Wolves in Sheep’s Clothing

Posted on: April 10, 2014 by Martin Curiel, CFA in Wealth management

At the time of this writing, if I were to buy a Big Mac, fries, and a medium Coke at my local McDonald’s, it would cost $6.58. But if I buy the combo meal that includes all three items it would cost me $5.99, and thus would save $0.59 . As consumers, we have been trained to believe that purchasing the “combo” is always a good deal. This idea, however, is not generally applicable in the financial services industry. Buying a “combo” financial product is likely to generate high fees and inefficiencies.

In this article, I’d like to discuss a few common combo financial products, which may appear to be docile, harmless sheep, but are actually wolves that can take a bite out of one’s wealth. My argument centers on the idea that in the world of finance and investments, it is almost always impossible to bundle products and create something greater than the sum of its parts.

Whole Life Insurance

The Combo: Life Insurance + Investment Vehicle

How It Works: An individual pays a premium each year and gets the equivalent of term life insurance and an investment account. The insurance company will pay the stated amount upon the death of the insured, and over time, the investment account accumulates a cash value that can be made available to the policyholder during his or her lifetime.

The Sheep Disguise: The insurance salesperson will typically argue that the product is a great way to save for retirement and save on taxes (since insurance payouts are generally tax-free), while protecting one’s loved ones. The product eliminates the hassle of putting money aside in a separate account. The agent will usually present a projection of “theoretical” payouts from the investment pool, which always appears highly attractive. The documents are hard to understand and compare from a fee perspective, so the purchase of the product ends up being largely an emotionally driven decision.

The Wolf: The commissions on whole life insurance can range from 90 - 100% of the first year’s premium and 6% on the remaining years (see http://personalinsure.about.com/od/life/f/lifefaq3.htm). It is one of the most profitable products for insurance companies, and so salespeople aggressively push it. The commissions paid are in addition to fees paid to the asset managers that handle the investment pool, which means that what the investor keeps in the end is reduced significantly.

Efficient Strategies: Buy stand-alone term life insurance and invest available funds separately in low-cost financial products. Even if an investor pays an advisor to allocate the investment funds, it is likely to be less expensive compared to total fees paid under a whole life insurance policy.

Multi-Asset Mutual Funds

The Combo: A “pool” of investments that allocate to different investment categories: stocks, bonds, cash, and other investment classes

How It Works: Investors buy one mutual fund, which has a management team that selects multiple asset classes for a single fee.

The Sheep Disguise: One-stop shopping appears to eliminate the hassle of taking the time to build a diversified portfolio of investments. These combo funds often rebalance over time, so it also eliminates the hassle of rebalancing and maintaining a certain target allocation.

The Wolf: In almost every case, combining assets under one roof is more expensive than building an equivalent portfolio of individual asset classes. Having a multi-asset mutual fund will also make it extremely difficult to benchmark performance. In our experience, most investors who hold such funds won’t do the appropriate performance comparison analysis, and thus will not be aware of any potential underperformance fees incurred.

Efficient Strategies: Take the time to build a diversified portfolio of disaggregated mutual funds and/or pay an advisor to accomplish the task. If a combo mutual fund is the only option (as is the case in many 529 plans and some 401(k)s), then selecting a target date fund can make sense. Target date funds that are built using primarily index mutual funds can be good choices, but when there is an option to build the same asset allocation using separate funds, the fees are usually lower for the separate funds.

Variable Annuities

The Combo: Annuity (Guaranteed Income Stream) + Investment Vehicle

How It Works: The variable annuity guarantees a certain level of income plus an excess payment amount that fluctuates with the performance of the annuity’s investments.

The Sheep Disguise: The argument generally centers on the idea that variable annuities offer a comfortable balance between guaranteed retirement income and potential participation in the growth of an investment portfolio. A typical argument is: “If the markets go up, you’ll win. If the markets tank, you won’t lose, since you’ll have a guaranteed income.”

The Wolf: In our experience, a variable annuity combines a very bad mutual fund with an overpriced deferred annuity. It is also extremely challenging to fully understand the underlying investment products and fees, which are generally very high compared to alternative strategies. Like its cousin, whole life insurance, the variable annuity is aggressively pushed by salespeople because of the associated high commissions.

Efficient Strategies: Avoid variable annuities (as well as other types of combo annuities such as indexed annuities). A well-designed portfolio can generally replicate a similar risk/reward profile and achieve similar tax benefits compared to those associated with most annuities. Although not our first choice, Single Premium Immediate Annuities (SPIAs) could be a reasonable option for some investors who are set on buying an annuity.

Structured Notes

The Combo: Put/Call Options + Zero Interest Bond

How It Works: This combo product allows investors to protect against a down market (“Portfolio Insurance”) while giving up some of the upside.

The Sheep Disguise: Like variable annuities, structured notes seem like a great product for those who are risk averse and do not want to see their portfolio holdings go down significantly in a bad market. It also provides an upside potential during the good times.

The Wolf: The products are generally saddled with high fees and complex terms. It is also very challenging to determine the particular underlying risk exposures of these instruments. One significant risk is that the issuer could go bankrupt. Structured notes are guaranteed by the issuer, but the issuer saves an extra 2 – 5%/year by not having to pay normal interest payments on the notes.

Efficient Strategies: Avoid structured products. Managing or reducing risk is generally best accomplished by shifting one’s asset allocation – among cash, bonds, and equities – as opposed to financial engineering or the purchase of esoteric products.

In conclusion, in the world of investments, 2+2 will never equal more than 4, and will likely equal less than 4 because of investment-related fees. In other words, one can expect to get a “fair deal” but not a “good deal” when buying financial products. Products such as whole life insurance, variable annuities, and structured notes are sold with the illusion that by combining multiple financial products into a single instrument, one can somehow achieve more (e.g., reduce risk, lower fees, or increase return). More often than not, combo products are just a clever way to charge high fees and earn high commissions. We believe that in almost every case, one can replicate the risk/reward profile and tax exposures of any combo product using disaggregated and simpler products.

Beware of the wolves in sheep’s clothing.

Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.