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How To Use Behavioral Finance Techniques To Generate “Advisor Alpha” In Financial Planning Relationships
Saturday, April 12, 2014 12:39

Scott Burns and Uri Pomerantz, who have designed an app to help financial advice professionals capture the three-percentage points of return annually squandered by consumers on common behavioral finance mistakes, spoke yesterday at an A4A continuing professional education webinar entitled, Applying Behavioral Finance Research To Mass-Affluent Financial Planning Engagements.

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Burns and Pomerantz, who met at as graduate students at Harvard, and have a track record for trying singlehandedly to make the world better, have built an app that tries to optimize advisor alpha, a concept Vanguard Group a year ago researched. They spoke about the underlying concepts of their financial planning app, Guide.
 
Their software uses behavioral finance techniques to maximize advisor alpha. It’s a pioneering effort that could influence advisor technology significantly by shifting focus of advisor apps to advisor alpha and behavioral finance.
 
Burns and Pomerantz agreed to speak about the underlying concepts behind their software and were faithful to that commitment. We’ll cover the software in another post. I asked them to focus on the behavioral finance ideas driving their software because it uniquely applies behavioral finance lessons to financial planning relationships. Behavioral finance techniques are often discussed with regard to mental mistakes in investing. But this growing body of knowledge has not been applied to making consumers more likely to succeed at achieving long-term financial planning goals.
 
If these the two young entrepreneurs are represent the future of the profession, our children are in good hands. Burns and Pomerantz both have demonstrated a deep commitment to making the world better.  
 
Burns, a CFA charterholder, served in the Peace Corps in Kazakhstan, where he grew an NGO to financial sustainability and taught economics at a regional university. Then, as an investment manager in Moscow, he deployed commitments from a $160 million private equity fund and served on the boards of several Eastern European logistics providers. More recently, he built an emerging-markets line of business in a major European energy consulting firm (part of a $2 billion annual revenue DNV group). He holds a graduate degree from the Harvard Kennedy School of Government in International Development.
 
Pomerantz, at 21, co-founded a non-partisan, non-political microfinance fund working with Israelis and Palestinians, and has since been involved in finance and technology work at major corporations (consulting at McKinsey and Company, investment banking at Goldman Sachs) as well as smaller, entrepreneurial organizations. He is an experienced programmer and worked as a Program Manager and Business Development Manager at Microsoft, and contributed to various strategy and technical roles at IBM and several Silicon Valley startups. as a B.S. from Stanford University in Symbolic Systems, a graduate degree from Harvard University in Economic Development, and an MBA from Stanford Business School.
 
Attendees gave the session a 4.2 star-rating. Below are comments from those attending:
·       Awesome. We need more programs that help us deal with behavioral issues and specifically how we can help move the needle. Hopefully, Guide financial will provide us with some practical tools to accomplish just that.
·       Nothing new for the advance planner. This was more suited for the beginner. Disappointed in this presentation.
·       Great webinar -- very engaging!
·       One of the best I've seen. And thank you for continuing to do these.
·       Thanks for asking them to record a tour of their software. It will be easier to see how they implement what they talked about.
·       Very respectful of their audience. Can't wait to see their demo.
·       Good.
·       Very helpful and interesting
·       Great presentation. I would have enjoyed hearing more about their business model for Guide and the cost to employ their software.
·       Time for questions during webinar.
·       Pretty good stuff. Interesting
·       Very interesting, I'd like to learn more about them
·       It was ok.
·       Interesting software product and discussion on behavioral finance. The first few charts were very informative, particularly the one about the difference in ending value of an account in which the participant increased his contribution from 3% to 8%. That was remarkable. It's ironic because the clients who complain the most about their returns, etc. are the ones who don't want to save the amount needed to reach their goals. I could see that issue percolating in these charts.
·       I wish that they had spent more time doing a demo of the software.
·       The webinar seemed to be about establishing the fact that people act in accordance with certain principles of behavioral finance. But I would hope that an audience of financial advisors would know that. I would have preferred more concrete suggestions of how to apply behavioral finance principles to client interactions/ client management, and would REALLY have liked more time on the software the presenters have developed. I don't care if the webinar is a "product pitch" if the product if effective.
·       Right out of Dan Ariely's Irrational Behavior class.
·       Not bad, yes they need to work at this. Not sure if they know what we do, manage client capital not babysit people who are trying to save. Nice objective but economically not viable. But, maybe their software could be used and, thus, I thought your suggestion on the software was good. Let's see!
·       Probably better suited for advisors with younger clients.
·       I would like to see the software and how it works.
·       Would have appreciated less chatter from Andrew and allowing more time for questions. Thx.
 
