Of course, you want to protect your family and your savings from unforeseen consequences, but is life insurance the best option? Can life insurance be an investment rather than a cost? In today's episode of the Rational Reminder Podcast, we take a look at everything life insurance and dig into some hard-hitting research on the subject. We break down the various insurance products available and unravel the nuances regarding returns, dividends, and the associated fees. We discuss why there is so much confusion regarding returns and associated risk, how your contribution can affect your returns, and why you may not get the payout you expected. We also delve into what makes each insurance product different from the next, whether predictions on insurance policy returns are possible, and how insurance compares to other asset classes. If you’re looking for insight into the potential tax benefits of life insurance and a breakdown of the different scenarios where life insurance is needed, this is the episode for you!
Key Points From This Episode:
The main topic of the episode: permanent life insurance. (0:04:29)
Defining insurance and how it is typically structured. (0:04:44)
‘Term life insurance’ and how it works. (0:05:41)
A brief outline of the differences between term insurance and permanent insurance. (0:07:37)
Details about term life insurance and the benefits to the policyholder. (0:09:37)
Another type of life insurance: universal life insurance. (0:11:05)
How investments within a life insurance policy are designed. (0:13:20)
An interesting insight Ben came across while researching insurance. (0:14:38)
Non-participating whole life insurance and the associated cash value. (0:16:00)
A breakdown of participating life insurance and what makes it different. (0:18:42)
The basis for performance and premiums on participating insurance. (0:21:43)
Whether or not it’s possible to predict returns from insurance products. (0:25:25)
Reasons for the obscurity surrounding insurance products and expected returns. (0:25:49)
The policy illustration software that many insurance companies use. (0:29:35)
Insight into post-tax returns of permanent insurance on death. (0:35:23)
An overview of when you would need life insurance. (0:40:58)
The long-term expected death benefits compared to other assets. (0:43:03)
Insight into the commission incentive associated with insurance policies. (0:45:47)
Highlights of a recent presentation that Ben gave at an IAFP conference. (0:46:53)
Feedback received about the Jonathan Berk and Jules van Binsbergen episode. (0:49:01)
A summary of recent news about rate changes and developments at Vanguard. (0:56:23)
This week’s review of The Art of Gathering, about meeting more effectively. (01:00:55)
An honourable mention of another book, Your Investment Philosophy.(1:06:22)
Read the Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to Episode 221, as always. This week, beside me, I don't have Oscar. Oscar is going to see the vet tonight, so I hope he's okay. He's got a bit of a shoulder issue going on. He is not with me today. I can't wait in a few weeks, I'll be in my new office upstairs. Hardwired to the Internet, proper sound and people won't be able to see my living room, which is nice.
Ben Felix: Did you do any sound engineering in there? You got panels up or anything?
Cameron Passmore: No. We're designing some panels now. The team is helping me design some panels and the colors and stuff for the background. Yeah, it's going to be very nice. Going to keep the carpet down. It's a nice space upstairs. Window looking out front. It's going to be pretty nice. As people walk by, they won't worry about interrupting me, so that'll be good.
Here in this episode, things have been super hectic of late. Lots of travel, lots of presentations, lots of meetings, lots of face-to-face, which is a whole new experience, given the past two years with the pandemic. You dig into some good research on insurance, which I think is super important. You also dig into some feedback we got on the Jonathan Berk and Jules van Binsbergen interview that got some interesting comments.
Ben Felix: I'm more trying to clear it up. There was a lot of misunderstanding. There's three reactions. One type of reaction was that it was new information, that it was great to have something that’s thought provoking. Another reaction was, yeah, that was interesting, but they didn't actually say anything useful. Okay. Which from a practical perspective, from our perspective as investors, they may be right. I mean, from a maybe regulator’s perspective, or I don't know, I guess, just justifying the existence of the active management industry, sure. From our perspective, sitting here and looking at which funds to invest in, did anything that they say change much? Other than their disagreement on the existence of factor premium, it doesn't mean – Anyway, so that was two reactions. What was the – Oh, and then the third one was just a total misunderstanding of what they said, which was people were thinking like, they're saying that we can then pick active managers, but that's not. We talked about that during the episode. That's not what they're saying.
Cameron Passmore: The main feature this week is your deep dive into permanent life insurance, which is terrific and nice to have that done. I do a quick book review on The Art of Gathering by Priya Parker and talk about a book called Your Investment Philosophy. We did discuss reviews and Ben got a little feisty, so stick around at the end on that.
Ben Felix: I hope I didn't offend anyone, but, oh, well. I don’t think we did.
Cameron Passmore: We will see, Lisa was real. As always, don't forget the merch store. Lots of cool swag in the merch store and everywhere gets a free beverage cozy and a pair of socks and according to Costco, it's Christmas season. If you're looking to buy Christmas presents with the Rational Reminder on it, help yourself. Remember, the podcast is also available on YouTube, where you'll find, I think, more charts and information. As always, follow us on Twitter, @rationalreminder on Instagram. #rationalreminder on Peloton. Of course, connect and reach out to us on LinkedIn.
Ben Felix: Peloton still a thing?
Cameron Passmore: Peloton is still a thing. Absolutely, still a thing. A lot of people show up in there.
Ben Felix: Oh, yeah?
Cameron Passmore: Yeah, for sure. I check all the time to see what other Rational Reminder riders have been on different rides. We don't ride together, but you can see there times. It's cool.
Ben Felix: Interesting. I went on an actual bike ride yesterday.
Cameron Passmore: We went to Montreal on the weekend and parked on the Lachine Canal. It was fantastic. I'm going out to get a bike rack for the car, so we're going to have to put in the back of Lisa's SUV. We had a blast. The cycling trails are along the Lachine Canal, right down through the old port and you can cut right through the city up to the mountain are phenomenal bike paths. Where did you go?
Ben Felix: The trails around where I live.
Cameron Passmore: You got your bike?
Ben Felix: Nope. I'm running my wife's bike. People would probably think I look hilarious.
Cameron Passmore: You've ordered a new frame, right? Or new bike?
Ben Felix: Yeah. Yea, I don't know when I'll get it. It’ll take a bit.
Cameron Passmore: Yeah. Anyways, we're going to do a lot more cycling. It was so much fun. Just beautiful on Lachine Canal. Awesome. Anything else?
Ben Felix: Let's go to the episode.
Cameron Passmore: All right, welcome back to Episode 221.
Ben Felix: All right. Right into the main topic with the new format.
Cameron Passmore: You're still getting used to the new format, aren’t you?
Ben Felix: Well, of course. It's like, what? Our third episode?
Cameron Passmore: Maybe even the second. Either way, you got a pretty important topic, one that gets lots of attention in the wealth management industry in general, I think it's safe to say.
Ben Felix: Yup. We're talking about permanent life insurance. There's a lot to cover. Hopefully, it's interesting.
Cameron Passmore: It's good that these are all put in one package. I think it's important we don't do it over two episodes, so it's one parcel.
Ben Felix: Yeah. All right. Insurance is typically designed to cover a low-probability, but catastrophic loss. You think about life insurance of a young working person, has no financial assets, lots of human capital, maybe they're supporting a spouse or kids, or whatever the case may be. If they die, that is catastrophic to their surviving family, because all of the assets were in them, in their human capital.
Likewise, for car insurance, we pay our premiums. If you get in a big accident, that pays. Stuff like that. The role that the insurance company plays is that they allow risk to be shared across lots of people. That's the key. They make a big pool. If a low-probability event, if three people out of the thousands or whatever it is in the insurance pool have a catastrophe, then it's much less of a blow to the group as a whole, than it would have been to that one individual. That risk sharing is really the intended function of insurance.
Term life insurance, so that was just insurance in general. Now moving on to a term life insurance. Term Life insurance is a type of insurance contract, where you lock in a fixed premium for a fixed period of time. If you're, again, the young working person, and you're building up your retirement savings, you might buy a 20-year term insurance policy, you know exactly how much you're going to pay for the life insurance coverage over that term. The intention would be that by the end of the term, you either don't have the insurance need anymore, or you have a reduced insurance need.
To renew a term policy, without going through underwriting and all that stuff, your premiums jump up. Depending on your age, they can start to jump up pretty dramatically. Ideally, if the insurance need is longer than say, it's a 20-year insurance need. You may not want to buy a 10-year insurance policy and then renew at the renewal rates. It's potentially better to buy the 20-year policy. Now, of course, that I'd have to look at the exact pricing of different policies to say that for sure, but just conceptually, that's the idea.
