A wise physician will have a solid insurance plan and a solid investing plan. But she shouldn’t mix the two. Remember the combination TV/VCRs? Seemed like a great idea initially. But then you ended up with the worst of both worlds, and when one of them broke, the other became useless. It’s the same with investing. Instead of providing some kind of synergy by mixing the two, you end up with the worst of both worlds.
These “products” go by different names- cash value life insurance, whole life insurance, universal life insurance, variable life insurance, variable universal life insurance, variable annuities, equity-indexed annuities, deferred fixed annuities…the list goes on and on. A large percentage of doctors (including myself) have been suckered into one or more of these at one point or another. Why does that happen? I think there are a number of reasons:
- Lack of financial sophistication – As we’ve discussed previously, doctors aren’t exactly in the same category as accountants when it comes to knowledge of the financial world. This knowledge gap handicaps them when they go to make financial decisions. They are too trusting, too naive, too worried about things that don’t matter, and not worried enough about things that do. Even simple financial cliches that most investors know (such as “Don’t Mix Insurance and Investing” and “Buy Term and Invest the Difference”) can be profound revelations to a doctor who just spent a decade worth of 80 hour weeks inside the hospital walls. These products are purposely made to be very complex. They are NOT simple to understand, and when an investor points out issues with it, the salesman will quickly move on to another feature of the product. The complexity always favors the issuer, not the buyer.
- Mistaking an insurance salesman for a qualified investment adviser – Everyone markets themselves as a financial advisor or a financial planner these days, no matter what their qualifications. Insurance salesmen, stock brokers, and mutual fund salesmen like to take advantage of the fact that they know just a little more than you. Unfortunately, most of their training is in sales, which means they can make whatever product they happen to profit from look extremely attractive to you. Learn more about selecting and checking up on your advisor here.
- Belief that doctors need to invest differently than everyone else – We like to think we’re special, and in some ways we are. We have highly specialized skills allowing for relatively high salaries with correspondingly high tax burdens, we have high debt burdens, we have a significant delay to the start of our earnings, and we are big targets for litigation, both malpractice and non-malpractice. When financial salespeople tell us we’re different and special, that makes us feel special (and better). But you know what, 95% of what we need to do financially is no different from any other middle class investor. And for nearly all physicians, the additional benefits of a mixed insurance/investment are not worth their costs. Most of the benefits are either unnecessary or available in a less expensive manner.
- Belief that insurance products provide asset protection benefits not available in other ways – Advisors are quick to point out that the cash value of a life insurance policy or the value of an annuity is protected from malpractice and other litigation. What they usually fail to point out is that so are your 401Ks, IRAs, and sometimes a great deal of your home equity.
- Belief that insurance products provide estate planning benefits not available in other ways – The salesman also love to illustrate how life insurance proceeds are estate tax-free. Of course, hardly any Americans (including physicians) pay estate taxes at all. A typical married physician has to leave behind more than $10 Million at his death to pay ANY estate tax. Most doctors will never have that amount of assets. Estate tax law can change at any time, of course. It wasn’t that long ago that the exempt amount was only $1 Million. But through gifting and trusts there are ways to eliminate or minimize that burden without paying for overly expensive insurance.
- Belief that insurance products provide tax benefits not available in other ways – I am appalled at how many physicians don’t max out retirement accounts such as 401Ks and IRAs before “investing” in life insurance. The tax benefits of a 401K exceed those of cash value life insurance. Not only do you get the tax-free growth over the years, but you also get an upfront tax deduction. Cash value life insurance doesn’t offer that. Don’t expect to learn that from someone who sells it though. Even fully taxable investment accounts provide some tax benefits not available in an insurance product.
- Misunderstanding the value of a guarantee – Most of these products come with some kind of a guarantee. It might be a certain amount of guaranteed value at some point down the road, some kind of guaranteed minimum growth rate, or a guaranteed amount payable at death, but I can assure you there will be some kind of guaranteed benefit. Is there a value to that guarantee? Of course, and it seems especially valuable in times of high market volatility or political uncertainty. However, in nearly every case the buyer is overpaying for that guarantee. The complexity favors the seller, not the buyer.
- Misunderstanding of the importance of keeping insurance costs down – As these products become more and more complex, they become less and less like commodities. Commodities are all the same and are sold based on price. If a company sells a variable annuity that is different from every other variable annuity on the market, it becomes very difficult, bordering on impossible, to compare competing products and the investor usually ends up with the one that pays the biggest commission to the salesman. Each of these products have some type of an insurance component. The insurance company can charge whatever it wants for that. If you have no way of determining what the insurance cost should be, how will you know if you’re being ripped off? You won’t, and you are.
- Misunderstanding of the importance of keeping investment costs down – To make matters worse, the investment component is also often overpriced. Variable life insurance and variable annuities in particular place your money into the equivalent of mutual funds, except they are managed by the insurance company. The company not only doesn’t hire very good managers (why would it, no one buying the fund is looking very closely at them), but it also overcharges for them. The expense ratios on these variable annuity “funds” are some of the highest I’ve seen. They can range from 1.5% to 3% or even higher. That’s 10 times what you’d pay for a mutual fund at Vanguard, even an actively-managed one.
- Misunderstanding of the value of liquidity – One of the biggest downsides of these insurance products is the lack of liquidity. A pretty good rule of thumb in investing is to never buy something that you can’t look the price up in the Wall Street Journal every day. Stocks, bonds, and mutual funds can generally be sold any day the market is open. You can “go to cash” any time you want. This allows you access to your money to invest it elsewhere, spend it, or give it away. Insurance products always limit your liquidity. In fact, the only ways you can access your cash in most products is to “borrow” from your policy (which has its downsides, including sometimes causing the policy to fail) or to surrender it completely, often for much less than what the “cash value” is supposed to be. Liquidity has a value, and far too often insurance product investors give it away for nothing.
In future posts I’ll discuss each of these products individually including their origin, how they’re sold to unsuspecting (and sometimes quite sophisticated) investors, the benefits of each (there are benefits, believe it or not) and the downsides.