Today, we’re talking about the “scam” that has been perpetuated by life insurance companies for over a hundred years. I know, I can hear you saying to yourself, “which scam is that, there are so many to choose from”?
Am I right? I'm talking about the supposed scam to sucker you out of the gains that you could be making. if you skipped life insurance and bought the investments that they put their money in—yourself.
As you know, when you give a life insurance company your money (aka paying your premium), they're just investing your money in something you could do for yourself. And it’s a question we get a lot. Various articles and blog posts have been written on this argument, suggesting that you could skip that, avoid paying those fees and invest your cash in those things they are going to buy yourself.
Well, you could also put your house on the market by yourself, leave it there for a couple of years, and make way less money. Your choice.
Okay, we’re hitting the punchline early today, and we’re going to suggest that maybe—just maybe, it’s a little more complicated to invest in those securities yourself than some of those people have led you to believe.
Let’s break it down, shall we?
We’ll back up and roll the argument out as it’s traditionally presented: about 85% to 90% (or more) of the general account at most insurance companies are invested in bonds. So, the argument is: you just go buy the bonds yourself.
Now only if we were in a big room of people, and we could ask everybody in the room to raise their hand if they’ve ever directly bought a bond—not a bond fund—an actual bond. I'm guessing it would be a small number. Likely, if you do not know what a CUSIP number is, then you have not ever bought a bond.
And for those of you not familiar with a CUSIP number…every security that’s traded has one. It’s a unique identifier, and they’re very important. Most companies issue more than one bond. So, to identify each one, the bonds get a CUSIP number.
Now, you can buy them from most discount brokerages—but it’s not an online transaction. You will have to call in and talk to a broker, and it’s not something you’re going to get $7 a trade for. There’s a markup in bonds—which is not disclosed and not required to be.
Not saying this good or bad, just the facts.
So, when you buy a bond—an actual bond—you don’t necessarily know how inflated the price you pay is. But you will find out a few days later when the trade settles and you're able to see the market the value of your bond. In my experience, it's usually less than what you paid for it. Bonds have a market price, and it will fluctuate. A fact that's misunderstood by way too many people.
Okay, this point might be a little cryptic, so let’s use an analogy.
Imagine you buy a house, and the price is set at $305,000—and you don’t have the luxury of an appraiser. You decide to pay with cash–no appraisal necessary since there's no lender. A day or week later you discover that the house is actually worth $275,000. It was just marked up to $305,000.
Or in a similar scenario, you find out it was actually worth $305,000, but when you decide to sell, you have to pay a realtor and as luck would have it, you'll net some number less than $305,000.
To be clear, we’re not maligning the bond industry or real estate transaction costs. This is just the way it works.
Bonds can be a wonderful place to invest, but it’s not a beginner’s game. It’s not even an advanced investor’s game. Most people will live their entire lives investing in the stock market and mutual funds and never touch bonds.
So, ninety-nine percent of the time, exposure for most Americans to bonds is through ETFs or mutual funds. But there’s one tiny problem with that. ETFs and mutual funds do not function at all like investing in bonds directly. You’re not buying what you think you’re buying when you buy a bond mutual fund or bond ETF.
The diversification or asset location models say you should have 30% of your money in fixed income, so people go out and buy whatever is hot—say the Vanguard Total Bond Market Index—and that’s how they get exposure. And that’s the super savvy. For most people, it’s whatever fund company they have their IRA set at after they roll over their 401k.
The problem with that approach is if you are investing directly in bonds, usually you’re doing it to create income—not to pay the bills—but to create a yield that is supposed to accomplish other goals within your overall portfolio. Let’s assume most bonds pay you twice a year, and you get a coupon every six months that accumulate as cash. That’s a risk-aversion strategy.
But for some very savvy and sophisticated investors, there’s a strategy to capture capital gains in those bonds. When the yield is high and the interest rates are going to dip, the underlying bond is very likely to be worth more on the open market.
Or maybe the company just had some bad announcements undermining their ability to actually repay their debt (which is what a bond is). That would definitely cause the price of their bonds to fall; investors might see a sweet deal. The yield is going to be phenomenal, and in the long run, the price of the bond will go up. Or at least that's the speculation.
The great thing about buying bonds is unless the issuer pays the debt off early (the bond is “called”) or there's some deep issue with the company's ability to repay the debt—there's not much pressure for you to do anything other than collect your coupon payments a couple times a year.
