An Insider’s Perspective of the Investment Marketplace

How are Financial Products Distributed?

The average person goes to school, graduates, then gets a job. Between buying a car, house, and other post-graduate purchases, there is usually not much thought giving to saving and investing, but once someone is ready to start investing, what is the first step? Everywhere you turn there is an investment opportunity.

The banker says invest your money in a guaranteed CD, the insurance agent has the “perfect” policy for you, the stock broker picks “hot” stocks which will make you rich, late night infomercials promise that you will be the next real estate mogul, and your neighbor is investing in oil & gas. How does someone sift through all of this information? Where do you begin?

In this multi-part series, I will attempt to walk you through the basic framework of the sale and regulation of investments, and the potential advantages and pitfalls of different investments.

How are financial products distributed?

When you want the latest technological gadget you know exactly where to go. Most items can be purchased or sold without a specific license. This is not true of financial products. Most securities must be purchased through a broker/dealer and insurance products from an insurance company. Generally, a registered representative of the broker dealer is the salesperson who assists you with the purchase of securities. An insurance agent sells the insurance policy for the insurance company. Even a real estate agent needs a license to broker real estate transactions. However, none of the above mentioned profession requires a fiduciary responsibility to the buyer.

Most insurance agents are only paid when you buy a policy. Real estate agents can work for countless hours without any pay. They only get a commission check when a house closes. Many securities brokers also only get paid when a securities transaction gets completed. As you seek a resource for advice and counsel, do not forget how the person across the table from you is paid. They must feed their families and cannot spend time with you without a profit motive. They often receive compensation only when you make a purchase, so that is what they want from you.

An insurance agent can only sell insurance products for insurance companies with whom they contract. Many are “captive agents”. Meaning they can only sell insurance products from the companies their employer says they can. If the agent works for an independent agency, products could be a broad range of companies; if the agent works for an actual insurance company, it is generally only that insurance company from which they can sell. The insurance agents are usually only paid upon placement of an insurance policy, and they can only sell certain policies. If you don’t buy one of those, then they don’t get paid.

While similarities exist between the insurance and the securities industries, the securities industry is somewhat different. Like insurance agents, registered reps can only sell securities products which the broker dealer allows. As in the insurance industry, some broker dealers only sell products from a specific insurance company or investment company. More common than in the insurance industry, broker dealers tend to be independent and sell investments from a broad range of companies. Independent broker dealers may sell one company’s mutual funds right along with another company’s.

I would conjecture that it is usually better to deal with an independent agency and independent broker for a broader range of investments and policies. The narrower the product offering, the more likely a salesperson will try to make you fit into what doesn’t quite fit your situation. Sales people may not be bad or out to take advantage of people, but they must make a sale of what they can offer to make a living.


Although many investment professionals sell both insurance and securities, the regulation for each is completely different. Insurance is regulated by each individual state. The insurance license to sell life and health insurance is usually separate from the one for property and casualty policies. The exam can be taken by anyone without any educational prerequisites. Most states do require a minimum proficiency score and a background check. Typically, someone has already contracted with an insurance company or agency before taking the exam, but this is not required in all states.

I rate the difficulty of the exam as easy. When I entered the industry, the first firm I worked for gave me a textbook and some practice questions. Four days later, I took and passed the exam, and two weeks after that, I was selling insurance. Scary, I know.

An insurance agent represents the insurer. Most state regulation is based upon making required legal disclosures and avoiding “churning,” or the practice of switching from one policy to another just to generate more commissions. Insurance agents are working for and representing the interest of the insurance company by which they are contracted or employed.

Securities are regulated at the Federal level. Stocks, bonds, options, etc are sold through registered broker/dealers. The Securities & Exchange Commission (SEC) is a government agency tasked with overseeing the securities market. The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization. Broker/dealers must be members of FINRA to buy or sell securities.

To be licensed to sell securities, a registered representative must pass certain exams. To sell mutual funds, passing both the Series 6 & 63 exams is required. To sell stocks, bonds, and options, a Series 7 is required. There is no education component required for these exams, but the breadth of material for the exam is more extensive than an insurance exam. The national pass rate is approximately 65% for the Series 7.

