Words to the Wise Investor

, author of ‘Survival Investing: How to Prosper Amid Thieving Banks and Corrupt Governments’ tells you what he thinks of financial products with enormous sales commissions. 

The investment products he has trashed include some mutual funds with high annual costs – which make them a poor investment choice in the long term. The math is simple enough:

If a mutual fund total costs run 2% per year and the fund generates a 3% real return after inflation you are, in effect, giving Wall Street two thirds of the profits that are earned on your investment portfolio.

ETFs (exchange traded funds) – which are mutual funds that are traded in the stock market, instead of just redeemable by the mutual fund company that issues them – have become popular because there is a ready market to buy and sell them.  Still, some can cost up to 1% per year, possibly taking as much as one third of your profits over time.

Talbott’s Rules of Thumb

More complex products have annual costs that exceed 2% per year, some with sales commissions of 5 to 12 percent. Talbott’s take is that if a  company is paying its salespeople a 5% upfront commission, they must be making multiples of that over the life of the product to make it profitable for them. Talbott has some general rules about judging the value of an investment product.

Talbott’s Rule 1: Product Complexity: 

As a general rule the more complex and complicated a financial product is, the higher its cost to investors and, most likely, the higher sales commissions it earns for your broker. The entire idea is to create financial products that are so complex that no one completely understands them, it is impossible to analyze them and so it is easy to hide large expenses and fees inside them.

I can see the logic in adopting this as a general rule/rule of thumb. However, the view that complex financial products are simply being nontransparent to cheat people does seem rather paranoid – especially in an industry as highly regulated as financial product sales. Insurance products are dual regulated – by state insurance departments, as well as Federal laws that apply to securities (for variable life insurance products) and regulatory compliance is extremely strict.

Talbott’s Rule 2: Necessity

The first rule about insurance is that it is so costly that if you can afford to take the loss don’t buy the insurance. You should only buy insurance for events that are so unpredictable and destabilizing to your family that they really could not get by without it.

Where Life Insurance Fits

Certainly life insurance falls into the category of a product that is necessary for an event that is so destabilizing to the family that they could not get by without it. The dire circumstances that families face when a household earner dies is a clear and chilling reality. Additionally, given the financial struggles most of us go through just to get by, a gift of tax-free life insurance proceeds provides a valuable legacy that can help a young family make better lives for themselves – for example, buy a home, pay off costly expenses like student loans, or ensure a fund for their childrens’ future.

Since life insurance is such a vital product, it behooves us to understand that there are two basic types, each of which has its own place in our financial portfolios:

  • Term Insurance: For the least expensive premium, you get life insurance coverage for a certain period of years – typically 5, 10, 15 or 20 years. After that, coverage expires. Then you can repurchase, but at a much higher premium rate, since the chances of death are now much higher. And you’ll need to take a physical exam, so if your health has worsened with age, as it inevitably will, you’ll either have to pay an even higher premium, or, even more unthinkable, you won’t qualify for coverage at all, leaving your family without income protection.
  • Permanent Insurance:The premium is higher, but it’s well worth the additional outlay. Why?
    • First, the premium can remain level and not increase, as it would with term insurance.
    • Second, these policies accumulate cash value, and this cash value can be used to pay the premium after several years, so you will not have to pay premiums any more.
    • Third, the cash value can be used as an emergency fund if needed.
    • Fourth, and most important, coverage lasts your entire lifetime. You’ll never face the dilemma of becoming uninsurable or having coverage become unaffordable.

Talbott’s Highly Illogical Blind Spot

Surely Talbott would get that? What does he say about life insurance? He writes:

…Products like life insurance are very costly. Insurance companies get away with it because proper pricing depends on understanding annuity tables and probability calculations unavailable to consumers. It is why some of the largest buildings in most American cities are owned by insurance companies. If you have to buy life insurance stay away from whole life policies also known as cash value, universal life or variable life policies. Buy term insurance and only for the shortest time period you absolutely need it.

OK, so he doesn’t quite get it, does he? But he’s not alone. Investment gurus have been bashing life insurance for many years, so it’s there’s clearly a gaping blind spot in their logic. That blind spot is that they think narrowly in terms of investment return rather than benefits that far exceed return on investment.  Wall Streeters like these who have been taught to think inside the box of investment return often miss much more obvious truths.

One of the facts that investment gurus often fail to calculate is that the return on investment provided by life insurance can far exceed the return of almost  any investment product.  What is the rate of return for a family that has paid an annual premium of $1,000 for a $250,000 life insurance policy, and then loses the bread winner? If you had instead listened to Talbott, and put that $1,000 into a no load mutual fund, would you be pleased with your 10% return – or $1,100 minus taxes, vs. a tax-free life insurance proceeds of $250,000?

Another fact that investment-oriented individuals don’t take into account is that, for all the premiums paid into term life insurance, less than 1% of all policies ever result in a death claim.  The rest of them expire, leaving the customer uninsured when people discover that a new policy is unaffordable or that they are no longer healthy enough to purchase one.

Death and Taxes

What would Talbott say about that? He writes:

Just remember, if a financial product is too complicated and too complex for you to understand, this is not an accident. It is intentional. And it will cost you.

What Talbott’s calculations ignore  that death is not a question of if, but when. It is a 100% certainty. So if you have loved ones who could benefit from a financial legacy, there are few material things you could leave for them that can better serve them than life insurance.

If a financial planner advises you either to skip life insurance altogether, or else eschew a permanent policy in favor of term exclusively, then I suggest that you seek a second opinion. This kind of planner can help you plan for taxes, but not for death.

Forget the investment advisor’s rules of thumb and consider the first rule of life insurance: for a policy to pay a benefit when it’s really needed, you must first be willing to pay for it before you actually need the benefit.