With most life insurance needs that you can think about, needs, and there are other reasons you might want to buy insurance that are not as obviously needs. Most insurance needs are going to be temporary. They're replacing human capital, that's temporary need. Funding a mortgage, paying off mortgage debt on the death of a person who was helping to pay the cost of the mortgage. Again, that's a fairly obvious temporary need. Yeah, if we frame it as insurance needs, term life insurance is typically going to be the most efficient solution.
Cameron Passmore: It's also very simple. Very clear what you're buying, how much you pay. No bells and whistles. It's just stripped-down basic needs.
Ben Felix: Yeah. We'll get into the bells and whistles that you can have in different types of insurance. The two main types, and the main one that we want to talk about is permanent insurance. The two main types of life insurance are term insurance and permanent insurance. Term is the one I just talked about, where you have a fixed premium amount for a set period of time. Then at the end of that period, the premiums go up. Permanent insurance has typically, level premiums for life, or you can pay for a fixed number of years, and then the policy can be paid up forever.
That's called a limited pay policy. A limited pay policy, you might pay much higher premiums for 20 years, but at the end of 20 years, your policy is paid up and you're guaranteed to be insured for the rest of your life. Then the other approach is paying for life. You'll pay premiums typically till the age of 100. Then in most cases, the premiums are on the house. If you live to be a 110, the last 10 years, you don't have to pay premium. That's nice.
With permanent insurance, like you mentioned the bells and whistles, Cameron, you can buy term to 100 insurance, which we'll talk more about in a second, which is like a term policy with level premiums to age 100. It's permanent insurance, but it's like a term policy. It's a pure insurance contract. In a lot of cases, and especially when we're talking about what type of insurance gets sold, and we'll talk more about that later, too. There are other types of permanent insurance that have a cash surrender value built into the policy. It's like an account that exists in the policy. It gives you a payout, if you decide to cancel the policy. You can also borrow against the cash surrender value, either from the insurance company, or you can use it as collateral and borrow from a third party.
Cash surrender values tend to be pretty low in the early years of a policy, but that also depends on the type of policy. Some policies and I am going to go into detail about the different types of permanent insurance, but some types of premium insurance have intentionally very high premiums. Part of that intention is to build up an early large cash value, so that you can do things like, borrow against the policy.
Okay. Back to term to 100 insurance, this is, like we said, plain vanilla permanent insurance. You pay your premiums, there is no cash value, you're guaranteed to maintain the same level of premiums for life. It's the closest thing to a pure permanent insurance product. I mean, it is. That's what it is. You pay premiums for nothing, but lifelong insurance coverage. No cash surrender value. Because of that, the premiums are going to be lower, because the insurance company is taking less risk with a term to 100 policy.
If you cancel partway through your term to 100, the insurance company gets to keep all the premiums that you've paid, and they don't have to pay out the death benefit. Whereas, in other types of policies where there is a cash surrender value, the insurance company does not get to keep all your premiums, because they have to give you your cash surrender value back if you cancel. Stripping out that bell or whistle makes the T100 premium cheaper than some of the alternatives that we'll talk about in a second.
Because it's that bare bones plain vanilla situation for the T100, it acts as a nice benchmark comparison, I don't know, to see if you were to do some other type of policy, how much are you paying for those additional features? If you want to have a cash surrender value policy instead of a T100, how much are you paying for that benefit to get the cash surrender value? Likewise, for more exotic policies, which we'll talk about how much are you paying to access that. Okay, so that's T100. That is the most basic permanent insurance.
The next one we'll talk about is universal life insurance. This is permanent insurance that allows the policyholder to choose an investment option within the policy. I means, it's a pretty neat product. It's cool what you can do with it. I wouldn't buy it, probably, personally, but it is neat.
Cameron Passmore: It was wildly popular. I remember back in the late 90s, early 2000s.
Ben Felix: I'd love to hear your commentary as we go through this, because you've been in this world for –
Cameron Passmore: I remember seeing these policies back before. You were telling us use interest rates like 10%, or 11%, for expected returns inside the investment account inside ULs. That's before, I guess, the industry ended up putting in caps on what expected returns you could use. I can remember those illustrations, just had wild growth projections.
Ben Felix: Yeah. With the UL policies, the underlying policy can be all sorts of different things. Well, not all sorts. It can be a few different things. The underlying policy in a UL could be like a term to 100, where there's no cash value. If you pay the minimum premiums on the UL, you basically get a term to 100. It could be a guaranteed whole life policy, or the same thing. You pay the minimum premiums, you basically get a guaranteed whole life policy, where there's a guaranteed cash value. It could also be a yearly renewable term, which is the one I think you were probably referring to just now, because I saw this, when I came into the insurance industry, whenever, 10 years ago, I was seeing the tail end of what you just talked about. Because what happened was there are these yearly renewable term policies, which means that it's sold as a permanent policy, but the premium increases each year.
Now, if you're adding more than the minimum premium to the account, and that's – I'll talk more about how that works in a second. It's compounding at 12%, even with the annual increase in cost of insurance, that policy will be projected to stay in force forever. The problem, of course, is that returns aren't 10% to 12%, especially after the fees that you're paying inside the UL policy. What happened was a lot of people got screwed, basically, where they thought they had been sold a permanent insurance policy. 25 years in or whatever, they realized that the cost of insurance has far exceeded any cash value that’s built up in the policy, because they'd earned 2% or something, instead of 12%.
Cameron Passmore: Exactly.
Ben Felix: That was a big mess in the insurance industry. Anyway, so I mentioned that you can have investments inside the UL policy. You pay your minimum premiums to fund the policy. Then there's a maximum amount that you can over-fund, that you can contribute to the policy to be invested as you see fit. You end up with a guaranteed death benefit, plus some investment component inside the policy. There are investment options that you can pick from the insurance company. They range from basically, cash to GIC-like investments, guaranteed interest options. You can also invest in risky assets, like stocks and bonds. In the case of the yearly renewable term example that we just talked about, I think that's probably what's going on, where people are saying, well, invest in this stock fund, and we expect to 12% a year. Then of course, that didn't happen so it blew up. You can invest in stock and buy mutual funds.
I went and looked through some of the investment options available from insurance companies that offer UL and offer variable investment options, or variable interest options, I think is what they call them. Typically, the fees are well above 2%. I remember, Glenn Cooke a long time ago when he was on our podcast, he mentioned that some insurance companies are offering access to index funds, but the fees are still very high, relative to buying an ETF.
Now, one of the things that I found interesting in looking at this insurance stuff, a little bit later we'll talk about the after-tax returns of stocks, bonds, and insurance. In running those numbers, I have the difference between the pre-tax and post-tax return for stocks, which is about 2% at the highest tax rate in Ontario in 2022. Now, what's interesting is that if that's the difference between pre and after tax returns in a taxable account, and you're paying about 2% in fees to own investments, which are not taxable, at least not as part of the death benefit, inside of a UL policy, you're giving up any tax benefit to fees.
Now, the other thing that I think is problematic there is that if you realize much lower returns in stocks than what I was projecting in my example, your taxable portion will be much lower. Whereas, you're going to pay the 2% fee, regardless of how markets perform over your investment horizon. The tax gives you a bit of a downside hedge, whereas fees in a UL policy don't.
I mean, maybe it's important to mention that a lot of these insurance products are sold as investments, or tax shelters for high-net worth investors. Once you've maxed out your registered accounts, maybe you should be looking at these more exotic insurance products, which can shelter some of your income. Okay, so that's UL. Non-participating whole life, or guaranteed whole life is like, to go back to the T100 example. It's like that, or it can be. You can pay for life for a 100 years, or you can do the paid up policies, like the 20 pay that I mentioned earlier, where you pay the premiums for 20 years, and it's paid up. Pay much higher premiums for 20 years, and it's paid up.
In the case of whole life, the difference between that and term to 100 is that with whole life, you do have the cash value that I mentioned earlier. The cash value grows over time, at a guaranteed rate, you pay higher premiums, as I mentioned earlier, to get access to that cash value. I looked at just one example of a million-dollar whole life policy, I found for a 40-year-old, healthy woman, you would pay $8,240 per year for the whole life policy. Well, at T100 for the same amount, would be $7,270 per year. It's a 1,000 bucks per year additional that you're paying, the same debt death benefit. It's otherwise the same policy, but the difference is you have a cash value, which again, if you cancel the policy, you can access. Although, there could be tax implications, or you can borrow against the cash value.
Whether that's valuable or not is a interesting question. It is interesting, though, to look at the data on how frequently permanent policies are cancelled. I don't have data for Canada on this, but I did find a study that use US data. 2019 studies, so fairly recent. They gave policy lapse rates for whole life policies sorted by size. I took for this example, the largest policy size. For whole life policies with death benefits $500,000 or higher, based on the annual lapse rates in their studies, only about 31% of policies remain in force after 30 years.