 
 
 
Awesome. We need more programs that help us deal with behavioral issues and specifically how we can help move the needle. Hopefully, Guide financial will provide us with some practical tools to accomplish just that.
Nothing new for the advance planner. This was more suited for the beginner. Disappointed in this presentation.
Great webinar -- very engaging!
One of the best I've seen. And thank you for continuing to do these.
Thanks for asking them to record a tour of their software. It will be easier to see how they implement what they talked about.
Very respectful of their audience. Can't wait to see their demo.
Good.
Very helpful and interesting
Great presentation. I would have enjoyed hearing more about their business model for Guide and the cost to employ their software.
Time for questions during webinar.
Pretty good stuff. Interesting
Very interesting, I'd like to learn more about them
It was ok.
Interesting software product and discussion on behavioral finance. The first few charts were very informative, particularly the one about the difference in ending value of an account in which the participant increased his contribution from 3% to 8%. That was remarkable. It's ironic because the clients who complain the most about their returns, etc. are the ones who don't want to save the amount needed to reach their goals. I could see that issue percolating in these charts.
I wish that they had spent more time doing a demo of the software.
The webinar seemed to be about establishing the fact that people act in accordance with certain principles of behavioral finance. But I would hope that an audience of financial advisors would know that. I would have preferred more concrete suggestions of how to apply behavioral finance principles to client interactions/ client management, and would REALLY have liked more time on the software the presenters have developed. I don't care if the webinar is a "product pitch" if the product if effective.
Right out of Dan Ariely's Irrational Behavior class.
Not bad, yes they need to work at this. Not sure if they know what we do, manage client capital not babysit people who are trying to save. Nice objective but economically not viable. But, maybe their software could be used and, thus, I thought your suggestion on the software was good. Let's see!
Probably better suited for advisors with younger clients.
I would like to see the software and how it works.
Would have appreciated less chatter from Andrew and allowing more time for questions. Thx

 

 

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Six Hypocrises of the Life Insurance Industry
Monday, March 17, 2014 13:00

 

Yes, I know what you’re thinking: only six? But let’s start with these, and you can add to the list.

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1. We want the benefits of being trusted, but we don’t want the constraints of being trustworthy.

 

Many people have observed that trust lubricates the wheels of commerce. It reduces sales effort, so salespeople naturally want to be trusted. On the other hand, being trustworthy imposes limits on what you can do, and sometimes you can’t do things that you would like to.

 

The business model of the life insurance industry relies, in part, on establishing trust and then betraying it. It’s fair to say that many life insurance transactions would not take place if the buyer had better information about the pros and cons. Two examples:

 

Most whole life policies, and some other types of policies, give the agent the ability to use riders to lower his commission and improve policy values. In my experience, agents rarely use this feature to create a process of honest negotiation about their compensation. Instead of presenting the full range of options and explaining the implications to the buyer, they choose one or more policy designs on their own and leave the buyer in the dark about what is going on.

 

Perhaps they are assuming that their trusting customer will never discover what took place in the sales process. Again in my experience, when a policyholder learns what the agent did, the policyholder’s view of the agent’s trustworthiness quickly changes. One of my clients was so angry that he contacted his state’s attorney general to complain.

 

A second example: Flexible-premium policies give the policyholder the ability to choose the amount and timing of premiums, within limits. The policy design can sometimes create significant incentives to depart from the illustrated premium schedule. Insurance companies do not encourage policyholders to explore this policy feature to make intelligent decisions. More often their communications convey a tone of “Don’t worry your little head about it; just pay the illustrated premium.”

 

Agents are generally unaware of the technical aspects of premium flexibility, so they are in no position to offer useful advice. They also have a conflict of interest in risking the loss of a sale if the prospect becomes overwhelmed by complexity, or in having reduced compensation as a result of premium optimization (although premium optimization can sometimes lead to higher commissions).

 

2. I want you to look at long-term projections, but I’ll look at the first-year commission.

 

In 1992 a task force of the Society of Actuaries warned about the serious limitations of using sales illustrations to compare life insurance policies (see “How Should People Choose a Life Insurance Policy”). Shockingly, insurance companies and their agents did not immediately stop using illustrations to make sales.

