Understanding Conflicts of Interest: Financial Advisors vs Insurance Agents

Original article posted on "Separating Value From Bias" Substack here: Understanding Conflicts of Interest: Financial Advisors vs Insurance Agents #6

The lack of alignment of interests in the financial advisory and insurance industry prevents clients from getting good advice about using insurance products as financial planning tools

In my two previous posts on annuities and permanent life insurance, I talked about how insurance products—while having significant downsides—can also have significant upsides in financial planning particularly for wealthy clients in high tax brackets.

However, these products are rarely being utilized in the clients best interest because of the conflicts of interest involved between financial advisors and insurance salesman who are on opposite sides of a tug-of-war with you as the client in the middle.

The advisor is incentivized to convince you to have him manage your assets in exchange for an ongoing yearly fee while the insurance salesman is incentivized to have you spend your assets on a life insurance solution so he or she can earn a large upfront one-time commission.

A common proffering by financial advisors who are fee-only and don’t take commissions is that they are fiduciaries because they lack a conflict of interest—in contrast to their insurance salesman counterparts.

Their position is that since they charge a fee based on your assets that there is more of an alignment between you and your long-term interests than an insurance salesman selling a product who primarily earns a large upfront commission.

There is some merit to this position.

After all, if I’m charging a 1% fee on the assets that I manage for you and I screw you over (and most importantly you notice that I screw you over) you’re immediately going to cancel our relationship and no longer pay me my fee anymore.

So from that sense I have an alignment of interest to act in your best long-term interests so I can continue to charge my fee.

This is supposed to be in contrast to an insurance salesman selling you a product for a large one-time upfront commission. If the insurance agent sells you a bad insurance product and earns a large commission, he or she often gets to keep the commission even if it’s not a good fit and you’re stuck with a bad product that is extremely hard to get out of.

However, this position also conveniently leaves out a couple of key caveats:

1) This same incentive structure also incentivizes the financial advisor to find a way to ensure that you never realize how expensive the cost of his or her services are. The more he or she can hide the true cost of his or her services—or the lack of value you are receiving from them--the longer he or she can continue to charge the fee.

2) The cost of the right insurance solution over the long-run is less than that of the advisor while providing more protections and tax-benefits.

1) An incentive to provide an expensive subscription service you don’t benefit from

Have you ever signed up for a subscription service like Netflix or Hulu that you forgot about?

Every month they take out $15.49 a month even if you never opened up the app that month.

If you’re not checking your bank statements every month this can go on for months or years before you see it one day and think to yourself:

“Why am I paying for this?”

The AUM based financial advisory business model is actually a lot more malicious than this in that a lot of the fees can be hidden.

For example, let’s say you give $1M to an advisor to manage your assets. The advisor puts your assets in the same investment model that his 100 other clients are in.

At the end of the year you get a statement showing that your portfolio value has gone up by $84,000.

You’re of course ecstatic.

An 8.4% return is a solid return.

What’s not always being shown are all the fees that are being charged.

The underlying investments probably went up close to $100,000.

However, the advisor had to charge his or her 1% fee so that’s a $10,000 expense taken off the top.

On top of that the investment expense for using the funds is $5,000.

And then the custodian charges another $1,000.

That’s $16,000 in fees you’re being assessed. So of your 10% gross return, you’re losing a total of 1.6% in all-in advisory costs. That’s in line with advisory studies that show on a $1 million portfolio clients lose 1.65% in all-in advisory costs.

You could get the same investment performance from a low-cost index fund invested in the same underlying assets for a fraction of the cost.

So instead of an 8.4% net return, you could be getting a net 9.9% return while only paying 0.1% in investment expenses.

In order to counter this large expense ratio, advisors would need to add a LARGER amount of value via financial planning (tax-efficient planning/withdrawal strategies, customized individual solutions, etc).

In reality this is difficult for an advisor who has a client with fairly average needs. And in practice it requires a lot of extra effort on the part of the advisory firm that they could be spending on getting new clients instead and scaling a business.

It’s much easier to show clients the 8.4% net return and hope they don’t probe into it any deeper all while continuing to charge the ongoing fee.

