Because we aren't shy about pointing to misleading marketing efforts in the financial services industry, we're starting to hear from more and more people who see curious things in the marketplace and wonder what to believe.
The latest example: A correspondent sent a spirited defense of variable universal life insurance (VUL), a seven-page document (link below) dedicated to the proposition that "storing capital within variable life insurance policies can be a very credible alternative when matched up against many of the alternatives people currently are using."
Now, we should make our own bias clear from the outset: We think insurance has an enormously important role to play in people's financial lives. But most products and strategies that mingle insurance and investment compel clients to pay too much--often far too much--for something they don't need or could secure through more direct, less expensive means. As the saying goes, these products are sold, not bought.
So about this 2003 brief for VUL. The author, a Ben G. Baldwin, Jr., first cites Peter Bernstein in claiming that conventional asset allocation programs, based on historical rates of return and covariances among asset classes, are "arrogant" because we can't know the future. (We don't think this is a faithful representation of Bernstein's worldview, but that's a story for another time.)
Baldwin then goes on to suggest that because managing money in a taxable environment is challenging, investment professionals should consider "the costs and benefits of wrapping a variable life insurance contract around investment capital."*
in his effort to compare the relative efficiency of assets held and managed in a taxable account and those held and managed inside a VUL policy, Baldwin's key point of departure is his Table 2, which we've reproduced here.
Now, when one takes a good, hard look at the assumptions on display in this table, one might detect a set-up...of a classic straw man.
Let's take that "Income Taxes" line. The estimate of a 2% tax hit on a portfolio that returned 10% in a given year strikes us as wildly exaggerated and extremely unlikely. We don't often write about our own investment programs in this space, but speaking from experience we can say that we've never seen a client account produce a tax liability of 2% of capital in a single year.
First, the vast majority of annual "gains" in a strategic account are unrealized, and thus untaxed. This is a very efficient form of tax-deferred compounding in its own right.
Second, a responsible rebalancing process offsets some realized gains with realized losses, thus reducing any end-of-year tax liabilities.
Third, the use of tax-efficient vehicles such as exchange-traded funds will minimize (and, in many cases, avoid altogether) the unhelpful distribution of capital gains.
Now look at the "Management Fees, M&E" and "Advisor Fee/Commission" lines. Whatever the reality might be on the VUL side, the world we live in would never see total expenses of 2%. Consider a client with $500,000 invested in our strategic asset allocation program. Add management fees of 0.875%, ETF expenses of roughly 0.20%, and commission expenses of roughly 0.025%. Total: 1.1%, with minimal implicit costs (which cannot be said of most mutual funds and separate accounts wrapped up in insurance contracts).
So Baldwin's premise is broken from the start. The precise comparison will vary by account size, market conditions, and other variables, but once all costs, explicit and implicit, are figured in, we estimate the apt bottom-line comparison would be more like 8.6% and 4.6%. And given that withdrawals of gains from the VUL will be taxed as ordinary income, where withdrawals from the taxable account will be taxed as long-term capital gains, the relative efficiency of the distribution phase makes our case that much stronger.
Insurance is important. The prudent management of investment capital is important. But they're different things with different purposes. Every rule has its exceptions, and we don't want to argue that mingling insurance and investments never makes sense for anyone. But we think those instances are far less common than the insurance industry and its sales reps want rank-and-file investors to know.
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*In our view, any form of the word "wrap" in the investment business is a bright, flashing yellow light. Investors should slow down and be careful when they see it.
Source
Ben G. Baldwin, Jr., "Variable Life Insurance: A Storage Place for Capital," 2003
Download baldwin_on_vul_2003.pdf
