So whose fault was it? Some might say it was the insurance companies that developed products and proposal systems designed to illustrate well for prospective clients. Others might say it was the fault of insurance agents who showed the most aggressive illustrations in an effort to close the sale, rather than help people make intelligent purchasing decisions using more realistic (and conservative) assumptions. Another contingent might say the fault belongs with the advisors who were looking for the "lowest price" (premium) for clients as a way to justify and offset their fees. Any and all of these could only lead to an unhappy transaction result for the insurance buyer/advisor/agent/company in the long run.

Each of these groups should all remember the old maxim, "There's no magic--only magicians." Each party to the transaction is trying to make the best possible deal for itself based on its own interest. What each group needs to remember is that, ultimately, there are certain basic costs of providing insurance protection. These costs consist of mortality charges (cost of death claims), expenses of running the insurance company, and the interest or other earnings which are credited tax-free to the policy reserves/cash values. The best value for all parties can be achieved only when the transaction is fair on all sides. Smoke-and-mirrors illustration gimmicks or other forms of magic tricks cannot enhance long-term policy performance. Long-term policy performance can only be enhanced by substantive improvements in the policy form--but I am getting ahead of myself.

In order for any advisor or client to make a proper evaluation of any insurance product--especially second-to-die--it is important to first understand how any policy works. If we think of a life insurance policy as a car, it has two basic components: a chassis and an engine. The chassis is the framework and the wheels of the policy, allowing it to move into the future, taking on the risk of the death of the insured(s). The engine is how the investment performance is delivered through the policy.

Evolution of the Life Insurance Chassis

As originally designed, all policies were "term" insurance, which meant the premium increased as the insured advanced in age and the risk of dying increased. Term insurance provided basic protection, like horse-and-buggy transportation. Many people became disenchanted with term, however, because after they had paid term premiums for decades, they ultimately had to drop their policies because the premium rates got too high--just as they were nearing the age category when death would most likely occur. Then some brilliant actuary conceived of leveling out the premium payments over a lifetime, so that compound interest could work on behalf of the insured.

"Whole Life" was the traditional policy form, or chassis, the actuary invented. Premiums were payable for the whole of life (hence the name) or some shorter premium paying period, e.g., to age 65 or for 20 years. Premiums were paid, from which deductions were made for expenses and anticipated claims, and to which interest was credited tax-free. A guaranteed cash value was built up so that, at the terminal age of the policy (typically age 95 or 100), the cash value would equal the face amount. Thus, as people got older, the "net amount at risk" to the insurance company (the difference between the cash value and the face amount) would decline while the reserve built up tax-free. The true objective was not to build up a "savings account," but rather, to have a reserve against a claim that was 100% guaranteed to happen.

With whole life, the best financial performance generally came from "participating" policies. Companies charged guaranteed maximum premiums over some contractually agreed upon period, that guaranteed the face amount of the policy for a lifetime, regardless of the company's mortality experience, expenses, or investment return. To the extent the company had overcharged the policyowner, it paid out dividends retrospectively through the "black box" of the dividend formula. The dividends to policyowners were based on savings in death claims and the expenses of running the insurance company, or from greater interest earnings than the assumed rate of around four percent. Policy investment performance could, by definition, never be any stronger than the portfolio in which the funds were invested. Historically, these reserves/cash values were invested in long-term, fixed income instruments such as bonds and mortgages. The financial performance was akin to that of a traditional six-cylinder or small block V-8 engine--good, but not exciting--but certainly better for long-term coverage and travel than a horse-and-buggy.

During the 1970s, the Federal Trade Commission (FTC) published a scathing report on the low returns provided policyowners with traditional whole life. While it may have been off target in some areas, it did lead to the development of new products.

"Universal Life" is an unbundled product, in which things are done on a prospective basis. The company charges its current cost for mortality and expenses while reserving the right to charge up to a higher stipulated maximum amount in the contract. It can best be likened to paying premiums into a money-market account, from which current term insurance charges are extracted. The cost of insurance (COI) is computed by taking the monthly COI rate for the particular age/smoker/risk category times the "net amount at risk" to determine the monthly mortality charge. To the net premium (gross premium minus COI and expense charges) is then added interest. This consists of a guaranteed floor interest rate, which is generally around four percent, plus excess interest.

