At a recent conference of financial planners who strongly consider themselves fiduciaries, I explained the benefit of tax-favored longevity insurance using a qualified longevity annuity contract (QLAC). I even called them a "no brainer" when building a retirement income plan for a client who doesn't have a pension.
A planner in the audience raised her hand. "I'm struggling with why I'd recommend a QLAC. I mean, I'd have $130,000 less in assets under management."
For fee-only planners, recommending costly insurance products presents a challenge. In a recent Wall Street Journal article, two financial planners debated the merits of life insurance. One argued, "Most people are very likely to outlive their coverage, which makes their rate of return on the policy zero. In fact, they will be getting a negative rate of return."
A negative rate of return is what insurance is all about. It's one of the reasons that insurance is less sexy and often more difficult to explain than accumulation.
The expected return on insurance needs to be less than zero for the insurance company to stay in business (though some types of insurance can provide a positive return net of taxes). This means that buying insurance results in lower expected financial wealth.
Why would a fiduciary recommend a strategy that results in lower wealth? People want security, and wealth maximization isn't the point of financial planning. The point is to provide expertise and guidance that helps people manage their finances to meet life goals.
We all face financial risks that can derail a carefully constructed investment plan. Failing to account for these risks as part of an investment strategy exposes the client to the possibility of financial disaster, which is a lot worse than missing out on a few basis points of return.
Time for a Change
One voice advocating a new approach to insurance among financial planners is Bob Veres, a longtime author and thought leader in the field. Veres sees the lack of pricing transparency among insurance products as a significant barrier for fiduciary planners. This is particularly true of more complex cash value life policies and variable annuities with an expense structure that can be challenging to unpack (even for academics).
Would a movement toward transparency and away from commissions increase the use of insurance products among financial planners? Veres argues that bans on commissions in the United Kingdom resulted in an increase in demand for financial planning services.
Advisors were incentivized to sharpen their value proposition to clients, and financial service companies had a greater incentive to focus on product characteristics that provided the greatest value to clients.
In the United States, comprehensive planners are essentially in one of three boats. Fee-only planners lose compensation by recommending insurance products that are paid for with assets they would otherwise be paid to manage. They could select from a small market of insurance products that provide fee compensation, or they could choose to be fee based and receive commission compensation for recommending insurance products.
As a researcher who often simulates the efficiency of various insurance products, I'm a little skeptical of those with businesses structured to throw off fees that aim to compensate for lost AUM. Why?
Commissions on many long-term insurance instruments, such as annuities and cash-value life insurance, can be far less expensive to the consumer than recurring 100 basis point fees. Many of these products don't require management over time; they are a set-it-and-forget-it instruments with sinking compensation that falls below the ongoing expenses of a fee-only advisor after a few years.
Before indicting commissions, let's revisit the history of insurance sales in the United States — specifically life insurance. For most of the 20th century, life insurance agents were the primary providers of financial advice to average Americans.
In a recent research paper, my co-authors and I document the decline in cash-value life insurance ownership among middle-class Americans that can be traced to the emergence of defined contribution savings plans in the 1980s. Commissions provided the incentive needed to call prospects or knock on doors to help families protect against the loss of a breadwinner and build wealth.
Between 1990 and 2000, the number of life insurance companies in the United States fell by 42%, from 2,196 to 1,269. In many ways, the rise in fee-compensated planning was fueled by employer-sponsored savings that required investment management expertise, as life insurance lost its comparative advantage as a combined tax sheltering and protection instrument.
Fee planners and insurance agents continue to clash online, each defending the legitimacy of their compensation model and the value of their approach to advice. According to fee planners, commissions encourage a culture where the focus is on the sale of a risk product, and too many view these products as the solution to all planning needs.
Investment advisors point to the superiority of portfolio strategies that supposedly solve all planning needs, even those that most economists believe could be more efficiently addressed through risk pooling. The reality, of course, is that a sound financial plan requires both.
A New Breed of Planner
At a recent research presentation in Des Moines, Iowa, I met Ross Junge, CFA, who mentioned that he considered working at a few local RIAs after he had left a longtime position in institutional investments: "Strategically, I believed very strongly in the wealth management philosophy of significantly improving financial outcomes by integrating tax efficient cash-value life insurance, deferred income annuities and a tax efficiently structured investment portfolio."
It's worth remembering that the tax efficiency of many insurance products, which the industry spends significant effort preserving, is often overlooked among fee-only advisors. In a convincing (if complex) article on the tax benefits of deferred annuities in the Journal of Financial Planning, Wharton Professor David Babbel and financial engineer Ravi Reddy estimate the tax benefits of sheltering investments within a deferred annuity wrapper to be as high as 200 basis points per year.
In another Journal of Financial Planning article, insurance gadfly (and very smart person) Brian Fechtel, CFA, breaks down complex cash-value policies to estimate when they provide value to clients. In addition to excoriating the industry for what he sees as intentionally opaque sales practices and illustrations, Fechtel finds that cash-value policies can in fact be recommended by a fiduciary planner for a high-income client who holds the policy for a long time and has a death benefit need.
Fechtel notes that "cash-value policies do not inherently constitute unattractive investments … [and] much conventional disparagement can be erroneous and misguided."
