Stories are powerful and investment narratives are no different. Last week, I fought fire with fire and told some stories about some expensive tales that we are told by The Narrator. Narrators get paid for the story and your investment outcome is irrelevant to them. This week, I’ll continue with The Sales Advisor who also uses investment narratives. Except they get paid to sell you a product and just use the story as the hook.
The products sold are “suitable” for a purpose. However, they may or may not, be the optimal route to take. If you know the whole story. Pause and dig deeper to separate alluring stories from realities. Today, I will do that with a couple of common tales told by The Sales Advisor.
The Sales Advisor
Sales Advisor: I have got a special solution to a problem that you may not realize that you have. It will suit your needs nicely. You are wealthy and this is what smart wealthy people do. It has lower risk, but higher returns.
You: Risk and return are priced in. The public markets are efficient enough to do that.
Sales Advisor: Ah, but this is not a strategy that is available to the average person. Here is a comparison to a carefully selected index or a model that we’ve put numbers into. Look at the pretty colors. Look at the photos of happy investors and smart people. See the higher return and lower volatility. Plus, there can be tax savings.
You: It is still priced in. Those benefits will be accounted for when a provider designs and prices that product for the most profit while remaining competitive. What are the alternatives?
Sales Advisor: Well, here are a couple of our other offerings and similar competitor products.
You: Yeah, but those products are all of similar high cost and complex structure. What about other simple strategies? Like a transparent low-cost investing plan and some basic tax planning.
Sales Advisor: Huh?
Who is the Sales Advisor?
The term “financial advisor” can still be used pretty loosely in Canada to describe just about anyone who can help you manage your money. That can include certified financial planners, investment managers, and accountants who sell you their advice and services. However, it can also include insurance advisors (paid to sell you insurance) and financial advisors paid to sell you investment products (like retail mutual funds, pensions, or private equity funds). Or advisors that receive a referral fee to send you to a salesperson who sells those products.
These products are sold using stories. This post on tips for selling insurance even has a graphic showing that communicating the value of your product [via stories and visuals] matters more than intelligence, skill, talent, personality, or the substance of the discussion.
What differentiates The Sales Advisor from The Narrator is that they don’t get paid for the story. They get paid to sell you the product.
Are they evil? Usually not.
It may not be that they are malicious individuals. Some are, but most are not. However, they get trained to sell the products by the companies that profit from them. So, they may not know any better. A Canadian study showed that they usually invest using these products and strategies themselves. Not only while they work for the company that sells them, but 90% even continue afterward when they have retired.
They know and believe in their products or strategies. They must for regulatory reasons. However, that doesn’t mean that they fully appreciate the alternatives. Unfortunately, the products sold may also be opaque and complex. That makes a deeper understanding beyond the minimum required to sell it or construct an apples-to-apples comparison to alternatives challenging. Even if they truly wanted to do that.
The other reason why this is important is because it is a reason why fiduciary duty alone does not protect you against suboptimal financial advice. The Sales Advisor may believe that they are meeting that standard and it is hard to prove otherwise. You must know enough to see the alternative endings to the stories they tell.
The Legend of Permanent Life Insurance
A common opaque product that is sold with large commissions paid to The Sales Advisor is permanent life insurance. It comes in different flavors, but the core concept is that it is insurance that pays upon death. You can also “over-fund it” and have the surplus invested within the policy. Unfortunately, the actual cost and returns are not readily apparent.
The chance of death is 100%. So, actuaries price the insurance premium and pay out accordingly. That is all an extra cost, if it is insurance that you don’t otherwise need. Generally, You should not need life insurance in retirement because you should be financially independent by definition. At that point, you can die and all of your financial obligations will be met by your existing assets.
Participating whole life is often marketed as a way to save on personal or corporate taxes. What is not commonly known, is that there are up to three layers of taxes embedded within the policy. Added to that are embedded fees and adjustments made to the “dividends” or investments in over-funded policies. Ask the person selling you a policy about them. See if they can tell you that part of the story.