Cameron Passmore: That's incredible.
Ben Felix: Yeah. It is neat statistic.
Cameron Passmore: Wow.
Ben Felix: Maybe they shouldn't be buying in the permanent life insurance, because there clearly wasn't a permanent need in those cases. If you are going to buy permanent insurance, knowing that you might cancel it, maybe the cash value is worth it. I guess, we'd have to run the numbers on that. Because there's an opportunity cost in the premiums, too, which is interesting.
Cameron Passmore: Yeah, exactly. We need to know what people got out of it in terms of the cash value, because there was a permanent protection that you had all the way along, but what did those cash values grow, too? That would be neat to know. I would have guessed, that number would have been significantly higher than that. Interesting.
Ben Felix: Higher, remaining enforced?
Cameron Passmore: Yeah. I guess, maybe that then leads to the premiums being lower, since there's such a large cancel rate.
Ben Felix: Yup. Yeah, it's very possible.
Cameron Passmore: Interesting question.
Ben Felix: Yeah. That's non-participating whole life insurance. The next one is the one that I think, again, in terms of what gets sold to investors, what gets sold to high-net worth people by the insurance industry, it tends to be this one. I'll spend a lot of time on this one, because it's the most involved intricate product of the ones that we've covered, above any type of permanent life insurance to start. It's guaranteed whole life, as a building block. Step one. It's a guaranteed whole life policy.
The difference is that participating policyholders participate, which is why it's called that, in the performance of the block of participating policies. I'll explain what that means, and it's a lot to wrap your head around, but we'll hopefully get there. The way that you participate in the performance of the block of participating policies is through these things called policy dividends. It’s like how a stock pays a dividend. People who own participating life insurance policies can also receive dividends. Those dividends can be used for different things. They can be used to purchase additional units of paid-up insurance. They can be taken as cash. There can be different tax implications depending on what's done with them. If they use to buy paid-up additions, like to buy additional small insurance policies that are guaranteed paid-up going forward. that is not taxable. When people are looking at how do you make these policies compound and grow, that's typically what the suggestion would be.
Now, the thing with the participating policies is that they're way more expensive. You're participating in the block of insurance business, but you're really paying a high premium in order to do that. It's like, to get access to those, the potential for policy dividends, because they're not guaranteed. I don't know. We'll talk more about that in a second. You are paying a premium. It’s like, it really is an investment on that portion. You're paying some premiums to have a guaranteed whole life policy, and then you're paying, I'll talk about it later, but you're paying about double the premium, holding the life insurance amount constant to get access to the participating dividends.
Cameron Passmore: To be clear, these are not dividends, like stock dividends. They may have the same name, but it's not the same thing as getting a dividend from the insurance company. This is a dividend from the block of participating policies.
Ben Felix: Yeah. It's confusing. It's even more confusing because of how it's often marketed. It's explained out there. If you really go and dig through the detailed documents that insurance companies produce, this is all explained. It took me many years, including working in insurance before I understood how participating policy dividends work. The way that it works is the insurance company prices their product based on assumptions about the future. That should be fairly obvious. If the actual experience of the block of participating policies ends up being better than expected when the insurance companies set their prices, policy dividends are paid out to participating policyholders.
Now, what are the performance expectations based on? What are the effectively policy premiums based on? It’s things like expected mortality. So how many people in the pool do we expect to die and when. Expenses for running the block of policies. Policy lapses, so if somebody cancels their policy. Policy loans. If people borrow against their cash value, like I mentioned earlier, from the insurance company, not from a third party, the insurance company collects interest on that loan, and it's typically at a fairly high rate of interest. That's a whole other interesting thing.
When you borrow against your policy, it's usually contractual that the insurance company will lend you the money. Great, you have access to cash. But because of that, because they're guaranteeing access to capital for you, they're taking more risks, so they're charging typically a higher rate on the policy loan, than if you went to a third party. There's also situations where policy loans from the insurance company can be taxable, but we won't get into that.
Another thing that goes in there is claims experience, how many people claimed versus what was expected. Taxes on the side of the insurance company. Then the big one, and this one's super interesting is the investment performance of the participating account. The reason I say it's interesting is because when you look at marketing materials for participating whole life policies, you always get shown the participating account. It's always highlighted how it's an institutional mandate and they've got hard asset real estate, and they've got this manager and that manager, and they show you the historical performance of the participating fund. I'll reiterate in a moment why that's not super useful.
The premiums from the participating block in excess of claims and expenses get added to the participating account and invested. In that big, fancy institutional fund that I just talked about, all of the excess premiums go in there and get invested. Keep in mind that the insurance company has an assumption about what that account is going to return, and they built that into the price of the policies when they sold them. There's an expectation question in there, which again, is if the participating account does worse than expected, then you're not going to have as high of policy dividends. If it's much better than expected, then you do get some policy, dividends.
It's pretty interesting, because if the participating block does better than expected, it's an indication that you overpaid for your insurance. Then the dividend is like a refund of the excess premium that you paid. Then likewise, it can go in the other direction, too. Again, I want to make sure it's clear that how the participating account performs is not directly relevant to the policyholders. It's how the participant account performs relative to the expectations used and priced in the policies. That's very different from, did the participating account perform well, relative to a benchmark, or relative to some absolute return figure or whatever, irrelevant? The only thing that matters is how it performed relative to the figures that were used in setting prices for the bloc of participating policies.
Cameron Passmore: There's more to the story than the performance of the pool of investments.
Ben Felix: Well, we tried a few years ago, quite a while ago, to do proper due diligence on permanent insurance, because the rules were changing, and there was a limited amount of time where you could access policies at the old rules, right? We did a bunch of due diligence like, should we be rushing in to recommend permanent policies to our clients before the rules change? It’s like, the amount of tax-exempt room you could have for investments, I think, and the policy decreased after the rules changed.
We did a lot of work trying to figure out, should we be recommending this before the rules changed? We came away from it, basically, with what you just said, Cameron, that realizing that these things are very opaque. It doesn't mean that they're not right for certain circumstances, and we will talk about that, but they're very opaque. How do you assign an expected return to these products? You really can't.
Rightfully, the insurance companies keep a lot of the information proprietary. They'll share certain things with you. They're open as open as they can be, but part of their competitive advantage relative to other insurance companies is their proprietary information. It makes sense that they wouldn't share that. As an investor, that's also scary. Okay, so you mentioned the opacity in policy dividends. One reason for that is that the policy dividends are smoothed. A good year in the participating account, or a good year in terms of claims, or whatever, will not necessarily translate to a good year in policy dividends, because the insurance company knows that they might have a bad year in the future, so they smooth out their dividends over time, which makes sense.
I mean, I think regular corporations do that with their dividend policies, too. They're not going to send all their profits out as dividends, just because they had a good year. That's fine, but it also, again, makes it difficult to know exactly what's going on. The other thing that's really tricky though, is that in addition to the general opacity of what is going to be distributed and what should you expect, the insurance company has discretion over how dividends will be distributed among policyholders. Even if we knew how much to expect in policy dividends, different classes of policyholders can receive different treatment in terms of dividend distributions in proportion to the amount that the class is considered to have contributed to the participating account earnings.
If you're grouped in with a cohort of people who contributed negatively to the profitability of the participating bloc, you won't receive the dividends scales. If they say they're going to pay 7% policy dividends, you and your part of a cohort within the participating trading bloc that detracted from overall performance, you might not receive the full dividend. How much more opaque can it get? Not much. I do want to make sure that's clear. I think it is, because I've reiterated a few times.
One of the things you'll see in sales material for participating insurance is the dividend scale, the historical – one of the participating policies received in aggregate as policy dividends, that will be compared to GICs, or to other investments. It's not a fair comparison. Because you're overpaying for the premium in the first place, the fact that you're getting the dividend, a part of that is really going to recoup some of the costs of the insurance overpayment. We'll talk more about that. I have some data on pricing for participating versus non-participating whole life, and where the break evens are and stuff like that.
Yeah, so you could and we'll talk about this in a second. You could be in a situation where you do have positive policy dividends throughout the life of a participating policy, but you end up in the same boat as if you had just bought a cheaper, guaranteed a whole life policy. It is what it is. I mean, participating whole life can perform well. This is another thing that's tricky. You cannot get that data, which is fine. We have some clients that have participating policies that they bought before we became clients. In those cases, we get a glimpse into what the participating dividends look like. In aggregate, you can't go and collect that data. There are all these individual insurance contracts.