The translation to bond funds is that none of that is true. Bonds are a great way to secure a certain amount of additional income for other purposes, but we have this totally warped idea as general investors and investment advisors, that bonds are a safer place to put your money.
There’s less volatility—until there is.
Unfortunately, you got stuck with some hefty percentage of your total net worth in a bond fund or bond index ETF because the pretty pie chart said that's what you were supposed to do. Right?
But here's the problem. You’re not really investing in bonds just to be safer. In many respects, they’re not, especially when we’re talking about a lot of corporate bonds, and we have a condition like right now where interest rates are rather low and there is an ever-present possibility that they creep higher.
And we don’t even need a massive jump. There’s been a discussion for many years that there could be a pop in interest rates. There could be, but it’s not super likely to take place. A gradual rise? Absolutely.
And if that happens, there’s going to be a gradual decline in bond values. And the value of bond funds is going to follow. It’s very simple.
For example, if a bond fund bought a bond five years ago, let’s say a twenty-year bond, and you paid $1,000 par value with a coupon of 3%, that means your yield each year will be 3% total. But now five years have passed, and the Fed has raised rates.
Now you can buy a new twenty-year bond, but it has a coupon of 3.5%. Why would anyone want to buy the bond that pays 3% from you for $1000 when they can buy a new one for $1000 that pays 3.5%? They won’t; they’ll offer you less than $1000 to make it yield something closer to the 3.5% that they could get from buying the new bond. That’s the risk that you have. Whereas, a bond fund has a huge pool of these things: hundreds, if not thousands.
Here’s a real-life example for you. A couple years ago I decided to take some money sitting in an IRA and move it to something that was cash-like, but for some reason, the particular fund company didn’t have an option for me to do that the way I wanted to. So, I decided to go about this in the way that insurance companies go about it.
I did exactly what insurance companies are supposed to do, and I put it all in a short-term (six month) bond fund. We know that insurers use bonds like that all the time as cash-like equivalents. They’re not locking it up very long, they get a yield on it, and they can do with it whatever they want. So, I did that a couple years ago, and theoretically, I should have a decent yield for the past couple years.
But actually, I have a loss of a $1000 right now.
And did I lose anything on the whole life insurance policy I own? Not a bit.
The thing that is fundamentally missed here is that insurance companies are institutional investors with a lot of money, and they can take advantage of that scale in a way that most of us will never even come close to. They have access to deals that retail investors don’t even have the opportunity to.
Even some of the small companies—five billion or less in assets managed—compared to the average 401k balance of $60,000…who do you think gets a better deal?
And those are the just the little guys. Imagine what kinds of deals you can broker when you’ve got five billion to buy new bonds with. The average general account is sixty billion. They’re not buying bond ETFs.
There is a sliver of the general account that invests in ways you would never even dream of doing such as private equity deals that aren’t even listed. And insurance companies do this knowing that they could lose a couple hundred million. What's different for them is that it's okay, they won't win 'em all. The ones they do win will reward them handsomely and you as a policyholder.
The point is that something as seemingly boring as bonds is quite complex. And if you think you can replicate that in the same way an institutional investor is, you’re kidding yourself. And the bigger point that people miss is that the insurance company is wrapping up those bonds so that you don’t have the principal loss. You’re not going to achieve the same result that an insurance company does.
If you buy bonds on your own, you can’t compound your growth; there’s no reinvesting. In a whole life policy, you’re able to take advantage of compound growth without a tax consequence and general investment expenses. It all adds up.
And at the very least you have someone to represent you when things go sideways.
There’s a reason that life insurance is not the same as buying bonds. Cutting the middleman out just means that you’re going to take on the role of being an expert on bonds. And chances are that your $5,000 IRA will not give you near enough bargaining power.
Essentially, we’re of the fundamental belief that an expert who tells you, “just invest in bonds yourself and cut out the middleman” is giving you advice that they themselves have never actually taken. It's right up there with, “oh no problem, yeah you're not insurable, but we'll just buy the policies on your kids.” Here's a secret: it doesn't work that way.
Brantley is a practicing life insurance agent and has been for over 18 years. After years of trying to sell like his sales managers wanted him to, he discovered that people want to buy life insurance if you actually explain the benefits.
IPB 136: Leaving One Life Insurance Company for Another
Why don’t more Financial Advisors Sell Life Insurance?
Questions About Dividends, Direct Recognition, and IRA Liquidation to Fund Whole Life Insurance
Whole Life Insurance Rates: What’s the Cost of Waiting to Buy?