Permanent Life Insurance Alternative Endings
Opacity makes insurance hard to unpack and compare to conventional investments. The folks at PWL Capital recently took a good crack at it in this white paper. The are many great points, but I will highlight a few.
The return on whole life insurance depends on how long you live. It is an actuarial risk. For a 40yo male, dying at age 80, the modeled return is 4.18%/yr. If they live to 100, that drops to 1.66%/yr. Women do about 0.5%/yr better. So, it is like playing a lottery that you hope not to win with an early death. In comparison, equities would return ~5.1%/yr in the model and bonds ~2.15%/yr (after taxes). When considering this as an investment, compare it to an asset allocation that you would otherwise be investing in.
Another important point is that the below analysis is at death. To access the money before death is much more costly due to fees and interest charged to borrow against the policy. That after-fees return to live off of a policy while alive would be lower. Selling stocks or ETFs is usually under $10 or even free.
What about corporately-held participating whole life insurance?
The above model is using insurance held by an individual. I use some whole life as a less volatile asset held in my corporation (a CCPC). That seems reasonable to me with my expectation of a low return and the fact that I include it in my comprehensive portfolio asset allocation. I can look at the value to soothe me when markets drop. However, it is not a good bond-equivalent. I cannot easily sell or buy insurance to rebalance my portfolio. Trying to access the money tied up in it would also involve taking a loan. That involves paying other fees and interest.
My policy is an optional and very small part of a larger plan. I am not sure that I would buy it again, but the other thing about permanent insurance is that it is like a marriage. A long-term commitment once you agree and expensive to get out of if you realize it was a mistake.
In terms of expected return in a CCPC, the purchase using partially taxed corporate dollars and payout via the capital dividend account may also improve the math. That utility also depends on how you estate plan for your corporation, and whether the alternative is a large fixed income allocation. If you totally blow it and don’t plan, insurance looks incredible (the tale usually told). If you use other tax planning, it is less compelling. Ben Felix is modeling this scenario also and we will unpack that on The Money Scope Podcast.
Real Life Whole Life Insurance Endings
Some of the real-life endings of the story are telling. Only about 31% of policies over $500K remain in force 30 years later. About 29% of policyholders bail within 3 years and two-thirds within 10 years. Sadly, most of the return from permanent life is later. If the policy is designed for estate planning purposes, the first decade may commonly be spent underwater or with minimal return due to the frontloaded costs. This high attrition rate implies either a poor understanding of expectations when they signed or inappropriate sales.
There are some Sales Advisors that do have good open discussions. Dr. Chadha had a 5 part discussion on Beyond MD Podcast with one. Unfortunately, that is not the only story. The FSRAO just recently did an audit and the results were eye-opening. Of 130 agents, half were cited with significant regulatory violations. Mostly for insufficient disclosures, incomplete educational training, and misrepresentation. If you want to use permanent life insurance, make sure that you get a second opinion from an independent adviser who does not sell the product. Nor profit for directing you to someone who does – ask about referral fees.
The Pandora’s Box of Private Equity
Private equity funds are frequently sold via a similar conversation to the intro of this post. They are touted for having a low correlation to public markets, lower volatility, and higher expected returns. You put your money in, a manager deploys it, and you cannot easily look inside the box.
Opening the lid and taking your money back out is even more troublesome. You must trust the manager’s skill and will be told stories and narratives to build that up.
When looking deeper past the stories, you will realize that the laws of risk and return have not been broken. The investment risk is still priced in.
Plus, there is the uncompensated idiosyncratic specific risk of management and execution. That should be diversifiable by using many managers, but that is not what private equity is sold upon. You are sold on the idea of not settling for the average manager that everyone can access. You are sold the tale of special access to the best manager.
Peek Inside the Private Equity Box
The full story is longer than I have space for in this post. However, I will give you the “Cole’s Notes”. For the younger crowd, that is like the Chat GPT summary.