You can find what the dividends scale is for all contracts, but you can't know what historical pricing for those policies was. It's very messy to try and understand exactly what's going on here. The participating policies are sold as the Cadillac insurance policy, because of its attractive investment attributes. They'll show you the participating account with its institutional mandate, and all that stuff. I think, it's super important understand that the participating dividends are paid proportional to the difference between the insurance company's assumptions when they price the permanent policies and the actual experience of the participating block over time.
At no point are you investing in the underlying assets. You're really investing in the actuarial assumptions, which is cool. Maybe that's a good asset class. Maybe actuarial assumptions are a good asset class. I don't know. Again, we don't have the data to know. Whenever you buy an insurance policy, all insurance companies have illustration software. There's a special software that has all of the insurance companies assumptions built into it, and you can run quotes for a policy. I can go and put your age, Cameron, and my age, or whatever, in the policy amount, and it'll spit out the premium and it'll spit out detailed data on cash values over time and stuff like that.
For participating whole life, typically, the software will have current dividends scale as the baseline, or the starting assumption. That's taking the current dividend scale. I guess, it's the most recent amount that was paid to participating policyholders. It'll project that out in the future. Now, it's not guaranteed. I don't think insurance companies tried to hide this by any means. It's not a risk-free investment. In recent history and this is, again, this is not the fault of insurance companies, but in recent history, the dividends scale, interest rate for most participating accounts has been falling. It's been it's been a rough period of time for institutions, like insurance companies that are managing these long-term liabilities. They're trying to hedge them with fixed income. Maybe you can't always duration match your assets with your liabilities. Falling rates in that case could have been a little bit uncomfortable.
Cameron Passmore: Falling, but still positive.
Ben Felix: Interest rates, or dividend rates.
Cameron Passmore: Yeah. Those rates have been falling, but they're still positive dividend rates.
Ben Felix: The dividend rates are still positive. Yes. Yeah, they're still – well, I have the data here. The average for the five years ending 2021, it was still 5.75%. If you look at the asset allocation, because these are all part of their annual reporting, if you look at the asset allocation in the participating accounts, they are heavily in fixed income. Where it can be a challenge, and again, we've seen this in the handful of participating accounts that we – or participating policies that we do have, or some of our clients have is that if you took an insurance policy that was illustrated in 2010, at the dividend scale at that time of 7.36%, and you just project forward that you're going to continue earning that same dividend scale. It's not as egregious as the 10% to 12% yearly renewable term example that we talked about earlier. If you purchase a policy based on the current dividend scale at that time, and since then, you've had an average of 6.23% in dividends, that's more than 1% lower than the projected amount.
Again, the software from insurance companies, it spits out the current dividend scale, but it also spits out a reduced example of current dividends scale minus 1%. It’s there. Again, they're not trying to hide this information. That is a potential risk. I mean, the other thing that's tricky is, we mentioned the opacity earlier. Even though we know what the aggregate dividend rate has been over the time period that I mentioned, it's dropped – say, it's dropped roughly a percent, or a little a little bit more, within the block of participating policies, some cohorts may have gotten less than that. Some cohorts may have gotten more. It's again, really tricky to evaluate how has this thing done for any individual?
Whenever I look at participating policies, I would always suggest, I do and I would always suggest at least looking at the current dividend scale minus 1% on an illustration. I think, it's useful to even look at the current dividend scale minus 2%. I mean, well, look at the data that we just talked about. The last five years, 5.75% dividend scale, the current scale in 2010 was 7.36%. It's not quite 2%. It's like doing I mean, like doing Monte Carlo and financial planning. What happens on the downside? What does it look like on the downside?
I mentioned with participating policies, they're expensive per dollar of insurance coverage. You have to view that as an investment in the potential for the policy to grow tax-free, at least on the death benefit. I ran an illustration holding premiums constant for a minimum funded universal life policy with no cash values from a major insurance company. It delivers roughly twice. Holding premium is constant. Roughly twice the death benefit of an otherwise, comparable participating whole life policy from the same company. That's the guaranteed values on day one.
Now, with the UL policy, min funded, you're going to get that. That's what your death benefit will be, as long as your policy remains in force. Whereas, with the participating policy, you could do better. I did find under the standard dividend assumption, the current dividend scale that I just mentioned, the participating policy would have a total death benefit of about 35% higher than the universal life policy by age 90.
If we push that longer, the participating policy looks increasingly good, which is an interesting feature of participating insurance not shared by guaranteed insurance, and we'll talk more about that in a bit. The challenge, though, is that at current dividend scale minus 1%, which I don't think is terribly conservative, the death benefit at age 90 is about the same as the premium matched universal life insurance policy.
If you get current dividend scale, and you get that for the rest of life of the policy, you do better. If you get current dividend scale minus 1%, you would have been just as well off buying the guaranteed policy. Of course, if it was less than minus 1%, you'd be worse off. You took a risk that didn't pay off. If you get more than current dividend scale, well, hey, that could be a very nice tax-free asset on death.
One of the questions we'll talk about later is why? Why take this risk? Why take the actuarial assumption risk? Of all of the different risk premiums we could pursue, why that one? I don't know. Okay, so I mentioned earlier, I looked at the post-tax returns with permanent insurance on death. Not cash values, not borrowing against cash values, but what does the death benefit look like over different horizons? I think, this is important, because, well, it’s like what I was just saying. The permanent insurance is often sold as this tax shelter, where you're going to maximize your post-tax returns. Look how much tax you would pay owning traditional investments. Look how little tax you'll pay with this policy, which is I mean, it's valid, as we'll see in a second. It is valid in certain cases.
Death benefits aren't typically taxable. There are some cases inside of a corporation where part of the death benefit can be taxable. We won't talk too much about corporations. We have run these numbers for both individuals and corporations. It's actually not a whole lot different, which may be surprising to some people. Because this is like, for high-net worth people, this is sold pretty hard for people with corporations, high-net worth people of corporations, it's sold even harder.
Now, one of the things we'll see in a second in the data is that there's an inverse relationship between how long you live and the return you realize on your guaranteed life insurance. That's another thing I'll say is that all of these following comparisons are for guaranteed life insurance, for guaranteed whole life in term to 100. The participating piece, you're going to get something better or worse. You're adding an additional unknown on there. We're just looking at guaranteed policies for these numbers.
Based on what I just said, buying permanent life insurance is like selling an annuity. I mean, it's a lot like selling an annuity, really. The longer you live, the worse it is. Whereas with an annuity, the longer you live, the better it is. I looked at 40, 50 and 60-year periods. I looked at stocks, bonds, whole life, term to 100. For each of the insurance policies, I looked for a male and a female, because the premiums are different, all else equal. For the stocks and bonds, there is a slight relationship between time horizon. After tax returns, just because you're deferring part of the capital gain for a longer period of time, particularly with stocks, less so with bonds. This is just using our PWL financial planning assumptions.
Okay, so I won't go through the whole table, but we can put the table in the video. Stocks, 40, 50 and 60 years, you're looking at a little over 5%. 5.09% at 40 years. 5.18% at 60 years. This is the compound after-tax return. Bonds, you're at about 2.15%. Whole life for a female at 40 years, keep in mind, this is – I didn't say that. This is for a healthy 40-year-old. The premium is based on a healthy 40-year-old. You're buying this when you're 40 and healthy. If a female does that and dies in 40 years from the date of purchase, their compound return after tax is 4.83%, which is pretty great. That's dying at 80. That's an earlier than expected death. Keep in mind, that still underperforms the expected outcome of stocks. Stocks are going to have dispersion. Insurance won't.
Cameron Passmore: These are nominal returns?
Ben Felix: This is all nominal. Yeah, that's a good point. Yeah, I mean, that's one of the things about insurance is that it is a nominal asset. It's a duration matched to your life expectancy, or to your actual time of death. You will get the face amount of the insurance at your time of death. You can't do the same duration matching with a bond, because your time of death is an unknown. The insurance companies managing the unknown maturity of that liability. Even if you have the cash available, you can't perfectly do that duration matching.
At 40 years for a whole life, for a female, 4.83%. At 60 years, 2.12%. The female buying the whole life policy at age 40, living to a 100, she would have actually been better off in nominal bonds, at least based on our expected return figures. For male, it's quite a bit lower. At the 40-year horizon, 4.18%, as opposed tax return. At 60 years, 1.66%. You're actually worse off in that case.