With some insurance products, the line between securities and insurance are blurred and are regulated by both. Variable annuities and variable universal life insurance policies are an example of this. In the case of these products, both a securities and insurance license is required to sell these products.

Fiduciary vs. Suitability

Most financial products are sold to consumer either by an insurance agent or a securities broker. Neither of these people have the legal responsibility to put your interests above their own. With securities brokers, the products have to be suitable based upon the information the broker has. For instance, if the broker had access to a mutual fund which is has similar risk/return characteristics but higher fees and lower historical investment returns, he could still sell it because it is suitable. A fiduciary would be responsible for at least disclosing that a better option was available, even if they could not sell it. Even if the broker has access to the better investment, but it pays a lower commission, they can still recommend and sell the higher cost/lower performing investment without any disclosure.

Insurance agents have an even lower level of responsibility to clients. Almost all instances of insurance agents getting into trouble has to do with a practice called “churning”, selling a new product to replace an older product solely to generate additional commissions. Many insurance contracts have multi-year surrender charges or other complex contract provisions which make switching expensive. Replacing of existing insurance policies is really the only major area of scrutiny of insurance agents.

Many people trust that their insurance agent or securities broker has their best interests at heart. Many do, but are not required to or legally responsible to do so. A Registered Investment Adviser is required to be a fiduciary and put their client’s interests ahead of his own. All conflicts of interests (like compensation & product limitations) must be fully disclosed. There are many dually registered Investment Advisers who are also registered representatives of a broker/dealer.

Where to buy?

All insurance must be purchased either directly from an insurance company or one of their agents. All securities must be purchased through a registered broker/dealer or one of their registered representatives. As stated before, none of these channels have a fiduciary duty. Investment Advisors may work as a registered rep of a broker dealer (usually not a fiduciary when participating in securities transactions) or may fully be independent and have limited power of attorney to execute trades on behalf a client as a fiduciary.

Many independent Registered Investment Advisers do not work for a broker/dealer, but instead represent clients who do business with a particular broker/dealer. Some broker/dealers only sell a narrow line of proprietary products; some sell a broad range of products but charge premium rates to cover the commissions paid to registered representatives. Discount brokers generally charge low or flat fees but provide very little service. They exist only to have an inexpensive marketplace for Registered Investment Advisers to direct investments for their clients or for individuals who do not want or need the help of an advisor or registered representative.

I think that the best way for an unsophisticated buyer to purchase insurance or investments is with the assistance of an independent party who is not compensated based upon which investment they recommend. For sophisticated buyers who know what they need, a discount broker may be the best route. For insurance, there are almost no true insurance consultants who are not agents themselves. When selecting an agent, I prefer to go with an independent agent who is licensed with multiple insurance companies.

Part 2 – Insurance Investment Products

When most people think of insurance, they think of the “what ifs”. What if I die, or what if my house is destroyed? Insurance for the “what ifs” is not investment, but rather risk management. After all, purchasing auto coverage will not make you rich but could protect you from becoming poor. Nonetheless insurance companies do provide investments. These investments are offered inside of “what if” insurance products like life insurance (for dying too young) or annuities (for living too long).

Life insurance maybe sold as an investment, but generally, I only recommend it as life insurance. That is completely shocking to some but common sense to others. Many of the investment features in life insurance contracts are similar to annuities, but for this discussion, I am going to keep this to just annuities. The tax ramifications and considerations in using life insurance as an investment are much more complicated than for annuities and would be confusing in the context of discussing investments.

Types of Annuities

Annuities are the most common insurance investment vehicle. An annuity’s concept is that a group pools their assets together through an insurance company that gives lifetime payouts to that pool. If someone lives longer than their life expectancy, they receive more benefits. If their life ends before their life expectancy, they receive less. This is how a traditional pension system works.

Of course, it is not that simple. Annuities come in many flavors and types. Most annuities sold are deferred annuities. A deferred annuity policy holds money and invests it for a future annuitization. At annuitization, the balance of the annuity is traded for a specified payout (e.g. lifetime, joint survivor, 10 years, etc). Annuitization is generally not required for deferred annuities, and actually is rarely done. Some statistics show as few as 1-3% of annuities are annuitized.