In a typical universal life policy, the cash value is invested by the life insurance company in short to intermediate fixed income investments. This makes the excess interest crediting rates "spiky," since those rates tend to fluctuate more widely than the longer term bonds rates that underpin a traditional whole life policy. This interest component is what made these policies more "investment oriented" in character, especially during the '80s when shorter-term rates were in double digits and why they were so popular for a time.

This particular policy form, or chassis, is very flexible in that premiums can be increased, decreased, or even skipped. This is also one of its main drawbacks, because many people fail to properly fund their policies, which will lead to long-term disappointment in policy performance. With the more widespread use of PCs, it was possible to illustrate a lot of coverage for not a lot of money, as high interest rates were presumed to carry into the future indefinitely. In continuing our car analogy, it is like reducing the weight of the chassis by using lighter weight metals, which may or may not be as strong as steel in the event of a serious financial accident.

"Variable Life" first came on the scene in the 1980s. It allowed the policyowner to have the cash value portion of the premium invested in a number of sub-accounts, which were basically mutual funds. The fund managers in some instances came from "name brand" Wall Street firms and in other instances they came from the insurance company itself. The chassis today is generally either the whole life form or the universal life form; there are even some hybrid products that use some features of both.

Initially, some companies offered proprietary products exclusively, while others outsourced most of the fund management to outside managers. The typical product allows the policyowner to choose a number of different options for investing his/her cash value. Variable products now offer a whole array of investment options and strategies, e.g., large cap funds, small cap funds, stock index funds, global funds, international funds, precious metals, bonds, and in some special instances, hedge funds.

The trend has continued, so that today most carriers offer some combination of both in-house and external "name brand" managers. Historical data has shown that over the long-term, equities have tended to outperform fixed income investments. By now making these investment options available to power the financial engines of single life or second-to-die coverage, it seems to be that we have now found a realistic way to power insurance policies without smoke-and-mirrors or computer magic. We now have realistic ways to turbocharge the performance of a life insurance contract.

This will not eliminate the ups-and-downs of stock market performance. But over a long time frame, equities will very likely continue to outperform fixed income investments, just as they have historically. Life insurance, by its very nature, should be viewed as a long-term contract, which should allow the higher long-term potential of equities to pay off for the benefit of the contract's beneficiaries. As Lord John Maynard-Keynes said, "In the long run, we're all dead." And ultimately, isn't that why people want to have the cash death benefit from life insurance?

WHO HAS AN AX TO GRIND?

By Richard Todd

The investment industry is loaded with conflicts of interest and many are not obvious. Disclosure often occurs, but it can be very difficult for the investor to understand the implication of that conflict. The amount of compensation to firms and their salesman is difficult to unravel, but higher fee commissions reduce net investor return. According to a September 30, 1996 Fortune article, "small investors pay 5 to 20 times more to trade a stock than institutional investors do. In most industries, wholesale gets a break over retail, but usually not 20 to 12." Let's look at some of the most alarming conflicts.

Market making and selling securities from the broker's account. Frequently, research reports on specific securities contain the footnote, "XYZ firm makes a market in this security." In other words, they own it. When the risk of owning it increases, it is not uncommon for that firm to motivate their salesman to unload it by offering extra commissions. The industry vernacular for this practice of offering added commissions is "feeding raw meat to sharks."

This phenomenon also takes place with bond inventories. Unless an investor is extremely well versed in the bond market, it may be difficult to realize the impact of bond commission on price.

Commissions. This inherent conflict is more obvious. Whenever the product is paying the professional and not the client, motivations change. A study in the 1996 Fall/Winter Financial Consultant found that a large number of brokers earn a disproportionate share of their income near the end of the production month. This probably results from brokerage industry's focus on monthly production and the broker's pressure to meet commission goals. This is obviously in the broker's best interest, not the clients'.

