point Home

Instead of making a brand new example, I’m going to use the accumulated value found in this post from Brantley about retirement income in a cash value life policy.

The Insurance Sale

The insurance agent is compensated based on incoming money. I don’t remember exactly what the target premium on this example was (it is a universal life policy so that’s where compensation would be focused) but it is over-funded and the general rule of thumb we use is that first year commissions on these cases is about 33% of the total initial incoming money (that is slightly skewed for this case because there’s an atypical higher incoming amount in year one, but we’ll ignore that fact and treat it like that’s the normal incoming money for that year and use the entire amount for the 33% calculation) so just shy of $10,000 is the total first year commission on this policy.

In subsequent years the incoming money pays out a much smaller amount as a “renewal.” This generally ranges between 1.5 and 3%. We’ll use 3%. That means close to $682 per year is paid to the agent for the incoming $22,720 (that’s actually inflated for this specific policy as the payout is less, but there’s a point to doing this, which we’re getting to).

The Investment Sale

Let’s pretend the yields are the same and the cash surrender value is the balance of the account the client has with some advisor. On smaller balances (less than $5 million) chances are high that the advisor is going to charge near the max advisory fee, but let’s pretend the advisor holds back a bit and only charges 1% of the balance.

The Comparison

By year 20, the insurance agent has earned a total of $22,860.63 from this policy. Not bad, but the investment guy has done much better.

I’m only going to take years 16-20 into consideration. In that time, the total GDC collected from a similar performing investment account nets $41,560 (all we’re doing is taking 1% of the balance). Obviously if we added years 1-15 we’d get a whole lot more. This compensation is taking directly from the account, which could hurt performance, but since the investment advisors tell me and you that they can outperform insurance products, I figure it’s a fair comparison.

Also, note the income stream that begins in year 29. Since there is no more incoming money, there is no more income derived from the policy for the agent. For the financial advisor, the fees taken from the balance continue, and the balance has grown to $2.3 million netting $23,000 in GDC in that year alone.

Keep in mind that I inflated the renewal on the insurance side a bit and used the high range. Additionally, a lot of these products stop paying that renewal after 10 years.

Incentives Matter

Cash Value Life InsuranceFor the investment advisor who is focused on accumulating assets under management, there’s a huge incentive to avoid the cash value life insurance discussion. The reason being every dollar that a client spends on insurance products is a dollar not sitting in a managed investment account where it can generate income to the advisor.

Though most advisors become insurance licensed (primarily to sell variable annuities) and could collect compensation on the sale of life insurance, most don’t. And those who do only talk about term insurance due to its simplicity and cheap cost. But that cheap cost has less to do with saving the client money and more to do with freeing up resources to place in a managed account.

Should we be Critical or Upset?

I don’t really want to get into an argument and label this model as incorrect. Because I don’t believe it is a bad model. Just like I don’t really believe any of these models are necessarily incorrect. The problem lies in the the attempt to manipulate them solely for one’s gain.

The one problem that does come up is the trend among financial advisors to try and gain access to all of a client’s assets (i.e. place all of their money in a managed account). Though they try to get all the money under one roof, a large majority of clients tend to spread it around, while most advisors live in a fantasy land about it.

The truth though is that there should be a spreading of assets. Wrap accounts may be able to include a wide range of investments, but they don’t include everything, and most don’t diversify all that much as they are limited by the advisor’s knowledge and expertise.

In other words, while they love to use the allusion that they are all knowing and all wise purveyor of financial wisdom, the incentives to do so don’t really exist and most “financial advisors” are focused solely on accumulating assets that fit their model, while ignoring the benefits of other financial tools–like cash value life insurance–that could seriously improve your overall financial situation.


4 Responses to “Why Doesn’t my Financial Advisor like Cash Value Life Insurance?”

  1. Jason says:

    I have several questions about this policy design:

    One, assuming no 1035 money the first year (i.e. assuming the first year’s premium was just regular cash), how much premium in $ would be required merely to keep the policy in force for that year (pay COI and any loads)?