The type of investments which power a deferred annuity can also vary. There are two major types of annuities, fixed and variable. A fixed annuity invests in the portfolio of the issuing insurer, who guarantees a minimum interest rate. The insurance company must credit a minimum interest rate regardless of their own investment portfolio returns. Because of this obligation and State regulation, insurance companies generally invest in very conservative investments to besure they can pay the guaranteed interest rates.

Variable annuities invest in sub-accounts which do not have guaranteed returns. These sub-accounts are very similar to mutual funds. Mutual funds companies often manage the investments like the major mutual funds available outside the annuity. Variable annuities put the investment risk on the policy owner. If the sub-accounts decline in value, the annuity value decreases.

One a type of fixed annuity is an equity indexed annuity (EIA). An EIA takes most of the investment pool and places it in safe bonds (usually in the neighborhood of 90%). The remainder goes to purchase call options on a major equity index (most common is the S&P 500). If the index increases in value then the options are worth money and additional interest can be credited to policyholders. If the index declines, the option expires worthless and the bond interest has replaced the investment in the call options. These annuities have the guarantee that they will not lose money.

One major disadvantage of a call option is that it is the right to purchase an investment at a future date at a specified price. The actual investment is not owned, it is just the right to purchase the investment for a specific price. If the investment pays a dividend, only the owners of the investment receive the dividend. The option holder does not receive anything. Historically, dividends have accounted for almost one-third of stock market returns. EIA’s do not get the benefits of these dividends.

Fixed: Guaranteed interest every year.
Equity-Indexed: No chance of loss, but limited upside from equity markets.
Variable: Possible gains and declines in value from the stock market.

Taxation of Annuities

Annuities have special taxation rules. Before the age of the 401(k) and IRAs, the annuity was the primary retirement vehicle available to individuals. There are many similarities between retirement accounts and annuity tax treatment. Contributions to a non-qualified annuity are not tax deductible like a 401(k) or IRAs, but the growth inside them is tax deferred like those accounts. Also, like a them, annuities have a 10% tax penalty for withdrawal of gains prior to age 59 ½ and those gains are then taxed at ordinary income tax rates when withdrawn.

When investments are bought or sold inside an annuity, there is no tax consequence to that transaction. The annuity acts as a “tax blanket” while the investment is inside the annuity. This can be beneficial over time because taxes can have a significant impact on investment returns. Dividends and bond coupons are taxed when received outside of an annuity, but inside the annuity, they can be reinvested and grow free of current tax.

The major downside is that all investment gains are taxed at ordinary income tax rates when distributed from the annuity. Outside of the annuity, the qualified dividends and long-term capital gains are currently taxed at a lower rate. When taking a partial withdrawal, the gains must be removed before the original contributions. So, for instance, if $10,000 was contributed to an annuity and it had grown to $20,000 and $10,000 was distributed, all $10,000 would be treated as a distribution and taxed at ordinary income tax rates. For younger investors, the 10% tax penalty for early withdrawals prior to age 59 ½ makes taking early distributions less desirable.

When an annuity is annuitized into payments, the policy basis is returned pro-rata in each payment. Each payment will contain some gains (if any exist) and a return of principal. This continues until the basis is completely returned through scheduled payments. If the annuitant lives long enough, the payments can become entirely taxable income, once life expectancy has been eclipsed.

Unlike a taxable account which gets a step-up in basis, inherited annuities will still require ordinary income tax on the gains of the policy. Although annuities can be beneficial for deferring taxation over many years, there are several major considerations where an annuity can be less tax favorable than a simple brokerage account.

Annuities should not be used as a short-term investment vehicle. They are best suited to be used as a retirement savings vehicle when a 401(k) or IRA is not sufficient or available. They can be particularly unsuitable to young investors who may need access to the funds in the annuity before retirement.

Special Features of Annuities

Annuitization is probably the biggest advantage of annuities. A classic problem of planning retirement is how long retirement savings will have to last. With an annuity, payments can continue for life. This almost always provides the highest monthly income possible with the lowest risk. The part of annuity which really turns people off is that when they pass away, there is no asset left over for their heirs.

