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Summary: While the shift in the advisory space towards fee-only advisors has helped better align long-term interests of clients and their advisors in comparison to solely commission-based advisors, the presumption that fee-only advisors are fiduciaries means that these advisors are supposed to always act in the client’s best interests. However, if the client is better off paying a one-time upfront commission than a lifelong percentage of AUM trail on the assets, then the fee-only advisor has a conflict of interest since the fee-only advisor’s model hurts the client over the long-term.
Life insurance products offer a myriad of long-term tax and investing benefits for clients. The problem with most life insurance products are that most of these products have both high commissions and high expenses that negate any tax and investing benefits that may be afforded to clients. However, this does not mean that all life insurance products are inherently bad for the client. In fact, some life insurance products, particularly those that have low commissions and low expenses, are significantly better for the client than having an advisor charge a percentage of AUM fee over the life of the client while keeping those client’s assets in a less tax-efficient and investment friendly vehicle.
In order for fee-only advisors to truly be fiduciaries, they need to learn how to use life insurance products for the benefit of the client—even if it comes at the expense of their own compensation. This is the same critique that fee-only advisors have been making of commission-based advisors for years. Ideally the best outcome for both fee-only advisors and clients is for life insurance companies to create products that allow fee-only advisors to charge their advisory fee on the assets within the life insurance product in the same way that fee-only advisors are charging their advisory fee on the assets outside the product. This would create the necessary long-term alignment of interest that encourages advisors to use life insurance investment vehicles and structures that are better for both the client and the advisor over the long-term. But in order to get there, advisors have to accept that life insurance solutions can provide clients with better long-term results than their simplistic fee-only model allows them to currently offer.
Over the last 20 years a large shift has overtaken the financial advisory space towards fee-only advisors who only charge an advisory fee for managing a client’s portfolio and away from advisors who primarily earn their fees from commissions that come from selling clients securities or insurance products.
There were two reasons behind this shift:
Over time clients realized that there was a large conflict of interest between financial advisors selling them commissionable products/securities and the client’s own financial self-interest. The reason for this is that financial advisors that earn fees through selling commissions are incentivized to sell clients products that maximize the commissions paid—and the higher the upfront commission is, the larger the expenses in the vehicle have to be in order to make up for it. So ultimately the client is paying for the large upfront commission by acquiring an investment with a high expense ratio. Part of the progression towards fee-only advisors is that clients wanted advisors who advocated in their long-term interest and not the advisors’ short-term profitability. Furthermore, advisors who truly did want to advocate for the best long-term interests, didn’t want to be forced by their firms to sell poor products.
Advisors that sell highly commissionable products to clients may earn a large commission in the first year, but they often earn just a small trail in the remaining years even if the client continues to invest in the product for many years. This means that in order for a commission-based advisor to continue to earn high commissions, he or she has to continually find new clients to sell products to. Over time it became clear to the advisors that it was easier to build a large base of clients so that the advisor could charge a small fee on these assets under management (AUM) over the life of the client, than to continually have to find new clients every year to sell high commission products to. While this change in business model meant that the early years of a new fee-only advisor would be financially less lucrative than the commissionable advisor, in the later years the fee-only advisor would earn just as much as—if not more than—the commissionable advisor without having to continually grind to find new clients. This had built-in appeal to advisors who wanted to build a long-term “lifestyle” business while sacrificing short-term profitability.
For the most part, the fee-only model encouraged better alignment of interest than the commission-based approach. The commission-based approach allowed commission-based advisors to sell clients a flashy story and financial projection only to saddle the client with a long-term investment product that was riddled with back-end expenses that the client wasn’t knowledgeable enough to decipher before agreeing to the terms. By the time the client realized the downsides of the product after purchasing it, the commission-based advisor had already earned the commission on the product and had no incentive to help the client out of the long-term predicament—unless the solution was to sell the client another high-commission/backend expense loaded product.
However, not all life insurance products have high back-end expenses and even high commission products may be better for the client than having a fee-only advisor charge a percentage AUM fee for the life of the client. As a simplistic example, assume that a client has the choice of purchasing an investment with a 10% upfront commission expense, but no long-term expenses versus investing with an advisor that charges a 1% fee on the assets each year. The option that is better for the client depends on how long the client plans on staying with the investment. If the client stays in the product longer than 10 years, then they are better off paying the large upfront commission in just one year rather than investing through an advisor that charges a recurring fee every year. Conversely, if the client only wants to invest for less than 10 years, then they are better off just investing directly with the advisor.
Permanent life insurance can provide a number of investing, estate planning, and tax-benefits for HNW clients. In spite of these benefits, fee-only advisors are reticent to use them. Perhaps one of the main reasons fee-only advisors don’t use these products is that most products have high upfront commissions and hidden expenses that negate any long-term tax benefits these products might have. However, even low commission products that are structured to minimize the insurance expenses and maximize the tax benefits are rarely recommended even though they may be in the best interest of the client. There are a couple of reasons for this.
