Thank you to all the credit union executives who inquired about my Oct. 31st article "Good Selling Vs. Selling Goods-The CU Challenge In Financial Planning."
In case you weren't able to read the article, the crux of my commentary was that credit unions are obligated to their membership to ensure that the practices of their in-house financial planning representatives and investment brokers are consistent with the credit union's larger purpose of properly serving their membership. There is strong evidence, however, that members are instead being sold high commission/high expense insurance products such as cash value life insurance and variable and index annuities. Commission-driven financial planners and brokers routinely earn 7% to 14% on the amount they collect from variable and index annuities. Additionally cash value life insurance, such as whole life, universal and variable life, may pay the broker up to 100% of the premium collected in the first year.
It is also noteworthy to point out that a financial planning representative has the option of suggesting lower fee/lower commission products, such as mutual funds and term life insurance. Yet planners and brokers seem to be fixated on selling the higher markup items, which leave the member with less financial benefits.
The practice of selling the highest-commissioned products is precisely what is occurring within the sacred walls of many credit unions. There are two problems with commission-driven in-house representatives. One is that if the CU fails to police its staff, they are arguably turning a blind eye toward their members' best interests. The second and more practical dilemma is that your members are hearing and reading a great deal of negative things about cash value life insurance and variable and index annuities from a variety of reputable written publications such as The Wall Street Journal and Consumer Reports and popular radio and television hosts Bob Brinker and Suze Orman. Unless all of your members are cut off from the outside world, these harmful critiques may very well cast your credit union in an unfavorable light. Although the credit union may have taken steps to insulate itself from any legal liability arising from discontent members, it may ultimately be held culpable for the members' ensuing mistrust.
Queries For Your Reps
Members who purchased these insurance products are likely to query your in-house broker or planner over all these critical allegations. Some credit union executives have already gone back to their in-house planner for a more thorough explanation of their philosophy and practice. In more cases than not, the representative will have a prepared argument (courtesy of the insurance company they place business through) designed to sidestep the concerns. For example, one credit union member told the agent, "I have read that annuities are a bad investment."
In a rehearsed response, the rep will normally dismiss respected publications as UNFOUNDED. They may even produce an article in support of annuities written by a source you probably never heard of before. The credit union decision-maker needs to ask if it is more reasonable to assume that The Wall Street Journal, Consumer Reports, Brinker, and Orman are mistaken, or whether one insurance agent representing a particular product with excessively high commissions is the more credible source? You be the judge.
Members may also tell your in-house broker that "I have read that annuities have very high expenses."
The representative may counter this concern on two fronts. First, he or she may argue that you need to "look at investment performance," implying that the company they represent is hiring SUPERIOR INVESTMENT MANAGERS with the extra fees charged to the member. This in turn, the argument continues, is designed to produce HIGHER INVESTMENT RETURNS for you. Add in the TAX-DEFERRAL feature and you have something that is BEST FOR THE MEMBER. This is, in my opinion, completely inaccurate on all accounts.
First, although annuities are tax-deferred, they are not tax-exempt. The money must be removed at some point, and when it is, figure on getting taxed at the less-than-favorable ORDINARY income tax rate. Appreciating investments, such as stocks and real estate, may receive the more advantageous CAPITAL GAINS treatment. Capital gains are inherently a form of tax-deferral because they are only triggered when certain investments are sold. Therefore, the additional ordinary income taxes you may eventually pay on annuity withdrawals may very well nullify any advantages of tax deferral.
What The Evidence Shows
Second, empirical evidence confirms that higher expenses are associated with lower investment returns. Indeed, research conducted by Morningstar and others confirms that variable annuities collectively underperform their mutual fund counterparts by a percentage approximately equal to that of their extra fees. The second part of the argument will normally include a discussion on all the wonderful benefits that variable annuities provide, such as living and death benefits. Modern variable annuities contain special provisions, such as guaranteed income for life and/or death settlements that may (among other things) lock in contract values should the holder die and the market is down. It is important to note that these features DO provide real benefits to contract holders which are not available on ordinary mutual funds. The question is, "how much are these extra benefits worth? In other words, are the extra costs worth the benefits?"
To determine whether the benefits of the variable annuity outweigh the extra fees you pay, I conducted the following experiment using expenses of one particular variable annuity. I have prepared a breakdown of the various options available to variable annuity holders and their corresponding annual cost as a percentage of contract value. The investor must choose benefit number one, but benefits number two through five are optional.
Now then, let's assume that you have $100,000 to invest by either a) selecting a lower-fee (0.9% expense per year) mutual fund without all the whistles and bells that the annuity contains or b) an annuity similar to the above-mentioned contract. Using the historic 10% per year return on the stock market, the following additional costs are:
if benefits then your contract value will cost you
cost you: $----- given holding period below:
5-year 10-year 20-year 30-year
1%/year 6,995 21,017 96,011 329,178
2%/year 13,657 40,356 176,548 580,914
3%/year 20,114 58,135 243,995 772,946
What does this mean?
