Advisor Blog

We've previously written about the insurance sales scams called "Be Your Own Bank" and "Infinite Banking".  But, the recent lies produced by the salesmen hawking a similar concept under the name "Circle of Wealth" go beyond what we've seen before.

A "calculator" sent by the promoter of the scheme to insurance salesmen that he's trying to convince to use his system compares the performance of an Indexed Universal Life (IUL) policy to a hypothetical S&P 500 index fund.  Of course, the comparison is made over a very short time period that includes the 2008 stock market meltdown.  We once heard an insurance salesman claim that "if you take away the good years, the stock market really hasn't done very well."  Brilliant!  Here's a great example of that type of thinking. 

Beyond this, the "analysis" makes the following assumptions for the mythical S&P 500 index fund used in the comparison:

• Adds a 5.64% sales charge
• Adds a 1.5% "management fee"
• Assumes 100% annual turnover
• Assumes that all capital gains distributions are short-term and taxed at 28%

The truth is that anyone can purchase the Vanguard 500 Index without any sales charge and the annual expense ratio is 0.17% (less than that for share classes with larger minimum investments).  According to Morningstar, it has a 4% annual turnover ratio.  Since the fund invests in the S&P 500 index and companies very rarely spend a year or less as part of the index, most of the distributions are taxed at the advantageous long-term capital gains rate (currently a maximum of 15% - maybe going to 20% next year).

We've been discussing the dangers of investing in life settlements for years, as have many other sources - including the SEC, GAO, Wall Street Journal and the Texas State Securities Board.

Life Partners, based in Waco, Texas and one of the largest brokers of life settlements has been charged by the SEC with fraud.  The SEC alleges that the company was systematically and materially underestimating the life expectancy estimates it used to price transactions. Life expectancy estimates are a critical factor impacting the company's revenues and profit margins as well as the company's ability to generate profits for its shareholders.

According to the SEC's complaint filed in federal district court in Waco, Texas, Life Partners misrepresented and failed to disclose in public filings with the SEC that the company's systematic use of materially underestimated life expectancy estimates constituted a material risk to the company's revenues. Beginning in 1999, the company used life expectancy estimates provided by Dr. Donald T. Cassidy, a Reno, Nevada-based doctor with no actuarial training or prior experience rendering life expectancy estimates. The SEC alleges that Life Partners failed to conduct any meaningful due diligence on Cassidy's qualification to act as a life expectancy underwriter and instructed the doctor to use a life expectancy methodology that was created by the company's former underwriter, a part-owner of Life Partners and that the company's executives were aware that the Cassidy-rendered life expectancy estimates were systematically and materially short.

Don't say we didn't warn you.

When you ha
ve a product to sell that really doesn't provide much of a benefit to anyone, what do you do?  If you're the insurance industry, you wrap it up in a concept that sounds great and try to get everyone to ignore how awful it really is.  Welcome to "Infinite Banking" or "Becoming Your Own Bank." 

Here's how it works.  You purchase a horrible insurance product with a low rate of return.  The insurance agent pockets a hefty commission for selling it to you.  In fact, some of them even suggest that you stop contibuting to your 401(k) plan and forego paying off debt so that you'll have more money to buy a larger policy (and they make a larger commission).  Now, instead of paying interest on a loan for your house or your car or whatever else you've financed, you borrow money against the insurance policy from the insurance company.  Yes, you still have to pay interest on that loan, too, but the trick is this - the insurance company credits a similar interest rate to the cash balance of the policy that's used to secure the loan.  The interest rates offset each other and voila!  You have a virtually interest-free way to borrow money.  Sounds good, so far, doesn't it?  Well, read on.

The insurance product at the heart of this scheme is almost always whole life.  We've written about it before and it's an awful product with a dismal rate of return.  Here is where the math stops working and the sales pitch falls apart.  The rate of return on the policy is so low that none of the rest of the equation really matters.  You will, over any reasonable amount of time, end up with a lot more money if you invest in a balanced porfolio of stocks and bonds with inexpensive term insurance, indexed universal life insurance or an equity indexed annuity.  We've read the books and we've built the model to see what the returns really look like.*  This is as close to a scam as anything being peddled on late night TV infomercials.

The industry is rife with these kinds of schemes.  We recently heard about a "personal pension plan" from an insurance salesman.  He even tacked a number onto the description, which turned out to be the number for a tax code chapter dealing with life insurance.  And, that's exactly what the "personal pension plan" was - a life insurance policy.  I guess lying about what you are selling to get your foot in the door is a strategy of some sort - a really bad one.

* Scott read the book and built the model in Excel, I just wrote the blog article.

My colleague and fellow blogger, Scott Maxwell, was at breakfast this morning and was asked a question about whole life insurance by one of his friends.  As he was busy explaining how awful an investment whole life is, he was interrupted by someone at the adjacent table who had overheard the conversation and had recently purchased a whole life policy from his insurance salesman.

Whole life is a product whose time has come and, for the most part, gone.  Think of it as a forced savings account with a relatively low fixed rate of return.  It's easy to purchase a bigger death benefit using inexpensive term insurance.  Simply investing the savings over the cost of the whole life policy will, over time, almost invariably result in far greater terminal wealth.  But, guess what?  It pays huge commissions to the insurance salesman who pitches it to the client.

The pitch goes something like this - "The stock market hasn't provided any return over the last ten years and look how great this whole life policy has done over that time period.  In addition, having your money in an insurance policy shields it from creditors and frivolous lawsuits.  The stock market is a scary and evil thing that's full of risk.  Why would you ever want to invest in stocks when you can own this safe insurance policy?" 

To begin deconstruction of the lies, the first statement involves "cherry picking" an index and using the typical dumbed down "broad brush" claim to try to convince the potential customer that the stock market has provided no return for ten years.  While that's true for a common index, the S&P 500, it's not even close to being true for a properly constructed and globally diversified portfolio.  Our Talis 100 portfolio, for example, more than doubled over this time period - net of all fees.  Not surprisingly, this return is much more than what a whole life policy earned over that time period. 

Owners of insurance policies do enjoy some protection from creditors in most states, but there are many other ways to accomplish the same thing without giving up the potential for higher returns.

Risk and return are always related.  Stocks have provided returns that far exceed any other asset class over long time periods.  Picking a ten year time period with one of the worst returns and presenting it as a reasonable expectation for the future is misleading.  But, providing misleading information is common among salesmen. 

Scott never got a chance to respond in a meaningful way to the interruption.  It would have been interesting to have this person come in and meet with us and learn more about how investing works when it's done the right way.  Unfortunately, we've found that many people are just looking for a way to validate their decisions, whether those are good or, like this one, bad.  Scottish author Charles Mackay first published the book "Extraordinary Popular Delusions and the Madness of Crowds" in 1841.  Not much has changed since then, apparently.