    Two, would it be possible to for the first year simply pay only the bare minimum premium needed to keep the policy in force (i.e. pay COI and loads as above but not actually accumulate any CV) and then spread the remaining several tens of thousands of dollars over the next four years?

    Three, if the answer to the above is yes, would it actually help the client have more CV (because less is paid in commissions since 2nd year comp is only 3%) to do the above? They’d lose 1 year of interest at anywhere between 2% and 12% but they’d end up putting more into CV and less into paying commissions?

    I actually got this (admittedly possibly dumb) idea from a paper by the Consumer Federation of America’s actuary and fee-only insurance advisor (Jim Hunt IIRC) about a UL (it was a VUL, I believe) that had a near 50% first year commission but that scaled down drastically after that. He told his clients to put in the bare minimum in year 1 and to put it all in in years 2-10 (the commission got lower each year, it was around 7 or 8% in year 2 and a little above 1% in year 10) as above-target dump-ins (since this was a variable product the money was to be kept in low-cost index funds until read to be paid in as premium at which point the funds were sold and any cap gains taxes paid and the money was then used to pay the premium).

    I know most agents would hate this because of what it does to commissions but your company seems to specialize in blending to reduce commissions and increase client CV in the first and subsequent years.

    If this WOULDN’T increase cash surrender value then there’s no reason to do it (simply taking a commission out of an agent’s pocket for no other reason than the sake of doing so is unethical and unfair) but if it WOULD increase CSV by decreasing the amount “lost” as commission then it’s something to think about…especially if one is competing against another agent showing something like one of SBLI’s 10-pay WLs (nearly 100% of the first year’s premium as cash value) or one of Midland’s IULs with the 100% early surrender value rider (do they still have those?), or even a true no-load UL like TIAA’s Intelligent Life .

    PS – I am neither a licensed insurance agent, nor an actuary, nor a finacial advisor. I’m just a layman who has read many of BNTRS’s, CFP83’s, and SCAgnt’s postings on the insurance forum; I probably “know just enough to be dangerous” so if this idea wouldn’t work please let me know exactly why.

    • Brandon Roberts says:

      Hi Jason,

      Thanks for stopping by and this is actually a really great question.

      To answer the first question–somewhat vaguely I’m sorry–there is a stated amount for all universal life contracts that is the minimum amount needed to issue the policy. And this amount is pretty much what would be needed to meet the expenses and little else.

      That exact amount I’m not exactly sure of when it comes to the policy used in this example as I don’t have the information sitting in front of me at the moment, but it’s a good bit less than the amount going in.

      The idea presented by John Hunt would not work in this example, and I’m at a bit of a loss regarding where that would work in general. The commissions paid are recognized by the insurance company as a loss, but they are not deducted directly from the contract. The surrender charge is indicative of that cost to the insurance company, but whether the client pays in year 1 or year 5, 6, 7, etc. the surrender charge schedule will not change (i.e. the insurance company is going to assume the cost whether it actually incurs it or not).

      Now, if this did work, the real analysis would be at what point does the delay begin to negate itself due to lost interest. I’m guessing, but based on the products that exist today (which admittedly are a fair bit different than the ones that existed 10 and 20 years ago) I’d say that timeline is pretty short.

      Note in the example that the first year dump in is $30,031 and the Net Policy Value is $29,018. Interest is paid on the Net Policy Value and only the contracts charges for mortality and administration are actually deducted (which is the case in all years). Acquisition costs (i.e. agent commissions are not deducted, but rather assumed/realized in the surrender charge schedule). In fact, this strategy could further be counter productive as mortality (i.e. the Cost of Insurance–COI) is going to grow larger. This means the percentage of incoming premium that goes above beyond base expenses is going to be larges relative to the guideline premium corridor in the first year, and decline from there.