In both cases for the T100, the compound returns are higher across the board. Although, even for a male at the 60-year horizon, you're still better after tax with bonds than with insurance. Again, could we have modelled participating whole life in this comparison? Yes, but there's going to be lots of uncertainty about what you're actually going to get. This is baseline what you get with insurance. Participating is going to be plus or minus, depending on how you end up doing in terms of your dividends over the horizon.
At the long horizon, the 60-year horizon, insurance does not look so good. We can generalize though and say that relative to bonds on an after-tax basis, for a high income earner, this is all based on the highest tax rate on Ontario in 2022, insurance looks pretty good relative to bonds at any horizon. It looks pretty bad relative to stocks at any horizon. Again, those are expected stock returns. I guess, similar to participating whole life, maybe we don't actually know what we're going to get. Whereas, the insurance payout is a contract with the insurance company. As long as they remain solvent, you're going to get that nominal payment. Who knows what it will be in real terms, but you're going to get that nominal payment. I will touch on this relative safety of assets in real terms in a second.
Okay, so I mentioned earlier that permanent insurance delivers a nominal death benefit that's duration matched to your unknown time of death. That's cool. I mean, it's the unique thing. When do you actually need that? We started talking about cases where there's a pretty objective need for insurance. When do you need permanent insurance? I think, it's a bit of a stretch to say, it's a need in any case. I think, it's always a want. Individuals rarely have liabilities that absolutely have to be covered in a set period of time with legal implications. Insurance companies have that.
Individuals, especially if they have other assets, it's pretty rare that you would find yourself in a situation where you absolutely are required to have a permanent insurance policy. There could be things like, maybe in a separation agreement, or in divorce or something. Maybe there are cases where that does exist, but it's pretty niche where I think this would actually be a need. Common cases of wants are pretty good arguments to use permanent insurance is an illiquid asset. I mentioned, you might have other liquid assets to cover liabilities. If you have an illiquid asset, and maybe you're worried about there being enough liquidity to cover a tax bill, so this could be a family business, it could be a family cottage. You can buy insurance to cover a tax liability on death. That's a liability that happens when you die.
Ideally, it's a case where there's been some estate planning done, and the future tax liability becomes known. If you do an estate freeze, you can lock in a future tax liability. Otherwise, you're trying a liability match an unknown liability, which of course, is tricky. That can be one of the cases where permanent insurance is interesting. If there's an estate freeze done, there's no one future tax liability on death. If we don't have to worry about that liability, matching that with permit insurance, sure. I think that's interesting.
Life insurance does allow the death benefit to pass directly to named beneficiaries. It bypasses probate in Ontario. There's immediate liquidity at death. I understand that insurance, beneficiaries are more difficult to contest, but it will. Maybe some interesting planning properties come from that as well. I mentioned earlier the nominal nature of the insurance death benefit. If you look at 30-year horizons, and this is co-authored by an upcoming guest for episode 224, 30-year horizons, a sample of 38 developed markets with data from 1890 to 2019, foreign stocks have had a 4% probability of real loss over 30-year periods. Domestic stocks, 13%. Bonds, significantly higher. Nominal bonds were 26%. That's nominal long-term government bonds.
Insurance is giving us this nominal death benefit, which I think in real terms, you're probably pretty sure you're going to lose at a normal life expectancy on that asset. In that unique case, where there is some fixed nominal liability, it can be interesting to make that go away. Relative to riskier assets, like stocks, not super interesting for a long-term investor. The last thing I want to say on this is the – we've mentioned, or alluded to a couple of times that you can borrow from the insurance company against the cash value. You can also pledge the policy as collateral and borrow from a third party, like a lending institution.
I'm not crazy about those as planning concept. I think, it's ideal to plan for the death benefit, if you're going to be buying. The death benefit being the main benefit if you're going to be buying permanent insurance. There are even arrangements where you can pay into a participating policy that has an immediate cash value, and you can borrow against that right away, and you can use that to invest. It maybe it reduces your opportunity cost of capital. I think, you can borrow against other assets, too. I don't know if it's a reason to buy permanent insurance. Yeah, so I don't know.
Cameron Passmore: I'm not sure we've ever seen that done before in our experience.
Ben Felix: Someone borrowing against life insurance policy while they're alive?
Cameron Passmore: Against the cash surrender value. Cash value.
Ben Felix: We don't have a ton of permanent policies in our client base, but you're right, we haven't –
Cameron Passmore: We don't have real experience to suggest that our experience of doing it.
Ben Felix: Yeah. That's it, I guess. I think, it's an important topic, because it gets sold. I kept it out of these notes, but I have other notes on – There's a couple of papers on conflict of interest in financial product sales. One of them is focused on Canadian mutual funds. One of them is focused on insurance, specifically, I think, actually in the Indian insurance market. Basically, there's clear evidence that there are conflicts of interest and sales. I haven't mentioned that part yet. Hold on, this is important. Why? I don't want to give the impression that I'm speaking ill of people who sell life insurance. I mean, I'm still licensed to sell life insurance, although I haven't done that in many years.
The commissions on insurance policies are enormous. We talked about, when I give the example of a 40-year-old buying a policy for $8,240 per year, the commission on that policy would be at least the first-year premium. It depends on the agent. It depends on the agency that they're with. It depends on a whole bunch of different things. It's like, somewhere between 50 and a 150 years, or maybe even in some cases, 200%, of the first year premium will be paid to the person who sold it as a commission. It's big money.
Cameron Passmore: That's not transparent either.
Ben Felix: Yeah. When I was actually selling life insurance, I was trained to make sure that it's being disclosed. It was like, it was a newish thing that they were training people to do. It's a best practice, of course. How do you explain to a client that you're going to earn a $500,000 premium from selling them a life insurance policy? I guess, you just tell them. I don't know. I've never been in that position before.
This is just a quick post-recording addendum. I listened to the episode and felt it needed a wrap up. We kind of left it hanging without a conclusion. In summary, most life insurance needs can be met by term insurance. Permanent insurance is interesting as a planning tool in specific circumstances. Ideally, we're looking at a taxable investor who plans on the death benefit being the value of the asset. As a living asset, permanent insurance is less compelling, cash value permanent insurance is less compelling, term to 100, it's not a living asset at all. So cash value life insurance is less compelling as a living asset for a long-term investor because many of its unique properties are diminished when it's used as a living asset. And then the other thing that we mention that's important from that perspective is that the US data that we talked about suggests that the majority of permanent policies do not remain in force after 30 years. So they're effectively used as living assets.
People take the cash value, but again, you give up many of the unique permanent insurance benefits by using the cash value while you're alive. And I know there are planning opportunities where you can borrow against the cash value and other things like that. I still don't find those to be compelling. So to generalize, when does permanent insurance make sense? I think the following criteria have to be met. We have to have an investor with max or registered accounts, we have to have an investor with more assets than they will need to consume during their life, so they have to have a fully funded financial plan, and we're allocating the access to permanent insurance. Ideally, they have a second generation or a charitable cause that they want to leave a legacy to because again, the death benefit is the main planning benefit here. They should probably be conservative investors because insurance death benefits do look pretty good against bonds after tax, as we saw during the discussion, but less so against stocks, even after taxes are considered.
Guarantee the whole life and term to 100 are relatively low-cost ways to lock in a death benefit, which also gives them the highest death benefit returns, assuming the policy remains in force until death. Universal life insurance offers the ability to invest in stock or bond funds inside of the policy, but the tax benefits of investing inside of an insurance policy are likely absorbed by the fees of the policy. So it's not really like an extra TFSA because one, you're paying the cost of insurance. And two, the fees on the investments inside of the UL policy for the excess contributions that you can make are going to absorb most of the tax benefits. Participating whole life does offer an investment component based on performance of the participating block of insurance, which is kind of cool. I mean, it really is an interesting product. That may or may not pay off relative to just purchasing a lower cost guarantee policy.
So when we're analyzing participating whole life, I think the policy's got to be illustrated using current dividend scale minus 1%. And we talked through an example with that during the episode. Holding premiums constant, participating whole life will start with a lower death benefit than a guarantee policy, an otherwise comparable guarantee policy. But you may end up with a higher death benefit depending on dividends with the participating policy. So again, there is this investment component to participating whole life insurance, but it introduces the risk of overpaying for insurance if you don't get high enough dividends, with the possibility of maybe getting a great after tax return if you get good policy dividends over the life of the policy. So it really is introducing a risk, where instead of just getting this guaranteed nominal death benefit, we're either going to overpay for the insurance or we're going to get a nice return from the participating dividends.