 

If you go shopping for a cash value life insurance policy, you’ll receive projections of premiums, cash values and death benefits that stretch out decades. Oh, you’ll have so much money in the 22nd century!

 

But if you try to get the minimum-commission version of the policy (see Hypocrisy #1), the agent may complain that the commission is too low. He means the first-year commission. He isn’t looking at the present value of renewal commissions stretching into the 22nd century.

 

3. Cash values don’t matter, unless I can use them to replace your policy.

 

With fixed-premium policies, such as whole life, there is a predetermined relationship between cash values and death benefits. The cash value gradually grows until it equals the death benefit at maturity.

 

Whole life policies with substantial cash values are a target for agents who can earn a big commission by rolling the cash value into a universal life policy with a no-lapse guarantee. The guaranteed cost of the new policy may be lower than the projected (nonguaranteed) cost of the old policy, but this comes with two sacrifices: you lose upside potential, and you lose liquidity (cash surrender values and policy loans).

 

Even though it is the cash value of the old policy that makes the agent’s sales pitch for the new policy possible, the agent pivots and downplays the significance of cash values going forward.

 

4. I want to know what the commission is, but I don’t want you to know.

 

Life insurance commissions are usually not disclosed. Variable life prospectuses do provide some vague disclosure, buried toward the back. New York’s Regulation 194, which took effect in 2011 despite agents’ efforts to stop it, requires commission disclosure if you ask for it.

 

But most life insurance buyers have no idea what the agent’s commission is, and most agents don’t see why the buyer needs to know. The insurance company pays the commission, some agents disingenuously say, ignoring the fact that commissions must be priced into the premiums.

 

Or they’ll ask if you know what the salesperson’s commission is when you buy a refrigerator. (A curious analogy, inviting this question: If you take your life insurance policy to Europe, will it still work?)

 

Or they’ll argue that the high-minded enterprise of life insurance will be turned into a grubby focus on commissions, inevitably harming consumers. (Fun thing to do: Flip through a trade publication for agents — for example, Life Insurance Selling — and count the number of ads that are high-minded versus grubby.)

 

But agents do think that it is important for them to know the commission. Aside from the obvious interest in their income, agents use commission information in due diligence. Conscientious agents may be suspicious of products that offer above-average commissions, because they wonder if that will come at the expense of long-term consumer value.

 

5. We want to say that cash value life insurance beats every other investment, but we disagree that the tax advantages are excessive.

 

If you look at sales pitches for cash value policies long enough, you’ll probably see a proposal to replace anything. Low-yielding safe money, municipal bonds, stocks, annuities (presented as a “rescue” from the taxes that should have been disclosed at the time of sale), tax-deferred retirement accounts, Roth IRAs, anything.

 

But as soon as someone proposes cutting back on the tax advantages of cash value life insurance, the industry mobilizes to contact every politician who might have some control over legislation. The current tax treatment is appropriate and necessary, they say. Is it really national tax policy to make cash value life insurance better than every other place to put your money, and if so, should this be classified as a tax expenditure or as an entitlement program?

 

6. We want to be careful when we’re selling our products, but we want you to be careless when you’re buying them.

 

Life insurance companies do not put products into the marketplace without verifying that they will meet their profit objectives. This process, called profit testing, often uses simulation techniques to construct a probability distribution of results. For example, a 2012 survey by Milliman, a large actuarial consulting firm, found that 17 out of 23 companies used stochastic modeling in assessing the risk of no-lapse universal life products.

 

There is a trend toward using stochastic methods in solvency regulation as well. Some capital requirements are based on conditional tail expectation (CTE), a coherent risk measure that is equal to the average of the x% worst outcomes. For example, CTE90 means that you take the average of the 10% worst outcomes in the probability distribution, and the company should have sufficient capital to cover that shortfall.

 

But buyers of cash value policies have to settle for sales illustrations that do not present a realistic picture of the benefits and risks. This is especially true for indexed universal life and variable universal life, which pass significant investment risk to the policyholder.

 

Sales illustrations unrealistically assume a constant interest rate in all years, thereby hiding the impact of volatility on the future policy values. Even if you can accurately predict the long-term average rate of return, the periodic fluctuations in the credited rate will create a wide range of outcomes, including the possibility of having to put more money into the policy to keep it in force.