When selecting an annuitization benefit, more than one lifetime can be selected for the payout period. A couple can extend payments over the joint lifetime of the couple. Also, a period certain can be added to a lifetime annuitization. With a 10 year period, certain the payments are guaranteed to last at least 10 years from annuitization, even if the annuitant dies. A beneficiary is elected to receive those payments if the annuitant dies in the first 10 years. One of the most important features to consider with annuitization is inflation protection. With inflation protection, the annuity payments increase with the rate of inflation. This ensures not only that payments continue through life but also that they will keep up with cost of living increases.

Variable annuities developed new and innovative features and riders during the 1990’s and 2000’s. They promised investing in the stock market (inside of the annuity) yet provided guaranteed returns backed by the insurer. Each rider’s specifics can vary greatly from company to company and product to product. With the additional fees of the rider, the insurance company can engage in sophisticated hedging strategies using options. They usually require significant holding periods of 5 years to life for these riders, and the investment options were often limited.

Historical computer models and existing strategies showed these riders were viable and would deliver the promised benefits. The financial strength of insurance companies put credence to the viability of these riders. In late 2008, these riders came under great stress. With the financial markets “dislocated” and credit markets drying up overnight, the historical computer models and strategies were broken. If deterioration had continued, it is questionable whether these annuities could have delivered on their promises. Since then, insurance companies have looked very closely at their policies and these special riders. Many companies have raised the cost of these riders significantly, eliminated them, or modified them to provide lower benefits.

In some states, annuities have legal protection from creditors. In these states, creditors may not be able to go after the value of the annuity when seeking a judgment or collection in bankruptcy. A regular brokerage account does not have this benefit.

Costs of Annuities

The largest complaint about annuities is their high cost structure. A variable annuity will typically have several types of underlying expenses. The most common types are M&E (mortality & expenses), administration and sub-account expenses. These combined expenses often exceed 2% a year. If riders are selected, especially a living-benefit, annual expenses can exceed 3%. Considering the typical mutual fund costs are 1-1.5%, an annuity looks very expensive.

One reason that expenses are so high is that annuities pay very high commission rates compared to other investments. Insurance companies will advance commissions to agents for selling annuities when mutual funds would pay a much smaller commission. Commissions may be as high as 25% paid to agents for the sale of fixed and EIA annuities. For variable annuities, commission rates may be as high as 10%. The insurance company advances those commissions because they know they will receive their money back over time.

Once in an annuity, the policyholder has limited control. Even in a variable annuity, where there could be hundreds of investment sub-accounts, the choice of sub-accounts is made by the insurance company. Insurance companies can change out sub-accounts as they see fit and change the fees and expenses for those sub-accounts.

In a fixed annuity, the insurance company declares an interest rate which is credited to policy holders. Countless policies pay up front bonuses and enticing initial interest rates, only to later have the rate decline significantly – even to the guaranteed minimum. In a fixed annuity typically no annual fees are charged, but the insurance company makes their “fee” on the spread (difference) between what they earn on their investment portfolio and the crediting rate of the policy. Insurance companies generally do not disclose the spread they earn on a policy.

Annuities almost always have surrender charges that are assessed if money is withdrawn from a policy within a certain number of years. Surrender charges can range from 5% to 20% and last for 7 to 15 years. Once the policy is purchased, the insurance company either earns their fees for many years to repay the large commission paid to the sales agent or they take a huge chunk of the investment to pay the commissions they have already paid out through a surrender charge.

Many agents point out the tax benefits of an annuity, but many annuities are sold inside of a retirement plan (IRA, 401(k), etc). Inside a retirement plan the annuity adds absolutely no additional tax benefit. The living benefit riders have become one of the most common reasons for recommending annuities for retirement accounts. In the wake of the 2008 financial crisis, the cost of living benefit riders have become even more expensive, and the promised benefits they provide are lower.

I have reviewed numerous variable insurance policies. Many policy prospectus and investment prospectus can run several hundred pages. In one particular case I remember, the contract provisions from a major insurer exceeded 100 pages and the investment information, 400 pages. Whenever something is that complicated, it is impossible for most individuals to understand it. Insurance companies write policies to make money. The more complicated policies are, generally the better they are for the insurer.

Part 3 – Stocks, Bonds, Mutual Funds/ETFs
Mutual Fund Explanation

Part 4 – Diversification & Asset Allocation
Differences & Types of Risk
Index & Active Management
Tax Efficiency
Market Valuations