Before I start on this tonight, let me say that I never begrudge any salesman a fair commission. When I was a bond manager, I made a point of never letting my brokers “cross bonds” to me, i.e., at no commission. I would raise my purchase price a little to compensate them. Had my client known that I did that, he might have objected, but it was in his best interests that I did it. As a result of that and other things that I did, my brokers were very loyal to me, and worked to give my client excellent executions whether buying or selling. They were also more frank with me about bonds they thought I should sell. Fairness begets fairness under most conditions, and suspicion and tightness also have their way of breeding as well. Consider that in all of your dealings.
My main reason for writing tonight is to remind investors to think about how the parties you transact with are compensated.
- If they are compensated on transactions, expect to see a lot of buying and selling.
- If they are compensated on asset-based fees, expect them to try to get business, and then retain it.
- If they are compensated on profits, they will try to get profits. Be wary of how much control they might have over the accounting, they will be incented to be liberal if they have any control. They will also be incented toward volatility, because volatile assets offer the best possibility of a big score, even if the probability is moderate at best.
The greater the potential compensation, the greater the tendency to act along the incentives offered. As a result, if a life insurance salesman has a product offering a high commission, and one offering a low commission, he may act in the following way:
- Figure out if you are price-sensitive or not.
- Figure out if you are willing to accept a product that has a long surrender charge. Long surrender charges lock in business, and allow for high commissions to be paid.
- Also analyze how much complexity you are willing to accept — more complex permanent policies and especially ancillary riders are far more profitable because even external actuaries would have a tough time analyzing them.
- If you are price-sensitive, bring out the low commission policy that is more competitive.
- If you are price-insensitive, bring out the high commission policy that is less competitive.
(Note: there are state laws in every state that constrain this behavior for life insurance agents, but it can never be eliminated in entire.)
Now, many agents will act in your interests in spite of their own interests, but some won’t, so be aware. Always ask a question like, “This seems expensive. Don’t you have another policy that is less expensive that accomplishes only the main goal that I am shooting for?”
You could always ask them what commission is that they will earn. Most won’t answer that. First, it’s kind of offensive, and second, they will argue that it is not material to your decision.
But it is material to your decision. Here’s why:
- The size of the commission directly affects the size of the premium that you pay.
- It also directly affects the length and size of the surrender charge that you would pay if you terminate the policy early.
- After all, the actuaries or other mathematical businessmen are trying to avoid the risk of paying a commission that they can’t recover under ALL circumstances. They will get their fees from you to recoup the commission cost. They will either get it from you coming or going, but they WILL get it from you, at least on average.
If the salesmen disagree with you after mentioning this (or showing them this), you can say to them that every actuary knows this is true, don’t argue with the actuaries, they know the math. (And its why we tend to buy term and other simple policies. Shhh.)
I’ve seen more than my share of ugly products in my time. I’m happy I never designed any. I did kill a few of them. That said, one of the most unpleasant duties I ever had as a life actuary was about 18 years ago when I inherited a department to clean up, and I got the responsibility of talking to the clients that were the most irate, demanding to talk to the man in charge. I never created those products, but I was nominally in charge of the division as I cleaned up the pricing, reinsurance, reserving, accounting, and asset-liability management.
I’ll tell you, it is no fun talking to people who conclude that they have been had. It is even less fun to be the one who has been had. Thus I would tell you to view all salesmen of financial with skepticism. It is hard to assure a good result with intangible products that are hard to compare. Thus aim for simplicity and lower surrender charge and commission products.
Now, I used life insurance as my example here because I know it best, and it excels in complexity. But this applies to all financial products, especially illiquid ones. Be wary of:
- Brokers who make money off of commissions
- Those who sell private REITs and structured notes
- Any product where you have a limited ability to liquidate or sell it.
- Any product that you can’t understand how the company and salesman are making money off it.
- Any product where you can’t understand what the legal form of the investment is (Stock, bond, mutual fund, partnership, derivative, insurance, etc.)
Here are some final bits of advice:
- Look for advisers who are fiduciaries, and are responsible to look out for your interests (but still be wary)
- Look at the fee structures, and look for lower cost alternatives.
- Seek competing products, salesmen and companies.
- Negotiate lower compensation where possible.
- Remember that higher yields are almost never free… what yields more typically has more risk. Yield is the oldest scam in the books.
Remember, regardless of what laws exist, you are your own best defender when it comes to your own economic interests. Be aware of the economic incentives of those who seek your business with financial products, and be reasonably skeptical.