#8: The Benefits of Inequality
We could create financial and insurance industries that benefit society as a whole, but both the benefits of inequality for the few and the illusions it provides for the many are too hard to give up
So in my last two posts here and here, I went into the principal-agent problem that occurs when a customer in a high tax bracket needs financial assistance, but the parties involved have incentives that don’t align with that of the customer.
What happens in that case is that industry pits the consumer against each other so that some benefit at the expense of the other and the industry collects a cut as profit.
It's a redistribution of wealth from those who don’t know what they’re doing to those who do—and the industry gets a cut along the way.
In this post I want to explain a more equitable incentive structure that is better for consumers as a whole, but is difficult to implement because consumers like the idea of chasing high unrealistic returns with large penalties for failure versus lower returns with more safety nets.
So as we’ve been talking about, currently a customer needing financial advice and solutions is stuck between a financial advisor who offers financial advice but no products, and an insurance agent who offers no real financial advice but plenty of financial products.
But the financial advisor doesn’t get paid if you invest your money in financial products and the insurance agent doesn’t get paid if you invest your money in the market.
So their incentives are antagonistic to each other when they should be collaborative since the consumer could benefit from strong ongoing financial advice about which insurance products are in his or her best interests and how to best position that product within a larger plan over time.
Insurance companies are starting to realize the problem with incentives here and the reputational damage that has been caused by life insurance salesman selling products that clients don’t need or don’t understand for the sake of a large one-time commission only for the consumer to cancel the product later, get hit with huge surrender charges, and walk away with almost nothing.
After all, if you’re at a dinner party and you ask someone what they do and they say “I sell life insurance” there’s a reason why you find the most expeditious way to exit the conversation (I say this as someone who sells life insurance products and gets a laugh every time I witness this reaction firsthand).
The prevailing thought here is for the life insurance company to change the compensation model to better align incentives.
So instead of working with life insurance agents that get a large one-time compensation and small residuals on the back-end, they would work directly with financial advisors who would get a percentage fee based on the assets in the product—the same way they get paid on the assets they manage for clients already.
The key advantage here is that it encourages financial advisors to build a business around using life insurance products as long-term financial planning tools to access tax-free or tax-deferred returns for their clients.
That way the clients as a whole get better value and the advisors are the ones getting compensated for providing that value.
This is an infinitely a better long-term solution for most consumers instead of encouraging highly compensated insurance agents to sell life insurance products that most clients cancel in the short-term.
What’s the problem with the current incentives?
The problem with the current incentive structure for most life insurance agents is that they have no incentive to ensure that clients keep the long-term insurance product they bought from them.
Permanent life insurance agents typically get 80%-100% of the first year premium you pay into the policy and ~3%-5% of the premiums you pay in years 2 and onwards.
It's not surprising then that when you look at the rates that people cancel the policy over time (orange line below), that they are typically highest in early years of the policy.
Insurance Compensation and Lapse Rates Over Time
Agents do a great job of selling you a product in order to earn their 100% of premium as a commission in the first year.
But the large drop off in compensation for them in the second year onwards means that they are better off financially by finding new clients who they will get paid a 100% commission on than servicing existing clients who they will earn a 3%-5% commission on.
So the incentives are towards selling something to clients that they don’t fully understand—and soon regret purchasing so much so that they cancel the product completely.
This is a business model that’s designed to burn customers over the long-run.
As you can imagine, if I have to pay an agent a 100% of the first year premium as a commission, I need to front-load the expenses of that product.
That’s why the early year IRRs in permanent life insurance products are negative. So clients need to keep the product for 20+ years to benefit from it.
Unfortunately, due to the compensation incentives mentioned above, few people are keeping these policies for 20+ years.
How to design and think of a better life insurance product
Permanent life insurance products should be thought of in the same way as retirement accounts that clients are planning to utilize to save for retirement in 20-30 years.
All life insurance and annuity products are best utilized as part of a long-term financial plan. That’s how you get maximum value from the tax, retirement, investment, estate, guarantees and downside protection they provide—which I will be discussing how to maximize the financial planning use of these vehicles in future posts.
And the only way that really happens is if a qualified financial advisor is educating clients over the long-term on how this is a key tool in their plan in the same manner that they plan on using retirement accounts or other financial planning tools.