But that's an unknown. Whether it makes sense to take risk in an insurance policy rather than buying guaranteed whole life and investing the significant difference in premium in stocks, I think is really a question of preferences maybe. I would tend to prefer the positive expected return even after taxes of stocks, as opposed to the actuarial assumption risk. That's really what you're getting with the participating policy. But it doesn't mean it never makes sense, I think the situation has to meet the very specific criteria that I just talked to for permanent insurance to make sense. And then there's the additional, do you want to take risk with your insurance policy with the participating whole life insurance?
Cameron Passmore: Awesome. That's a great recap. Great summary. Very important topic. Last week, you did a presentation of the IAFP Conference that was held – I think, I'm guessing is probably the closest hotel to where you live, which made it super convenient for you to go. It sounds like the talk went very well.
Ben Felix: I think so. It’s the Institute for Advanced Financial Planning, which is a Canadian body of well, advanced financial planners, I guess. I gave a brief talk on portfolio construction and professional responsibility, and basically, just talked about the CAPM and the ICAPM that we've talked about in the podcast in the past, and how people in the position to give financial advice should be using that information when they're analyzing portfolios and making investment recommendations to their clients. Pretty much it.
Cameron Passmore: Did they request this topic, or did you come up with it?
Ben Felix: They requested it. I guess, for FP Canada, which is the governing body for the CFP designation in Canada, they have continuing education requirements for professional responsibility. Those credits are difficult to obtain. We actually built this talk for the purpose of getting approved for that credit, which it was approved for. That's why it's so nerdy, I guess. Pretty nerdy topic.
Cameron Passmore: What’s the punch line and how did they react?
Ben Felix: I thought it was fairly well received. The punchline was just that the CAPM is from 1964. If we're giving people investment advice based on that, while ignoring the last 60 odd years of research, I think we're doing them a disservice. I talked about how that can be used in portfolio analysis, like how do we know what our clients actually own? Well, it turns out, there's a way we can use this information to figure out which risks they're exposed to. Then likewise, we’re giving investment advice to people understanding what their risk exposures are outside of their portfolio, and how should that affect the financial asset portfolio that we recommend to them.
Cameron Passmore: Cool. I think, there's a lot of people there. They were quite excited to meet you.
Ben Felix: Well, yeah. It wasn’t a huge conference, but I met a bunch of people who I knew online and had never met in person. I always sound like the Grinch when you say you're going to conference and stuff, but that was fun.
Cameron Passmore: You actually enjoyed it.
Ben Felix: It was nice. There were some people who were podcast listeners, so meeting them was also pretty cool.
Cameron Passmore: Cool. Last week's episode with Berk and van Binsbergen, you want to touch on that, because there's been a fair amount of discussion around the topic. I think, a lot of people were impressed. We opened up that discussion, that conversation, especially given our history with Professor Fama and Ken French.
Ben Felix: Yeah, we've had. We had Brad Cornell on, who was – he's also written papers that are like, Fama is wrong. I think, it's healthy to get perspectives like that. Make sure we're not missing anything. I did want to say, though, that a lot of people listened to, and it's technical stuff. It's not terribly surprising that it could have been misinterpreted. A lot of people based on the comments that I saw in the community seem to think that they were saying that we can pick active managers and that active managers beat the market. That's not what they're saying.
They're not saying that we should be doing research on active managers. Jonathan did say that if you're really interested in it, you can do that, but you could say the same thing about individual stocks, or whatever. He said, he himself buys index funds. All they're saying. I'll try and summarize what my understanding of their punch line is.
There are skilled managers measured by their measure, which is value added, which is gross alpha times the size of the fund. They find that there are skilled managers by that measure. Even though that's true, rational fund investors will allocate their dollars to skilled managers, to the point where all the benefits of the manager’s skill go to the manager. All the rents, all of the benefits of the manager skill go to the manager. The investors in the fund simply receive the risk premiums for whatever the risk exposure to the portfolio as. One of the other insights that I think is interesting is that a positive net alpha does not tell us about manager skill. It tells us that fund investors are under allocating to that manager.
They gave the example in the episode of mutual fund manager with foreign sounding names, that they had positive net alphas, but that doesn't tell us that they're skilled. It tells us that investors are under-allocating to managers with foreign sounding names. It's a neat way of looking at it. Their actual empirical results are actually pretty similar to Fama and French’s 2010 paper on luck and skill in mutual fund performance. Fama and French did find in that paper, evidence of managers with higher gross alphas than would be predicted by luck. David in their sample find an aggregate negative alpha for active managers.
Part of Berk and van Binsgergen’s whole thing is that a new equilibrium according to them, we should expect a net alpha of zero, not a negative net alpha. One of the ways they address that in their paper is that they use live Vanguard funds, instead of using the Fama French factors, which they say are on investable. With that setup, they find a net alpha of zero, rather than the negative net alpha. That means that, what do we learn from that? I don't know. Active managers can beat, or match the returns of Vanguard funds, I guess.
They also run. In their paper, they did also run the Fama French Carhart regressions. Doing that, they did find negative alphas. Again, their whole thing is that those factors are not investable. You can't go and buy the factor portfolios, even Dimensional and Avantis are not perfect representations of those factor portfolios. That's why they tried to build an investable benchmark to measure manager skill.
They reject multifactor asset pricing, which is I mean, that's a big one. They have empirical work suggesting that CAPM is what investors use to price assets and therefore, we can't be confident that the multifactor story for asset pricing is right. Now, this is a big point, from our perspective as people pursuing factor premiums, because if what they're saying is true, if tilting toward factors is active management, in the sense that they're modeling active management, we should expect all of the benefits of those tilts to accrue two Dimensional, or Avantis, or whoever the quantitative manager may be. We just get market beta, if that is what risk is. I think that's a big jump.
They've got a paper showing this. I found another paper that falsified their finding. It's not like it's a widely accepted fact that CAPM is how investors price assets. Of course, we also know that CAPM has lots of empirical problems. If we go back to multifactor asset pricing, then even if Dimensional is not delivering an alpha, they're just delivering asset allocation, exposure to priced risks, then the Berk and van Binsbergen and Berk and Greene stuff don't matter a whole ton to us, because we're buying asset allocation. We're not buying alpha.
Then the other point that I think is interesting to consider is that value can be added by fund managers through channels, other than security selection and market timing. If a fund manager is doing security lending, and generating revenue for the fund. Is that something that we expect all of the rents to go to the manager? That's that much less obvious than skill. Likewise, for liquidity provision. Dimensional basically sets a bunch of limit orders and lets trades to come to them. Is that something that we expect to accrue to them? Again, less obvious than skill, manager skill.
Likewise, for corporate actions, being thoughtful about corporate actions, that's a way that fund to companies can add value. Again, is that the type of skill that should collect rents that go directly to the manager? Less obvious. I think, asset allocation is the best one, though. Is asset allocation active management? Is it alpha, or is it a risk premium? Fundamental question. No clear answer, but we would hope that we're collecting risk premiums.
John Cochran did write about this in 2013, that I found after we recorded the episode. There was an interesting paper. He was commenting on just the finance industry as a whole and the size of the finance industry and stuff like that. His comment on the Berk and van Binsbergen and Fama French debate, because they went back and forth with each other in a few papers. Cochran said, basically, that he thinks that's the right debate to be having. He said, after 40 years, the research had done is finally about how to fit the facts into a supply and demand framework. Basically saying, it's easy to say that fund investors are dumb, or active managers are unskilled and not useful, but that doesn't answer the question of why we see this persistently large active management industry.
Cochran is saying that the Berk and van Binsbergen stuff might actually help us explain that. He didn't comment on who he's sides with, and maybe he doesn't side with anyone. It's interesting to know, that's what John thinks that this is a healthy debate to be having. That's why we wanted to have Jules and Jonathan on the podcast.
Cameron Passmore: It's really fun to think about this. It really shakes up your thinking and gets you to ask different questions and look at the world in a different way, which is the whole point.
Ben Felix: As a model, I think it's cool. Mutual funds are like stocks. If there's a skilled fund manager that has net alpha, they are undervalued. Investors are actually pretty smart. They will allocate to that manager. That manager will add value on a gross alpha basis for about 10 years in their sample. That's neat. It's a lot simpler to think about that than to think about the model, where fund investors are irrational, performance-chasing crazy people and mutual fund managers are fools charging high fees, or charlatans charging high fees. The model where everyone's a rational agent is a lot easier to think about.
Cameron Passmore: Great. Good follow up. Okay, a couple of quick news stories. Let's talk about fixed income for a bit. A lot of questions, I think we're getting, surround the recent price declines in fixed income. Our friend and fellow advisor, Ruben Miller, who is the Chief Investment Officer in Partner Perspective Wealth, and also writes the Fortunes and Frictions blog, he had on Twitter last week a neat chart from Dimensional Fund Advisors. It's a simple illustration, demonstrating that rate changes on fixed income, or net positive for long-term investors.
