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.
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.
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).
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.
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.
For 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.