So the idea here is to design a business model where the life insurance company designs a product as a vehicle for the financial advisor to charge his or her fee on.
This incentivizes the financial advisor to use the life insurance product as a financial planning tool in the planning for the advisor’s clients.
A financial advisor typically charges a percentage of AUM fee on the assets he or she manages. This is typically about 1% a year (that’s just the advisor’s costs. All-in costs are about 1.65%).
This means that as the clients contribute more assets into the life insurance product, and the assets in the product grow, the advisor’s fee grows over time.
We can see how this contrasts to the traditional insurance agent commission structure previously mentioned.
Insurance Agent vs Financial Advisor Revenue/Workload per Client Over Time
As discussed previously, an insurance agent generates the most revenue per client in the first year (orange line in chart). In successive years, the revenue per workload to maintain the relationship is small.
The financial advisor on the other hand, loses money in acquiring the client upfront but makes more money over time as their revenue increases and their workload decreases relative to that first year.
What if we were to design an insurance product in which we cut out the life insurance agent and allowed for the financial advisor to get paid over time instead as we discussed at the beginning of this post?
How would the IRRs of this advisor-based insurance product look compared to the traditional life insurance product sold by the life insurance agent who is compensated with a large upfront commission?
We can clearly see that the advisor-based insurance product helps to create a more level IRR pattern for the client over time.
The IRRs reveal a couple of things here:
1) The early year IRRs of the advisor-based insurance product are better.
This means it’s easier to get out of the product without paying such a severe penalty as is the case with the commission based product.
2) The later year IRRs of the commission-based insurance product are better.
While the early year IRRs are better for the advisor-based insurance product, the commission-based product has better long-term IRRs. So if clients are going to keep the product for the long run, they will achieve better returns than trying to replicate that strategy with an advisor using the advisor-based insurance product.
So the dilemma here is that the commission-based product is better in the long-run, but very few people end up keeping it in the long-run because they don’t have an advisor to help them understand the value of how to use it.
So in order for the average person to get the most value out of an insurance product, he or she needs an advisor who advises that client over the long-run on how to use the product.
So the idea here for the life insurance company is that instead of paying a life insurance agent a large upfront commission to sell a product, they pay the advisor a percentage AUM fee that is small upfront but grows over time which encourages the advisor to ensure that clients continue to use the product in a way that benefits the client so that the client continues to use the advisor.
This business model of charging a fee based on the client’s assets is one the advisor is already comfortable implementing.
This has a number of advantages:
1) Clients will appreciate the value of the product more
Since clients have a long-term advisor on board they will be using an insurance product that best complements the rest of their financial plan—as opposed to one that provides the highest upfront commission. There are financial planning, retirement, and tax planning benefits that clients wouldn’t get if they didn’t have a financial advisor about how to best utilize the product for these purposes.
2) Less clients will cancel the product
Furthermore, even those that do cancel the product will be able to exit the vehicle without paying the large surrender charges that come with commissionable products. Remember that when an insurance company pays a large upfront commission to a life insurance agent they have to include high early year expenses and charges if the client cancels the product.
But if there is no large commission then there is no need to have high early year charges and expenses.
So the average client here is getting a better deal here with this design.
Keep in mind that this type of design will also go a long way towards repairing the reputation that life insurance and annuity products have with consumers.
The reason why these products have a bad name is because the high commissions incentivize the sale of products to consumers who purchase them and then cancel them while walking away with nothing. But if the insurance company changed the incentivizes such that the individual recommending the product only benefits if clients keep the product for a long-time—while also reducing the enormous penalty for canceling the policy early—then these products wouldn’t have the negative reputation that they currently do.
What’s the problem?
The problem with this design is that while the average client is getting a better deal with this design, the best possible return is no longer possible.
And that’s because the commissionable product allows for the best possible return over the long-run—as we saw in the previous graph with the long-term IRRs.
Remember that commissionable products are able to afford high returns to clients in part because most people cancel the product.
So the few clients getting a great return are profiting off those canceling it early. I talked about this in-depth in my past article on whole life insurance.
This is an unequal return distribution.
However, if I create a product that is more equal to all parties (as an advisor-based insurance product would do) then by definition those who used to get a great deal as a result of the inequality will no longer be achieving it.
Let’s look at hypothetical pricing results of a permanent life insurance product vs taxable bonds.