I just thought that chart was very simple, because you and I did think a lot about it this afternoon, though, if they like to dig into what's really going on in this chart. Let's take a chance at trying to explain it to people. If your time horizon is longer than your bond duration, you're okay, if rates rise and prices fall. That's the key here. They give a very simple example. If you add a $100,000 in a bond portfolio that earns 1% for the next five years, and we assume it gets the same 1% for the 15 subsequent years, for a total of 20 years. In 20 years, your terminal value is a $122,000. That assumes no tax. Very simple math. It’s simply 1% growth rate. Okay.
Almost a year ago to the day, five-year US Treasuries were yielding 1%. It's October 8 last year. This is arguably close to reality. Scenario two is a same $100,000. You bought the same 1% five-year US Treasury. However, the day you buy it, interest rates jump to 4% for the five-year duration, and then you get 4% after five years for the subsequent 20 years. Immediately, when that interest rate jumps from one to four, the market value of your bond drops 14% to roughly $86,000.
This is pretty much for five-year US Treasuries are today, right around 4% today. That's the rate rise we've had in the past year. Again, the duration is five. It assumes in scenario one, the last 15 years are 1%. Scenario two, the last 15 years are at 4%. The ending value, the terminal value of scenario two is a $189,000, or 55% more. This shows you that even though your value of your bond dropped, because you're getting a higher yield, and let's assume that same yield carries on, obviously for 15 years after the next five, you will end up with significantly more.
Ben Felix: Yeah. Rising rates are good news. We talked about this a while ago, when we talked about, when we updated our expected return assumptions and all of our clients’ financial plans overnight got far better than they were previously. Remember, we talked about that?
Cameron Passmore: Yeah, for sure. I looked at the Dimensional global fixed income portfolio that we use in a lot of portfolios, the duration right now is 4.21 years. This is at the end of August, 4.21 years. The yield to maturity is just under 5%. Dramatic increase in expected returns on these.
Ben Felix: Yup, which is good news.
Cameron Passmore: Good news.
Ben Felix: Short-term pain, but long-term – should be good news.
Cameron Passmore: I think there's a lot of investors who might see the recent drop in bond values down, say, 10%-12% year to date in many cases. If you're in a longer duration portfolio, even more may cause people to make a shift, even though you'd have higher expected returns going forward. A lot of articles lately, I'm wondering if Vanguard is getting out of the factor business. I’ve seen a bunch this past week. Vanguard is liquidating its US liquidity factor ETF in November. This is the first time in 20 years of offering ETFs that Vanguard has out actually shut one down.
Ben Felix: A US one.
Cameron Passmore: A US one. Yeah. It's a relatively small ETF at 40 billion dollars. Anyways, this one article wondered if interest in factors is waning at Vanguard, since they launched factor funds in 2018. Currently, the factor suite has 3.4 billion of assets and six factor funds, which in Vanguard world is arguably peanuts. You may recall back in episode 173, we had a conversation with their portfolio manager and their head of factor-based strategies, Antonio Picca. Antonio recently resigned from Vanguard. This has caused all kinds of questions in the media to wonder, meaning the nerdy investment advisor, wealth management world to wonder. We'll see how it plays out.
Ben Felix: It's not just there. This was discussed a week ago, or two weeks ago. In the Rational Reminder community, people are on it. I don't even know how they got the information so fast that Antonio had left.
Cameron Passmore: There's a couple of short news stories for you. Let's get to the book review quickly. I just had another great book that I read in this research I've been doing, to working in a post pandemic world. Again, I think this will be a book that not necessarily you'll have to read, Ben, but you’ll appreciate the message, because I know you believe in this very much. We talked about the benefits of deep work, why we need to feel as organizations and how important it is for us to work asynchronously. This week, we dig into the question of how to meet more effectively. The book is called The Art of Gathering. It's written by Priya Parker.
This book came from your sister, Tessa. She recommended to me. Tessa is our lead of culture and people here at PWL. Priya Parker is a facilitator, strategic advisor and an author. She's trained in the field of conflict resolution, and she's worked on peace processes in the Arab world, Africa as well as India. She's a founding member of the Sustained Dialogue Campus Network, World Economic Forum, Global Agenda Council, Senior Expert at the Mobius Executive Leadership Centre and studied organizational design at MIT, public policy at the Harvard Kennedy School, and political and social thought at the University of Virginia.
Anyways, the point of the book, the point is very simple. The way we gather matters, yet most of us spend very little time thinking about the actual ways in which we gather. That leads to the great paradox of gatherings. She talks about how there's so many good reasons for coming together, that often, we don't know precisely why we were doing so. We spent so much meeting time and uninspiring, underwhelming moments that failed to capture us, changes in any way, or connect us to one another. I'm pretty sure you agree with all of that. You're not the biggest fan of meetings, but you're a big fan of very deliberate meetings. That is a safe statement, right?
Ben Felix: Yup.
Cameron Passmore: The first step in convening people meaningfully is to commit to a bold, sharp purpose. This is exactly what we learned from past discussion. To not let meetings become routine. Routine is the great enemy of meaningful gathering. How do you do this? How do you arrive at something worth gathering about? Her recommendation is to be as specific as you possibly can. Specificity is a crucial ingredient. The more focused in particular a gathering is, the more narrowly it frames itself and the more passion it arouses. She also recommends to put specificity in the title of the meeting, and not just the description.
If you have a point, you have an objective of the meeting, put that right in the title. Don't just put it, podcast review or something. What do you want to get out of the meeting? She argues that this makes it more visible and clear. It's exciting to find something that is specific that fits you. View every meeting as one moment in your life that will never happen again. That's pretty powerful to think about meetings in that way. If you think about that, you might realize that a lot of the meetings you have don't really meet that threshold.
She suggested, if you're struggling with specificity, move from the what to the why. Keep asking why until you hit a believer value. Why are you having this meeting? Keep asking that why. Think about what larger needs in your world that the gathering might address. How can this meeting alter you and the others to be the best stewards of time invested? Many people don't gather with a real purpose, because they're not clear on what a purpose is, or how to arrive at one. Having a purpose simply means knowing why you're gathering and doing your participants the honor of being convened for a reason. Think about the why. Think about who should be there. Think about who should be excluded.
There's a whole section in the book where she talked about the power of excluding people, when you learn to close doors. Over inclusion, she says, is a symptom of a deeper problem above all, a confusion about why you're gathering and a lack of commitment to your purpose and your guests. Too often, the name of inclusion and generosity, we fail to draw boundaries about who belongs and why. The conflict of who to invite often unearths purpose. You are forced with clarity of purpose to invite with purpose.
Another thing she talked about that I am absolutely have been guilty of, and what she calls the ubiquitous strain of 21st century culture that is infecting our meetings, and that is being chill. Chill is the idea that is better to be relaxed and low key. Better not to care. They're not to make a big deal. She says, chill is a miserable attitude when it comes to hosting gatherings. She was referring to social gatherings, which is a big part of the book. I think, it also applies in a corporate environment.
The chill approach to hosting is all too often about hosts attempting to wriggle out of the burden of hosting, the burden of determining the true purpose of the meeting, the why. I think that's so important. Being chilled just means you haven't put enough thought into why are you meeting, and just having a collection of people to get together to talk about something. No, no. You have to have a purpose to the meetings.
She also suggests that every meeting should open with shock and awe. People want their attention grabbed immediately, make them feel welcomed and grateful all at once. Any gathering’s blandness is because there was no effort made to create the ultimate goal, to transport us to a temporary alternative world. Never forget, and we've talked about this many times, never forget about the most powerful force that we all face, which is the addictive technologies all around us.
That means, you need the meeting to be even more impactful than before, because you got competition in the cellphones and other technology that's all around us all the time. Bottom line, 90% of what makes a gathering successful is put in place beforehand, and connection doesn't happen on its own. You have to design your gatherings for the kinds of connections you want to create. Excellent book.
Quickly, I want to mention another book, which just released by a couple of peer advisors from Sydney, Australia. The book is called Your Investment Philosophy: A Guide to Managing Wealth & Protecting from Fraudsters, Marketers & Doom Merchants. It was written by Peter Mancell and Daniel Crowe of the Mancell Financial Group in Sydney, Australia. You can see him holding it up here.
First of all, it's very readable. It's an easy read. It’s a short read. It's just over a 100 pages. It's absolutely jammed with the concepts that we talked about so much on this podcast. It's about developing your own investment philosophy and sticking with it as you make financial decisions through life. The authors very early in the book say, investing is about being repeatedly challenged and tested. How an investor responds in the short-term largely determines their long-term success.