 

In “Policy Illustration Technology: It’s All about the ‘Ups’ and ‘Downs’,” published in the March 2014 issue of the Journal of Financial Service Professionals, Richard M. Weber and Christopher H. Hause modeled an indexed universal life policy to show the disparity between deterministic and stochastic illustrations. The deterministic illustration — what we now have — showed a 100% chance that a $5,417 premium would keep the policy in force for life, assuming an 8% constant interest rate. A stochastic illustration using historical S&P 500 returns (8.45% long-term average, without dividends) with a 0% floor and 13% cap showed that this same premium would keep the policy in force until maturity only 20% of the time. With a 10% cap, failure was almost certain.

 

Furthermore, if you wanted to rely on a deterministic illustration to estimate the premium that would have only a 10% chance of failure, you would have to reduce the constant interest rate to 5.2% to 6.3%. depending on the assumed cap. So it would take a downward adjustment of 1.7% to 2.8% to get a premium that might be viewed as acceptably risky by the buyer.

 

Deterministic illustrations are so unreliable for making policy purchase and maintenance decisions that it should be a no-brainer to ban their use and require stochastic illustrations. However, insurance companies and insurance regulators have shown no interest in doing this.

 

What explains this behavior?

 

Does the life insurance industry have more than its fair share of unethical people? I doubt it. I would look for an explanation in Blind Spots by Max H. Bazerman and Ann E. Tenbrunsel, published in 2011. They write: “Findings from the emerging field of behavioral ethics — a field that seeks to understand how people actually behave when confronted with ethical dilemmas — offer insights that can round out our understanding of why we often behave contrary to our best ethical intentions. Our ethical behavior is often inconsistent, at times even hypocritical.”

 

Bazerman and Tenbrunsel argue that unethical behavior is often unintentional, due to bounded ethicality (“cognitive limitations that can make us unaware of the ethical implications of our decisions”) or ethical fading (“a process by which ethical dimensions are eliminated from a decision”).

 

I am willing to believe that most agents just don’t see the ethical implications of their actions, even when their behavior is inconsistent with the codes of ethics of Certified Financial PlannersTM, Chartered Life Underwriters, Chartered Financial Consultants or members of the National Association of Insurance and Financial Advisors. (I have a link to these codes at glenndaily.com/links.htm.)

 

Consumers and their advisors will be doing the life insurance industry a favor by pushing back firmly against its ethical shortcomings. If you start with the premise that these shortcomings are due to blind spots, rather than character flaws, you may actually have an impact on future behavior.

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What Is Cash Value Life Insurance?
Thursday, March 13, 2014 12:07

Which one is the best choice?

Cash value life insurance is…

A. an expense.
B. a combination of protection and savings.
C. a way of prepaying future insurance costs.

 

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You have probably read many times that there are two types of life insurance: term and cash value. Term insurance is pure protection, while cash value life insurance combines protection with savings.

Or perhaps the writer has put his thumb on the scale by calling cash value life insurance “permanent insurance,” as opposed to “temporary” term insurance. The actuary Charles Trowbridge had a wonderful observation about these loaded names: “There is nothing more permanent than a term policy fully in force at the time of the insured’s death — and nothing more temporary than a whole life policy that lapses shortly after issue.”

Terminology aside, this is a case where the description suggests the analysis. If cash value life insurance is a package of protection and savings, then you should naturally want to unbundle the package to figure out what you are paying for the protection and what you are earning on the savings.

Here’s an experiment that you can try: Get into your time machine, go back to 1850, find some people who know something about life insurance, and ask them how whole life insurance compares with buying term and investing the difference.

They won’t know what you’re talking about, because guaranteed cash surrender values did not become available until the late 1860s and the following decades. For consumers in 1850, whole life insurance was a way of making life insurance affordable until death. By charging more than the actual cost of death claims in the early years, the insurance company could charge less than the actual cost of death claims in the later years. When policyholders paid a level premium for life, they were prepaying some of the future costs of insurance.

If cash value life insurance is a way of prepaying future insurance costs, then you should naturally want to figure out what incentive the insurance company is giving you to prepay. Suppose you know the minimum amount to keep the policy in force each year. If you pay $1 more than the minimum this year, how much less than the minimum can you pay next year? And if you pay this year’s minimum plus next year’s discounted minimum, plus $1, how much less than the third year’s minimum can you pay? And so on. Each opportunity to prepay can be expressed as a rate of return that is earned by not having to pay a future premium, in the same way that multi-year magazine subscriptions provide a rate of return by prepaying the renewal costs.