      Now, one could push back and point out that the guideline annual premium (i.e. the corridor) is actually an aggregation over a period of time and not just a limit per period, meaning if the guideline premium is $30,000/year and one places $10,000 in for year 1 and $15,000 in years 2 he or she actually has the ability to place up to $70,000 in year 3 and remain within the parameters of the guideline premium test. So the relative gap between COI and total premium could theoretically be higher if making use of this fact. Again, however, it becomes an analysis of whether or not the lost interest in years 1 and 2 augment the delay, and since there is no difference in charges years 1 and 2 vs. year 3 waiting should not benefit the client.

      There are some contracts that will reduce or terminate the “premium load.” This usually happens after 10 to 15 years. This would save some money for the client, but skipping the load of 5% (on average) would not be outperform the earned interest of the assumed 6% (in our example). If performance were consistently below the 5% load, it would make sense to wait, but we’ll never know whether or not that’s going to happen, and the whole assumption that gets this idea off the ground is that it won’t happen.

      I should also point out that there is a difference between surrender free products and “no load” products, even though they function very similarly.

      Though they both basically have the same feature (no surrender charge), they operate under different strategies (i.e. their reason for being is different).

      Surrender free (aka surrender waived) products are traditionally used for two main purposes:

      1. Business planning purposes (Non-qualified executive compensation for example) to give the company needed reportable assets on its balance sheet

      2. Premium financing simply because the bank or lending institution wants to see a large portion of the loan immediately available to call if need be.

      There are some personal planning uses (primarily those who are dubious as to their future earnings ability). They do usually take a small hit to overall long term performance for having this feature, but the ability to recoup all premiums is sometimes worth the price. The trick regarding this is in finding companies that offer it on an individual basis. Midland/North American as you’ve pointed out is one option, and they certainly manufacture great products. They are, unfortunately, in the minority when it comes to companies that make this readily available to the individual (non premium financing) purpose purchaser.

      No load products are usually used by investment advisors for wrap accounts. They place the products in the managed money pool and collect their management fee off the cash surrender value. This too is becoming less and less common. TIAA CREF is a player, as you mentioned, and recently has some agents apply for a patent regarding the way they sold this product. Lincoln Financial is another player. Jackson National Life was a player, but this product regretfully went the way of the dodo when Jackson exited the U.S. life insurance market earlier this year.

      Thanks again for stopping by and for the excellent question. I don’t see a scenario where holding back favors the client any longer, at least not with the products that typically fall on the top of our lists. If you have any other questions regarding this or any other topic, please don’t hesitate to send them along.

  2. Jeff Hexter says:

    I have another question.

    Now that I see that the commissions are so front-loaded on the sale of life insurance (well, honestly, I figured that out earlier,) why would someone not go through the licensing process just so they could sell life insurance to themselves? If the commission is greater than the cost of licensing, it sounds like they come out ahead.

    The new agent would get the benefit of a commission rebate on their own purchase, so they could either buy a larger policy or pay income tax on it then apply it to later PUA.

    Aside from time, what is the downside?

    • Brandon Roberts says:

      Hi Jeff,

      The industry sometimes refers to this as controlled business. The biggest obstacle that one would face regarding this is the company appointment. It’s somewhat difficult to get appointed to a life insurance company with no history of production. Further, if a newly licensed agent approaches an insurance company to become an agent or broker and their first and only submitted application is on him/herself and/or his/her wife/husband or kids some insurance companies will hold it until additional business is submitted.

      Economically there isn’t a ton of reason why an insurance company would avoid this (the cost of licensing the agent/broker with the state–there’s a cost for the insurance company as well–isn’t prohibitively high) so the move to avoid is more a gesture of good will to protect full time agents.

      This isn’t the way it works everywhere, and there are some companies who would be willing to accept this as long as the individual never disclosed his or her intentions.

      Economically for the individual I can’t see this being all that beneficial to him or her. The time and cost of acquiring a policy negates the collected commissions in many circumstances. For those look for the types of policies we write, there’s no way a newly licensed lay person will know enough about the products to design it correctly, and designing it correctly will far exceed the earned commissions, and since this design is much more dependent on really long term commissions, losing your license a year or two down the road would make it worse.

      Thanks for the good question

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