2) A great insurance product will cost less in expenses over the long-run than an advisor—with more protections and guarantees

In our previous posts on annuities and life insurance I spoke at length about how these products can provide protections, guarantees, and higher after-tax risk-adjusted solutions than direct investment offerings most traditional advisors provide.

However, contrary to popular belief, insurance products are also significantly cheaper over the life of the client—in spite of the large commissions paid.

Let’s look at a quick, simplistic example. Assume you are in your early 50s and trying to plan for retirement.

If you give me $1M of your assets to manage, you can either pay me by paying $10,000 a year for every year that I manage your assets or pay me $60,000 one-time upfront and never pay me again.

Which option do you choose?

Well, the answer to this really depends on how long you choose to use my services. If you choose to use my services less than 6 years, then you are better off only paying me the $10,000 every year that you use my services.

But if you plan on using my services for longer than that, then it’s better to just pay me the one-time upfront fee and never pay me again.

And this is a simplistic way of thinking about the difference between the costs of using an advisor and paying an ongoing fee versus paying a one-time commission to an insurance agent.

Over the long-run, insurance products are a more cost effective solution than paying an advisor to try and replicate that solution using traditional stock and bond markets without any of the protections and guarantees that insurance products can provide.

However as we’ll go over in the next section—this doesn’t mean that insurance products are a best fit for everyone.

In fact for a lot of people, purchasing annuity and insurance products are one of the worst financial decisions they make because time and time again, when left to their own devices people who purchase these products often have no idea how to best use them for their benefit or identify which products are good from those that are bad.

Most people need an advisor—particularly for insurance products

Buying a low-cost index fund or target date fund and calling it a day sounds easy enough.

You can do this part without an advisor.

But in reality we as humans have trouble sticking to a financial plan the same way we have trouble sticking to a diet.

When the market crashes or we have a craving, our immediate reaction is to do the one thing that all our planning told us not to do in times like this.

An advisor helps us protect us from ourselves and hold us accountable to the goals we state we want. On top of this, an advisor should know and implement strategies that you might be aware of in order to help you meet those goals.

It's the same reason why many people hire trainers and nutritionists.

On top of that, the advisor gives us a peace of mind and sense of security that we’re going to be ok. This is a feeling that most of us aren’t able to get on our own.

So yes, earning a net 8.4% return doesn’t sound great when we could be earning a 9.9% return if we knew what we were doing.

The problem is that most of us don’t know what we’re doing—even when we think we do. We actually need the help of a financial advisor to stick with a long-term plan when our emotions say otherwise.

A Vanguard study shows that while using an advisor can help add up to 3% in net returns, the bulk of that value comes through “behavioral coaching”. In other words, helping clients not make brash short-term emotional choices that hurt their long-term investment goals.

So that 8.4% net return is actually a great value in comparison to the 5.4% return we would be getting if we tried to do it ourselves—all while feeling stressed about the moves we’re making.

Not all of us, however, like the idea of paying someone to help us manage our emotions—regardless of how much it may be needed.

It’s why many people opt for the “index-fund and chill” approach.

We may acknowledge that we could benefit from financial planning—we just don’t want to pay an outrageous price for it that we feel supersedes the value we’re getting back from it.

This mentality often leads people to buy life insurance and annuity products that they may not fully understand without having an expert available to help explain all of the value and the pitfalls to.

However, most insurance and annuity products are not a “buy it and chill” type product.

They require active management and ongoing reviews to prevent us from the pitfalls.

So sure, when used properly an insurance product can help us get a better after-tax, after-expenses, risk-adjusted return than when using an advisor.

But when used improperly we can lose everything and end up with nothing.

Which is infinitely worse than using an advisor and paying a high expense ratio and getting a decent return.

What consumers could benefit from is finding an advisor who understands how to use life insurance and annuity products as part of a holistic financial, investment, and retirement plan in a similar fashion to how they use other tools like retirement accounts, tax-bracket management, tax-loss harvesting, gifting strategies, etc.

Unfortunately the conflict of interest between financial advisors and insurance salespersons prevents this from happening.

So consumers are stuck between two parties who are incentivized to further their own interests often at the expense of the consumer.

Which is partly why the phrases “financial advisor” and “life insurance agent” have such negative connotations in spite of the fact that there is the potential to add so much value to clients.