Starts out with the starting five important concepts in building your philosophy, markets work, risk and return, diversification, asset allocation and discipline. All things that you and I have talked about all the time. There's one chapter for each of those, and each end of the chapter has its own easy takeaway list of key points. Then it goes through factors, how to start investing, dollar cost averaging versus lump sum. What about things like hedge funds and private equity and ESG? Should I work with an advisor or be a do-it-yourself investor? Anyways, solid book, easy read and it's short and people will read it. Highly recommend it.
Ben Felix: It doesn't look like it's available in Canada.
Cameron Passmore: It is, actually.
Ben Felix: Amazon Australia. Amazon UK, I can see it.
Cameron Passmore: This was printed in Bolton, Ontario. I got a hardcopy shipped to me from Amazon Canada.
Ben Felix: Huh. I wonder why it doesn't show up. Cool.
Cameron Passmore: I don't know if it's on Kindle. I didn't actually check. Your Investment Philosophy.
Ben Felix: Sounds like an e-book.
Cameron Passmore: All right. You want to talk about the recent letters we received?
Ben Felix: No. Eventually. I said this last time, and we haven't done it, but it was a busy – Last week was busy. I had to prepare for that conference and stuff.
Cameron Passmore: Cool. Well, we'll do it next time.
Ben Felix: I want to give more time to them and actually respond to the emails. Have you responded to them?
Cameron Passmore: I did.
Ben Felix: Oh, yeah. I haven't.
Cameron Passmore: We'll talk about them next time.
Ben Felix: I think it's worth doing that and then – I think, we have reviews in here. I think we decided to stop doing reviews. Are we doing reviews? It doesn't matter. If you want to stop listening at minute whatever we're at.
Cameron Passmore: We have some nice reviews. Tory Boy from Singapore, “Top-notch. No nonsense podcast in investing. They're grateful. As someone who’s not Canadian and firmly believe the knowledge you impart here is applicable to everyone. Keep up the phenomenal work.”
Ben Felix: I like what they said though, is that I'm expressing my informational belief that this is one of, if not the best evidence-based investing and personal finance podcast out there.
Cameron Passmore: They like to mimic you. Anonymous47853 from the states, “Good investment information. Episodes are really great. I've really enjoyed the crypto series The episodes on gender inequality were good at first, but it started to drift away from how it affects investing.” We appreciate the input on that. Dev Patel from Australia, “Unbiased financial learning with a hint of political correctness lately. I've been listening to it since episode 13. Thanks for doing the podcast. You guys have been phenomenal with the guests. I notified in the latest episodes that you were going towards politically correct ways. Please stay authentic as you've always been. We love your authentic selves. Thank you, once again.”
Ben Felix: These are terrible reviews. Politically correct. Get out of here.
Cameron Passmore: There's another comment on YouTube from Dark Shadows that said, “Even though I don't politically agree with these two amazing folks all the time.”
Ben Felix: What is all this politics? We have only two episodes on topics that are politically –
Cameron Passmore: You know what? As I said to you last week, I don't even know your politics. We never talk politics.
Ben Felix: People are ridiculous, man.
Cameron Passmore: I honestly don't know your politics. I don't know how you vote. I have no idea how your vote.
Ben Felix: Drive me crazy.
Cameron Passmore: We don't deliberately think about politics. We just try to bring interesting Information.
Ben Felix: Don't politically agree with us. What politics do we talk about on our podcast?
Cameron Passmore: I don't know. You don't know my politics. Maybe do, but I don't think we've ever talked about it.
Ben Felix: Outrageous. That just annoys me.
Cameron Passmore: Just want to give a shout out to the GAIA tour that we met a bunch of people from GAIA, which is the Global Association of Independent Advisors. This is a worldwide association with about 20 firms. Our company is also a member. It has been for quite a while. They get together for an annual conference every year someplace. I went to the one in Sydney, Australia three years ago. They skipped during the pandemic. They just had their next one this past week, a couple weeks ago in Montreal. Ahead of that, a bunch of the members joined us in our Ottawa office for a little due diligence tour, which was super fun, and got a chance to exchange ideas.
Great group of people. Treat the practice of wealth management very seriously, open to new ideas, open to sharing. Then I went and joined them in Montreal for a few days, as well as a few of our other teammates. Good, solid group of nice, caring true professionals in the wealth management space. Just want to give a shout out and say it's super fun to meet them. Anything else this week, Ben?
Ben Felix: Are we going to write a book? The fact that our peers in Australia have written a book makes me want to write a book.
Cameron Passmore: Maybe you're going to write a book. I don't know if I have a book in me. I don't think I've got the drive, or competence, or creativity to find something that hasn't been written so much better by somebody else. Maybe one day. We'll see.
Ben Felix: Well, I mean, the one that you described sounds like a good book, but it sounds like a Larry Swedroe book. Doesn't have to be new for it to be useful.
Cameron Passmore: True. We'll see. We have a lot going on right now. Maybe next year.
Ben Felix: I know. We do a lot more. We're speaking at something in November, right? Then I'm speaking at something – I'm speaking at two things in November.
Cameron Passmore: I'm speaking at two things in November. One thing on October. A lot of travel, a lot of gigs coming up, which is awesome. All right, everybody. Thanks for listening.
Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.
Be sure to add the episode number for reference.
Participate in our Community Discussion about this Episode:
https://community.rationalreminder.ca/t/episode-221-permanent-life-insurance-discussion-thread/19522
Books From Today’s Episode:
The Art of Gathering: How We Meet and Why It Matters — https://amzn.to/3CxeyRd
Your Investment Philosophy: A Guide to Managing Wealth & Protecting it from Fraudsters, Marketers & Doom Merchants — https://amzn.to/3e2qOjp
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
Shop Merch — https://shop.rationalreminder.ca/
Join the Community — https://community.rationalreminder.ca/
Follow us on Twitter — https://twitter.com/RationalRemind
Follow us on Instagram — @rationalreminder
Benjamin on Twitter — https://twitter.com/benjaminwfelix
Cameron on Twitter — https://twitter.com/CameronPassmore
'Bad Advice: Explaining the Persistence of Whole Life Insurance' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1786624
'The Long-Horizon Returns of Stocks, Bonds, and Bills: Evidence from a Broad Sample of Developed Markets' — https://business.unl.edu/academic-programs/departments/finance/about/seminar-series/documents/MikeODoherty.pdf
'The Sensitivity of Life Insurance Firms to Interest Rate Changes' — https://www.chicagofed.org/publications/economic-perspectives/2013/2q-berends-mcmenamin-plestis-rosen
'The Canada Life Assurance Company (the Company) Participating Policyholder Dividend Policy' — https://www.canadalife.com/content/dam/canadalife/documents/insurance/par-whole-life-insurance/en/Policyholder_Dividend_Policy.pdf
'Canada Life open participating account: Historical investment related performance' — https://www.canadalife.com/content/dam/canadalife/documents/insurance/par-whole-life-insurance/en/46-11488Z_FF_CL_Historical-PAR-Financials_Brochure_AODA_FINAL.pdf
'A Dissection of Mutual Fund Fees, Flows, and Performance' — https://www.osc.ca/sites/default/files/2021-09/rp_20151022_81-407_dissection-mutual-fund-fees.pdf
'Equitable Life: Understanding Participating Whole Life Insurance' — https://equitable.ca/media/92738/1038_final.pdf
'Lower for even longer: what does the low interest rate economy mean for insurers? Zurich: Swiss Re Institute' — https://www.swissre.com/dam/jcr:034ab136-3b5b-47a0-9021-56513647c6aa/expertise-publication-swiss-re-institute-low-interest-rates.pdf?msclkid=a8f5ca5cb5b111ecaf3f180f204d4bd5
'Behavioral Aspects of Household Portfolio Choice: Effects of Loss Aversion on Life Insurance Uptake and Savings' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2924196
'Understanding the Shift in Demand for Cash Value Life Insurance' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2752193
'Your guide to participating life insurance' — https://www.sunnet.sunlife.com/files/advisor/english/PDF/810-3596.pdf
'Policyholder Exercise Behavior in Life Insurance: The State of Affairs' — https://scholarworks.gsu.edu/cgi/viewcontent.cgi?article=1000&context=rmi_facpub
'Long-Horizon Losses in Stocks, Bonds, and Bills: Evidence from a Broad Sample of Developed Markets' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3964908
'Finance: Function Matters, Not Size' — https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.27.2.29