How you tell the tale of a private equity fund makes it look special. Several studies show the same thing, but Private Equity: The Emperor Has No Clothes undresses the issues nicely. What you compare private equity funds to matters. What their investing patterns most emulate are small-cap value company investments. Plus, they often magnify the results with leverage. Below are three charts from the article comparing an index tracking US private equity fund performance vs the SP500, US Small Cap, and US Small Cap Value equity. It is net of fees and trading costs.
Not captured by the above charts are a couple of other issues. One is that private equity funds are not valued on a day-to-day basis like public equity. So, you would expect less volatility because of fewer measurements. They are also measured by the internal rate of return (IRR). That metric is heavily skewed by early success.
Funds without early home runs are more likely to close (survivorship bias). The investors in the home-run-hitter funds at the beginning will benefit. The massive historical returns are used to display the success of the fund. However, moving forward the returns may be much lower, but the IRR barely budges. Similar to the Fable of Kathy’s ARKK.
Is Private Equity Bad? Like Pandora’s box.
This does not mean that private equity is a bad investment. You may want to use some leveraged higher-risk investments that are locked away from your behavioral interference. Just be aware that the risk and potential return are priced in. Just like other investments. And that the idiosyncratic specific manager risk is not a compensated risk. You cannot expect to get paid more for taking it.
Make sure that you know what you are buying inside the box. If want to hear more plot twists, listen to the long story by a world expert. Don’t buy the tale about how sophisticated it makes you look. Like the Emperor did from his tailor. Now, I should point out that I could consider the tailor to be another kind of storyteller. The Charlatan – I disrobe that incarnation of The Expensive Storytellers next week.
The Power of Cognitive Dissonance
The final chapter of today’s stories is about you and I. I have already linked to a study showing that The Sales Advisor believes in their narrative. They have been trained that way and also have a financial motivation to not question it. However, these are powerful stories for us also. There are kernels of truth in them and the main untruths are often errors of omission or poor comparisons that are hard to recognize.
However, there is also another powerful force at work. We desire to avoid cognitive dissonance. That is the uncomfortable psychological condition that arises when we act in a way counter to our beliefs. Now that you have read this post, you cannot unsee it. It may cause you cognitive dissonance if you buy or sell the products mentioned.
I know how it feels, because I do have a small permanent life policy. I tried to justify my reasoning in that section of this post. However, the truth is that when I bought it, I did not know what I do now. Fortunately, I got the right type and have not bought more (even though it has been brought up). Part of the cognitive dissonance that we face when we buy the story and the product that comes with it is due to The Story Teller. I bought my policy on the advice of an advisor whom I like and who has given me other solid advice.
So, don’t beat yourself up for decisions that you have already made. However, moving forward, remember today’s stories when you get the sales pitch. Look for the alternative endings and remember that The Story Teller gets educated and paid to sell you the product.
My impression is that the goal of insurance is to manage the risk of an unlikely financial catastrophe, and it does that well. Don’t ask it to do something it wasn’t designed for.
Private equity reminds me of private real estate. You’re getting less liquidity and less diversification, so you’re usually taking more risk. Are you compensated for increased risk with increased return? A piece of property earns the same return, whether it’s public or private; the same applies to a company. If private real estate/equity is priced lower than public real estate/equity, then the return could be greater. IIRC though, about 90% of commercial real estate in the US is private. If private real estate was cheaper than public real estate, there would be an incentive for private real estate owners to go public. I don’t see that happening. The same applies to private equity.
One could make the argument that even though private real estate/equity may not be cheaper than public real estate/equity, it might be possible to still come out ahead going the private route. The argument could be made that private markets are less efficient, and there would be greater opportunity for a minority to do well with active management. But the same arguments used regarding active management in public equity/real estate may apply even more here, as the cost hurdle to overcome is commonly greater in the private sector.
Hey Park,
I agree from a rational standpoint. That is why story-telling is so important to keeping the products and industry behind them going. Real estate and private markets are less efficient and there is opportunity for a manager/specialist to generate some alpha in that environment. Like other markets, the challenge is doing that net of fees, and even if they can do it, identifying the rare savants before everyone else does. It is hidden in the box or the unknowable future, but a good story about what is inside sells it.