The first reason is that there is an inherent conflict of interest. A fee-only advisor that recommends that a client invest in an insurance product is essentially making a recommendation that involves taking assets away from the advisor that he or she currently charges a fee on. Instead, another non-fiduciary advisor will earn a commission on those assets. The second reason fee-only advisors don’t recommend these products is that they don’t have the expertise to evaluate the insurance risk here and distinguish whether one insurance product is better than another. Fee-only advisors are not actuaries. They specialize in financial planning and investment advice. Making insurance recommendations introduces a liability to their practice that they are not prepared to take on. It’s easier to just forego the liability and make a referral to an outside insurance professional who can help implement the insurance solution—even if it takes away assets from the advisor. The problem with this approach of course is that the life insurance agent that the fee-only advisor is recommending is paid by commissions. So the agent has an inherent conflict of interest to sell the client a product that maximizes the commissions and not one that minimizes the insurance expenses and costs. The fee-only advisor isn’t being a fiduciary by passing the client on to an agent that will sell the client a high commission product. On the contrary, the fee-only advisor is abdicating their fiduciary responsibility by doing so.
The concept of asset location isn’t a new one. For decades now, fiduciary financial advisors have been using tax-advantaged retirement accounts to minimize the tax-drag of their investment strategies for their clients. Unfortunately, HNW clients are often phased out from contributing to these tax-advantaged accounts in any meaningful way. Life insurance is one of the only tax-advantaged vehicles left available to them. Nevertheless, fee-only fiduciary advisors are not using these tools for these clients in spite of the value they can provide.
For fee-only fiduciary advisors who want to implement better after-tax, after-advisory fee solutions for their clients by utilizing life insurance similar to how they use retirement accounts, here are some recommendations:
Many fee-only financial advisors have an inherent bias against life insurance products and solutions. This is probably because most financial advisors have had to help a client get out of a bad life insurance product with high expenses and surrender charges at some point in their career. However, this does not mean that all life insurance products and solutions are inherently bad. By summarily dismissing life insurance as a viable solution for clients, they are removing the ability to provide an asset location and interest rate risk solution for clients who would otherwise have to take on more investment risk and tax liability than necessary.
As we discussed, most life insurance products are high commission and high expense products. Fiduciary financial advisors need to be able to distinguish these high expense products from the low-expense ones—and just importantly how to structure the policy design to minimize these expenses. It’s also not sufficient to simply outsource this to the friendly life insurance agent down the street as most agents will be incentivized to sell the high commission/high expense product. Fiduciary financial advisors need to be able to partner with life insurance professionals who are willing to sell the low commission/low-expense insurance products in exchange for more volume of business between the fiduciary financial advisor and the life insurance professional.
As we’ve discussed at length in this series, life insurance can provide tremendous value to clients in a rising interest rate and high tax environment. However, fee-only fiduciary financial advisors who recommend these solutions are often recommending that clients take assets away from the fiduciary financial advisor who could be charging a fee on the assets and invest them through the life insurance solution that is better for the client. This is a win for the client, but a loss for the fiduciary financial advisor. The advisor needs to find a way to either bill for the service through increased AUM or financial planning fees or simply utilize the solution as a way to market the advisor’s services to more affluent clients who could benefit from the value add in exchange for providing the advisor assets to directly manage.
Life insurance is a solution best served to be managed by a fiduciary financial advisor. The reason for this is that life insurance solutions need to be managed over the life of the client the same way the client’s investment portfolio needs to be proactively managed and rebalanced over the life of the client.
Did the client stop paying premiums on the policy or did the underlying investment strategy perform poorly? If so, then the fiduciary advisor needs to look at reducing the death benefit in order to minimize the insurance costs.
Is the client getting older and now subject to increasing cost of insurance expenses? If so, the fiduciary advisor needs to look at taking less investment risk and use loans and withdrawals to essentially rebalance the portfolio.
These are all decisions that need to be made by a fiduciary financial advisor over the life of the policy who is experienced with how to manage life insurance risk. There is no incentive for the life insurance salesman who sold the policy to the client to help with these decisions. That salesman earned the large majority of his or her commission upfront and is economically better served seeking out new clients to sell new policies to than to service existing clients. This is why life insurance needs to be managed by a fiduciary fee-only advisor in the same way that an investment portfolio is managed.
By creating products that allow fiduciary fee-only advisors the ability to charge their AUM fee on the assets, it provides fiduciary financial advisors an economic incentive to utilize these products as part of their financial planning and investment solutions. Furthermore, a life insurance product that pays a small fee over the life of the product instead of a large upfront commission in year 1 will have significantly less back-end expenses and will therefore be significantly better for the client. This is why fee-only products like no-commission annuities and private placement life insurance (PPLI) always outshine their commissionable counterparts. However, neither of these products are in high demand or use. The fee-only advisors aren’t aware or willing to utilize the better products as part of their service. The commission-based advisors are more than happy to sell the bad products.
Fee-only advisors that truly hold themselves out as fiduciaries need to support the burgeoning development of fee-only life insurance products otherwise there is no incentive for life insurance companies to design them. If not, fee-only advisors will continue to lose potential AUM to the commissionable life insurance agents as there are no shortage of life insurance agents willing to sell bad insurance products in order to earn a hefty commission.
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