Insurance products, retirement plan services, and many investment products have commissions deeply buried and can be quite difficult to understand. Commission disclosure is rare in the insurance business, and although commissions are disclosed in mutual fund prospectuses, the impact on returns is sometimes overlooked. Front-end load mutual funds are becoming less common, but salesman can receive large compensation from B shares and C shares with commissions buried in the internal costs of the funds that are protected by heavy surrender charges.

Wrap accounts. Wrap accounts were designed to give investors professional management with an all-inclusive fee in lieu of commissions. But in many cases, the commissions are also buried in the products. Yes, mutual funds can be "no load," but some may also pay the brokers on assets in the wrap program. Additionally, many of the firms do significant securities trading with these brokerage firms. How objective can a firm be when it is recommending managers or funds, and these same firms are lining the pockets of the broker? It is crucial for the investor to understand the process that was used to get to the final recommendation.

Sales contests, prizes, and dinners. Sales contests are becoming less frequent, but even-fee only firms can be swayed by relationships. Objectivity is crucial in ensuring that the client receives untainted recommendations. Relationships between consultants and money managers can become quite cozy and judgment can be swayed. The investor needs to truly understand the process used in filtering the investment products or managers.

In-house products. If a particular investment style is readily available in the marketplace, why a proprietary product or fund is being recommended should be questioned. According to an article in the November 20, 1997, Wall Street Journal, "The nation's top brokerage firms have a problem on their hands: They're having trouble selling their own mutual funds. The funds' performance is nothing to brag about either." Retirement plan sponsors need to also be skeptical of insurance company products with a guaranteed income contract or stable value product attached. These are often huge profit centers and the cost may only be deciphered by a comparison to the marketplace. Additionally, money market fund costs vary greatly. There is a direct correlation between yield and cost with these products. The lower the internal expense, the higher the yield. Is it any wonder why brokers offer "free" custody?

Soft dollars. This well-oiled system allows money managers and mutual funds to pay for research, software, and other business that benefits the client. The more the trading, the more a firm has in commission "credits." Products purchased with soft dollars aren't necessarily bad since most do benefit the client. This is clearly a conflict of interest, and disclosure is required. The SEC has been fairly aggressive in examining investment manager soft dollar practices.

Managers/funds evaluating their own performance. Investors must be skeptical of how managers present their firms' performance. There are plenty of credible managers, but it must be expected that managers will put themselves in the best light possible. There are numerous examples of firms using questionable statistics and misleading benchmarks. In addition, with separate account managers, dispersion of returns between accounts can make the track record managers' report for marketing purposes somewhat misleading. Smaller accounts are often managed differently and results can vary greatly from the composite.

Having an objective consultant assist with manager evaluation and performance monitoring can help. Relying on managers' for evaluation is like having the fox guarding the henhouse.

Limited product array. Most brokerage firms offer a small percentage of the entire universe of investment products. Typically, true no-load investments won't be on their platform. By the same token, fee based advisors can also be limited by custodial alternatives. Many financial planners seem to favor annuity products, but with recent tax law changes, the viability of annuities can be argued. Furthermore, large commissions are buried in the products and some planners have significant limitations in offering product. Additionally, annuities are sister products to insurance and may be more familiar to planners who focus on insurance.

Planning points to a favored solution. How often does the financial or estate planning result in an insurance recommendation? It may be necessary, but the planning can certainly be tainted if an insurance commission is a part of the compensation. Ideally, a consultant's compensation structure should be determined up front, regardless of the solution. Therefore, the advice should be objective and in line with the investor's best interest.

Full Disclosure

Dan Tully, chairman of Merrill Lynch, in a report to SEC Chairman Arthur Levitt said, "The prevailing commission based compensation system inevitably leads to conflicts of interest among parties involved." Full disclosure of conflicts of interest is important when dealing with investment professionals. However understanding the impact of these conflicts is equally important; understanding who is truly working on the investors' behalf and who has an ax to grind. Furthermore, "fee-based" doesn't necessarily mean commissions aren't involved.

Richard Todd is a certified investment management consultant and a principal at Innovest Portfolio Solutions in Englewood, Colorado. (303) 694-1900.

Editors:
Milton Miller, CPA
Consultant
William Bregman, CPA\PFS

Contributing Editors:
Alan Fogelman, CPA
Clarfield & Company P.C.