-LD
LD, thanks for the good post.
Common advice when it comes to investing and taxation is don’t let the tax tail wag the investment dog. Life insurance is a good example where that is often disregarded.
I mention the possibility of alpha being greater in inefficient markets, because I’ve heard that stated so many times. But security selection or its equivalent being a zero sum game before costs and a negative sum game after costs applies regardless of how inefficient a market is.
That zero sum game is definitely a problem. You need losers if you are going to be a winner. One of the big issues with private equity that I didn’t mention in the post is that the amount of money and competition that is in that space currently makes it really hard to get a deal that you can force appreciation into. There is a lot of capital looking for a place to land and there is pressure for a manager to deploy it. That tips the scales to the person selling the business to be the winner and the private equity fund to take a less favorable deal just to deploy the cash. There may have been a time when information flow was lower and competition less fierce, but that is long gone. I have just heard that as a narrative (I don’t have data) which is why I left it out, but I think it is a reality.
-LD
Great post. Love that you tackled two of the most opaque products out there.
“Fiduciary duty alone does not protect you against suboptimal financial advice.”
Great point. Thanks for the work that you do, Mark.
Thanks Matt!
Mark
I’ll echo Matt’s point. Great to get some balanced insight into these heavily-sold investments.
I was on the cusp of buying (actually, being sold) whole life in my corporation a year or two ago. I have no need for life insurance but the “Adviser” showed whizzy graphs of how great WL would be as a tax strategy. I couldn’t find a lot of info at University of Google to justify why NOT to buy the insurance. Yet it just didn’t “feel” right so I declined. Based on the fabulous work you and Ben are doing to fill the permanent life counterpoint information gap that existed only a short time ago, I reflect positively on that decision. Love your commitment to providing relevant financial information that goes way beyond just scratching the surface.
Thanks Brian! Stories like yours are important for people to hear. It is hard to find deep balanced analysis. The whole life insurance in a corp analysis Ben is working on should be interesting. I am keeping an open mind honestly. Even if there is a role to diversify with some “actuarial risk”, there is no rush and the problems of actually accessing the money for personal use are pretty important and not discussed. The biggest irony to me is that it is insurance and its best use is still probably insurance – insurance against not making a good plan for your estate and taxes with more liquid and transparent options. And it is being sold by advisors who make plans.
Mark
In my experience Mark, when clients hear the words ‘tax-free’ all bets are off.
I had a chiropractor client pitched a $16 million WL policy (which he didn’t need) because he could access the money ‘tax-free’. I tried to talk him off the ledge and gave him a list of 10 questions to ask the insurance advisor (including asking how much he was going to make from selling this policy), but there was no changing his mind.
It was really interesting, actually. He first heard about the ‘strategy’ from a friend, who introduced him to the advisor. The advisor did a great job pitching the idea, and then his bank in turn thought it was a good idea, because they were going to loan him the $3.8 million or however much it was to pay the premiums (it was a 10-year pay, I believe).
So here I was, fighting for his and his family’s finances, while his bank, insurance salesperson, and him were trying to get him into something expensive that he didn’t need.
In the end, I lost.
Wow! That is brutal. Plus, they definitely can’t question it now or the cognitive dissonance and buyer’s remorse would be unbearable. Tax-free definitely gets people. Even though there are taxes buried inside instead. I bet most of the people selling permanent life don’t really realize that.
When on the whole-life topic, I often find myself saying that I’d rather make $1 million and pay $250K in tax than make $500K tax-free. People focus on tax because they hate tax, but forget that tax because you did better is better. The conflicts of interest are huge for the bank and sales advisor. They made a tonne of money on that one.
Mark
Totally, Mark. A lot of people made a lot of money on this. In the end, I don’t think it was the client.
The same guy bought $400,000 worth of weed stock prior to hiring me. It went up to $1.8 million at one point, but by the time we started working together, it was worth $300,000. There’s a lesson or two in there somewhere as well.
$100K: Up in Smoke.