There’s more. If the policy has a level death benefit, the prepayment is lost at death. So there are two possible outcomes: you earn a return of x% if you survive until the end of the prepayment period (with a probability of y%) and you lose all of your money (a -100% return) if you die (with a probability of 1-y%).

There’s still more. As you extend the prepayment period, you face greater uncertainty about your future health, your future opportunity cost of money and other relevant factors, such as your need for life insurance.

So it is not a simple matter to come up with an “optimal” premium schedule for policies like this. In fact, the problem may be mathematically intractable for long-term horizons unless you make simplifying assumptions. What you can say with some confidence is that the illustrated premium schedule is probably not optimal, except by accident.

What about paying a single premium for, say, a no-lapse universal life policy? That means that you are prepaying all of the future insurance costs to (usually) age 121. Are there any other significant costs that you would consider prepaying to age 121? Medical costs? Food expenses? Can you defend a single premium by invoking the “peace of mind” of knowing that no more premiums will be needed to keep the policy in force for life?

If you are reviewing a cash value life insurance policy, which tool should you reach for: a “buy term and invest the difference” analysis or a prepayment analysis? That will depend on the situation. Is the cash value policy being used as a place to put savings for retirement? A “buy term and invest the difference” analysis will help guide that decision. And you can complement it with a prepayment analysis to take advantage of whatever premium flexibility the policy provides.

Is the policy being used to provide liquidity at death? The protection and savings view isn’t helpful here. Look at rate of return on death, actuarial net present value (or the “money’s worth ratio”) and prepayment incentives (or, sometimes, disincentives).

For many people, a third view of cash value life insurance is prominent. They get a premium notice and the cash value policy seems like an expense, just like health insurance and the phone bill. This can lead to poor decisions.

If the policy is an expense, it’s natural to want to pay as little as possible for it, and it’s certainly not hard to find sales illustrations that create unrealistic expectations about the cost of cash value life insurance. You may also be attracted to options, such as using whole life dividends to pay premiums, that reduce the expense.

On the other hand, if the policy is an investment, interesting questions arise. Is it a good place to put money? How much money should be invested, and when? How does the policy design affect its performance? How should the policy be managed after issue to improve the return?

To answer the question at the beginning, B or C but not A.

 

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Discount Code For A4A Members For My StockOptions.com -- A Great Resource With Tax Season Upon Us
Friday, March 07, 2014 14:48

 

With tax season in full swing and stocks showing huge returns in recent years, advisors are dealing more with tax issues related to stock options, restricted stock and other compensation methods that can be complicated tax-wise. Here’s a discount code for A4A member from mystockoptions.com, which is one of the best resources on the Web covering equity compensation and has an outstanding tax resource center.

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To receive a $25 discount on a one-year Premium Membership (offer good until April 1, 2014), enter the promotional code TAXBACK2014 in the registration/upgrade form, or click here to sign into your existing membership and then upgrade.
 
Mystockoptions.com’s Tax Center teaches the withholding, reporting, and filing rules for stock options, ESPPs, restricted stock, and SARs, which could come in especially handy during the next few weeks.
 

 

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Beware Elder Fraud!
Sunday, March 02, 2014 23:19

Tags: client communication | client education | fraud

It might seem trite to bring up "elder fraud" again. Trite as it might seem, it is real and happening NOW! A good friend called me last week, upset after finding out about her parents' experience. It went like this:

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Her mother received a phone call early on the previous Monday. She was told, by the "arresting officer", that her grandson was arrested for drunk driving and had hit a car owned by a visiting Chilean. In order to avoid jail time, she would need to wire $3,000 to a Chilean bank by noon. She was instructed not to call her grandson (because his cell phone was confiscated) and not to call his parents (because he didn't want them to know).
 
Unfortunately, my friend's parents believed this story and it cost them $3,000.
 
Additionally surprising is how my friend found out. You see, her son coincidentally called his grandparents later that day. When they realized that they were scammed, they swore their grandson to secrecy. Fortunately, he told his parents. 
 
When my friend ultimately called her parents, they were embarrassed but also angry and defensive. They emphasized that they were not losing their minds and did not want financial control taken from them. 
 
Therein lies the problem. Were it not for their grandson's prudence in telling his parents, this fraud would not have been reported. Embarrassment and fear frequently keep this crime under wraps. What can we do? We must warn our elderly clients. We must warn our clients with elderly parents. And we must warn our own parents. 
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