If you purchase a variable annuity with some or all of the features in the first table above, expect those extra benefits to reduce your contract value by the amounts in the second table immediately above. If you opt for all the benefits at a total annual cost of 4% of the contract's value, those benefits may potentially cost five-year holders $20,114 less than a comparable mutual fund. The news gets worse the longer you hold the contract-over three quarters of a million dollars for the 30-year holder! Even the most vanilla contracts are likely to run at least 1% per year in additional expenses, which (according to the table) may cost a 30-year holder $329,178. Once again, these annuity living and death benefits are in and of themselves good things. The issue is whether or not all of those additional benefits are potentially worth the tens or hundreds of thousands of dollars in reduced account values.
Cost versus benefit analysis is basic to managing any business. For the credit union executive, what is the cost of your membership's potential mistrust? For the financial planning representative, be assured that he or she has already figured out that a high-commissioned life insurance policy or annuity provides the most benefit to their bottom line. The rep will emphasize the benefits of variable annuities, but who is the one profiting? Costs borne by membership need to be addressed.
What Can Be Done?
What can credit union executives do to monitor their financial planning program?
For starters, you need to better educate yourself on how commissions and fees work. Many mutual funds can be offered through commission-based brokers with annual fees under 1% per year. This seems more reasonable than annuities, which may double, triple, and quadruple both fees and commissions. Also understand that for most of the population, the death benefit portion of the variable annuity contract can be addressed more efficiently and effectively through the purchase of low cost/low commission term insurance. As an example, a $100,000 variable annuity sold to a 40-year-old member costs that member about $2,150 per year. That cost is made up of $900 or 0.9% on the investment management, and $1250 or 1.25% for the mortality and expense risk. The mortality feature provides that the contract owner can lock in his account value each anniversary so that if he dies while the market is down, the company will pay his heirs the higher of the attained value or contributions.
One Scenario To Consider
Let's say that the convergence of two unlikely events occurs: soon after purchase, the market loses 50% of its value like it did in the last crash and simultaneously the 40-year-old member dies. The company's exposure is the difference in contributions less the reduced contract value, or $50,000. In essence, the member will have paid $1,250 to buy a $50,000 life insurance policy. Did the financial planning representative bother to find out what a low-cost term insurance policy combined with a low-expense mutual fund would have cost the member? I do. For most healthy non-smoking people in this age group, $50,000 of additional life insurance can be purchased for under $50 per year. And term insurance pays your beneficiaries regardless of market conditions. Why would the agent sell a $1250 if the market crashes insurance policy when a $50 policy will work better? Understand that the agent stands to collect far more money through the sale of annuities and cash value life insurance rather than mutual funds and term life insurance.
I recommend auditing your in-house planner's book of business. Better yet, put all of your questions in writing and require written responses. What percentage of sales is getting placed into annuities rather than mutual funds? Did you discuss term insurance as an alternative to variable annuities? How much would a term policy cost? How many members have you sold term life insurance to? How many members have you sold cash value life insurance to? What are the annual expenses associated with all the products sold? How much are the commissions on these products? What are your brokerage firm's production quotas and show me your pay grid? Separately, randomly ask some of your members about their experience with the rep. What where they sold? If it was annuity, where annual expenses discussed? Did the rep discuss term life insurance as an alternate solution to estate preservation concerns?
What's Not Occurring - But Should
I don't believe that comprehensive auditing is occurring with any regularity, if at all. The results of an audit may prove rather disturbing. If the representative has a bias toward the high commission products, then the credit union executive's range of actions will go from do nothing to replace the financial planning representative. Or perhaps some modification of the planners business is in order. That is, if your members' trust and what they say to one another is important to you.
The seven credit unions representing 150,000 members where I serve as financial planner have a very simple policy to avoid embarrassing situations: we don't sell annuities and cash value life insurance. Under extreme circumstances the sale of these may be warranted, such as when complex estate planning situations exist or when the member has a need for life insurance but cannot qualify due to health reasons. In such an uncommon event, I would bring this issue up to the credit union CEO and explain the extenuating circumstances that may warrant a recommendation for annuities or cash value life.
The key to assuring that your financial planning representative shares your commitment to the credit union way of doing things is to establish the agenda from the start. Institute policy guidelines, educate yourself on how commissions and fees work, and surmise your rep's character before he or she meets with your first member.
Paul Ranieri is a certified financial planner and adjunct professor at Northwestern Unviersity, Chicago, who works with credit unions and their members on financial planning "the credit union way." For more info: www.paulranieri.com/
