Rekenthaler Report

Another Strike Against Bundled Investment Sales

John Rekenthaler

Bought or Sold?
Last week, The Wall Street Journal published "Steak Dinner and Annuities," which depicted variable-annuity providers as pitchmen. Entice prospects with an expensive meal; push the product as they dine; and then close the deal. If somebody has follow-up questions about the presentation, don’t answer the inquires casually. Instead, require the prospect to schedule an in-person meeting.

One explanation for why variable annuities are sold as if they are time-shares is that they aren’t any good. That certainly could be the case, concedes Bloomberg’s Matt Levine. However, he writes, there might be another reason why variable annuities are sold hard, while index funds, for example, are not:

"The alternative possibility is that variable annuities are also good but more complicated than index funds, that they need to be customized for each purchaser and then hand-sold, in person, over steak, so the investor can understand what she’s getting and why she should want it. Perhaps there are financial products that are sold, not bought, but that nonetheless should be sold (and bought)."

This, of course, is the argument of the industry’s defenders. Variable annuities can be excellent investments, but they are too complex for buyers to evaluate on their own. This makes moot any price comparisons with index funds, because paying financial professionals to explain investment products costs far most than filling Internet orders.

The Real Issue
It is true that variable annuities are complex (whether they can be excellent is another matter), but that is not the primary explanation for how they are marketed. The reason is instead because their sales costs are intertwined with the investment--bundled, as the jargon would have it--rather than separated.

Let’s begin by dispensing of the idea that simplicity sells itself. Mutual funds are not overly complex, are highly publicized, and are well regulated. Even so, they tend to be distributed through advisors. Indeed, the United States is one of the few markets with a thriving direct-sale channel. In most countries, nearly all funds are purchased through advisors.

Life insurance is another simple financial product that is routinely sold rather than bought. There is nothing difficult about the concept of paying a regular monthly fee in exchange for the assurance of a lump-sum payment should a specified event occur. People easily grasp that idea, so they routinely purchase homeowners or automobile insurance on their own. However, they usually buy life insurance through agents.  

Consider also target-date funds. Knowing which fund to buy only requires remembering one’s birth year. Such clarity has made target-date funds extremely popular within 401(k) plans. Outside of 401(k)s, though, they don’t sell. Anybody may acquire Vanguard’s target-date funds for their IRA accounts, or Fidelity’s, or any other providers. Few do, even though those funds are undeniably straightforward and are routinely held within defined-contribution plans.

The point here is, although the level of complexity does affect how financial services are sold--the everyday investor is likelier to be comfortable with an intermediate-term Treasury fund than with, say, a short-term multimarket income fund (don’t ask; they have long since been extinct)--the reality is that most people require nudging. For whatever reasons, they hesitate with their financial purchases. They need to be talked into their decision.

Making Costs Explicit
Which brings us back to the WSJ’s steak dinners. If most financial services are sold rather than bought, regardless of their intricacy, then why are variable-annuity presentations accompanied by filet mignon, while index-fund discussions are not?

The answer rests in the investments’ cost structure. Advisors who recommend index funds are paid explicitly by the investor for their services. How that payment occurs is immaterial. It could be a commission (as with a full-service broker using exchange-traded funds), or a flat fee, or, as is mostly commonly done these days, a charge based on assets under management. Those details matter not. What’s important is that those payments do not come from the fund. They come from the shareholder.

Removing the fee-collection duty from the fund--unbundling, if you will--has two effects.

One is that the investor reliably comprehends her costs. Expense ratios can feel somewhat theoretical, because people think more readily in dollar terms than in percentages, but most unbundled investments these days have low expense ratios (being either index funds or institutional share classes). But the explicit payments are not theoretical. Commissions are openly apparent, as are flat fees, as are the advisor’s asset-based charges. The unbundled investor, by and large, knows where her money has gone.

Which means that if the advisor offers a "free" dinner, the unbundled investor realizes that she is the true buyer. Her money bought that steak. (Or, if she is a prospect rather than an existing customer, her future monies did.) And the potatoes, vegetables, wine, and dessert. That connection is nowhere near as evident with a bundled security, such as a variable annuity; it carries high internal expenses, much of which are used to compensate financial advisors. In that case, the steak truly does feel free.

Thus, unbundling investment fees, so that advisors charge what they receive, while the investment-management company or insurance firm charges what it receives, clarifies the money trail. Investors are that much less likely to be wooed by expensive proposals that, ultimately, come from their own pockets.

Lost in the Shuffle
The second effect of placing advisor-related expenses within investments, rather than forcing them to be explicit, is that by burying such expenses, they may become higher than they otherwise would. Just as the glare of the spotlight may drive down such costs, the obscurity of variable-annuity financial reports can permit them to rise. The WSJ reports that variable-annuity commissions, generated from these bundled costs, can exceed 6%. It’s a fair bet that many of those buyers would not have signed the deal had they known that was the case.

It’s also a fair bet that if the industry’s 6% commissions were up-front and unbundled, they wouldn’t remain at 6%. Customer resistance would be too high. As a result, variable annuities would need to reduce their commissions, which would simultaneously lead to lower investment expenses and--as the sales process would no longer be so lavishly financed--fewer steak dinners.  

Given the ultimate price of those dinners, that would be a good thing indeed.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own. Put the coffee down. Coffee is for closers.