As I’ve talked about in different articles, when you invest in most permanent life insurance products like whole life and universal life insurance you are really just investing in tax-free bonds. I’ll dive more into this in later posts.
So there’s a couple comparisons that could be made here:
1. Investing in taxable bonds directly
2. Investing in taxable bonds via an advisor that charges 1%
3. Investing in a commissionable permanent life insurance product sold by a life insurance agent
4. Investing in an advisor sold permanent life insurance product in which the advisor charges 1%
It’s helpful to compare these options using a sample client example.
Let’s use the case of a married 50 year old couple working in California and making $400,000 a year who wants to invest in taxable bonds earning 5%. Due to their income, they are in a 40% marginal tax bracket which means that for every dollar they earn from investing in bonds they will lose 40 cents to federal and state income taxes.
Are they better off investing in these bonds directly, using an advisor that charges 1% to invest in those bonds, using a commissionable permanent life insurance product, or an insurance product in which the advisor gets paid an ongoing 1%?
We can see the long-term hypothetical IRRs below:
30 Year After-Tax IRRs of investment options
What are some high level takeaways we can see from the table above?
1. The commissionable insurance product that pays an upfront commission has both the best and worst possible returns for clients while the other options have a more equal distribution of returns.
This makes sense when we think about it. As I talked about in a previous article about whole life insurance, in order for some to get a great return others have to pay the price.
2. If the client is using an advisor to invest in taxable bonds, the client is much better off if the advisor uses an insurance product to do so.
This is because investing via the insurance product makes the bond returns tax-free which more than offsets both the advisor’s cost as well as the insurance products cost.
So instead of the clients getting a 2% after-tax return using an advisor to invest in taxable bonds, they get a 3.5% after tax return if the advisor uses an insurance product to invest in bonds tax-free. This is a huge financial planning benefit to the client that justifies the advisor’s fee. If the client invested in bonds directly without using an advisor, the chart shows that the client would only get a 3% after-tax return.
So the client needs the advisor to get the extra 0.5% return. The client just increased their return by 16.66% by having the advisor implement the same strategy but within a more tax-efficient vehicle.
And this is the value that properly aligning incentives between financial advisors and tax-efficient insurance products can provide: The insurance company and financial advisor are all adding value to their clients’ long-term plans and getting compensated for doing so.
The Benefits of Inequality
A commissionable product will always allow for the best possible outcome for the client. But a lot more people will get the worst possible outcome from it as well.
And this is the game being played.
Dangle a carrot in front of people and make them think all of them will achieve it knowing full well that most of them will fall into the pit in between them and the carrot.
It's hard not to fall for this.
It’s sexy and more attractive to chase after a 4.5% tax-free return that you probably won’t get instead of the 3.5% tax-free return that you will get if you work with an advisor who educates you on how to use it.
This is a deeper question about the type of society that we want.
Do we want a society where we chase after make believe scenarios in which only the few benefit at the expense of the many—who then come to resent the very system that they chose to participate in?
Or do we want a society in which the products, services, and incentives are aligned to create the highest maximum benefit for society as a whole?
That’s a question that the insurance industry and its consumers will have to answer in the decades to come.
As of now, it’s clear which version of society they both are choosing to be complicit in.
And that version is the current system we have in place in which the many chase after an illusory return so that the few who know how to play the system can benefit.
About the Author
Rajiv Rebello is the Principal and Chief Actuary of Colva Insurance Services. He helps HNW clients implement better after-tax, risk-adjusted wealth and estate solutions through the use of life insurance and annuity vehicles. He can be reached at rajiv.rebello@colvaservices.com
You can also book a call directly with him here:
With structured products, you don't even "cancel" the products, but they "cancel" you. So, you invest $20k in a structured note with say an NVIDIA underlier, a 3-year term and a 10% downside cap/90% upside participation. Good deal, right?
But, the note is autocallable, so if/when the underlier exceeds 100% in 6 months, the product gets "auto-called" by the bank. You don't actually get that 90% upside because your product almost certainly gets called in 6 months. The real cost is the commission you paid up front, and the commission you're about to pay when your advisor puts you in the next structured note. And the next one, and the next one.
In finance (and perhaps business more generally), it's always about turnover, turnover, turnover. That's what earns the fees. (And if you're a fee-based advisor, your "turnover" is effectively annual.)