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The agency problem in personal finance. What should you do?

Posted on 27 Apr 2022
Author: Sayan Sircar

Tags: Choosing Investments ; Insurance

10 mins read
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This post discusses how various agents pitch financial products to investors and how many of these products may not suit the investors’ goals.

The agency problem in personal finance. What should you do?

📚 Topics covered:

Introduction
Products with upfront commissions
Products with ongoing commissions
Special cases:
- How to deal with the non-mythical insurance ‘uncle’
- Mutual fund distributors
Identifying low or zero commission products

Introduction

Principal Agent Problem Source: Wikipedia

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. - Investopedia

In personal finance, this conflict exists mainly because of the existence of commissions. The agent trusted by the investor to suggest the most suitable investment products turns out to be acting on their own interests instead of that of the investor.

You can identify the agency problem when you are pitched a product with a likely commission structure if at least one of the following is true:

someone contacts you about investing: this can be a bank relationship manager (RM) or salesperson, a mutual fund distributor, a cold call about investing in a scheme like an insurance product like endowment or ULIP, a real estate property, a Portfolio Management Service (PMS) or something similar
you contact a bank, insurance company, investment management company for investing advice

In either case, the investor, i.e. the principal, will be pitched a product by the agent based on a single consideration: how much commission the agent makes on that sale. Commissions are universally paid out of the investor’s pocket and not out of the pocket of the investment management company, bank or insurance company.

While this is not necessarily bad per se, there are two problems:

the investor is not aware of the impact of commissions, or the impact is downplayed during the pitch
the investor is not offered a product suitable for their goals and portfolio

This article will briefly cover the types of commissions, hidden or otherwise, their frequency of deduction, the impact on the investor’s returns, and how to identify a product with a high commission.

Products with upfront commissions

Upfront commissions are substantially better than the option of ongoing commissions, as we will show below. Typically insurance plans have a high upfront commission that tapers off in the later years. Suppose you cancel the policy in the first few years. You will not get back much of the premiums paid so far since the company has already paid the commission to the agent, and the money is already gone.

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Products with ongoing commissions

Unfortunately, ongoing commissions are worse since they reduce your rate of return. Since the nature of growth in any asset is exponential, using the principle of compounding, even a 1% lower rate of return leads to a 30% lower corpus in 30 years.

Corpus = Principal * (1 + Return) ^ Time

which means that the difference in corpus per 1% less return looks like this:

The effect of 1% extra costs on a portfolio

This example is from our article on why investors should never invest in regular mutual funds and must always choose direct funds. Here are the details: Do not make this mistake when investing in mutual funds

Unit-linked insurance plans, or ULIPs, have both of the above problems:

extremely high commissions in the first year years called premium allocation charges (from the first few years’ premiums that includes the agent commission)
high ongoing charges and fees: mortality (that pays for the life insurance premium), fund management charges (just like the TER of a mutual fund) and admin charges (since a ULIP is a complex product). If you surrender the product early, you need to pay surrender charges as well, along with the previous charges that are now wasted

Also read
What returns should we expect from equity investing?

Special cases:

How to deal with the non-mythical insurance ‘uncle’

Many youngsters, especially when word gets around that they have joined their first job, receive a visit from a friendly neighbourhood insurance agent. Often well-meaning parents of the new joiner have a family friend who is an insurance agent who is brought over to make a pitch to the family.

The pitch revolves around having a life insurance policy with an investment component like endowment, whole life or ULIP. The policy will have benefits like tax savings under 80C on the premiums, life coverage and excellent customer service from the ever-helpful agent.

The agency problem occurs here if there is no mention of :

the poor returns (measured by IRR) of the policy
the poor coverage amount (5-10 lakhs) being useless for living expenses beyond a few months to 1-2 years
better and cheaper alternatives of low commission products like term insurance
other tax-saving alternatives being present under 80C that make insurance-based investments unnecessary
and most importantly, the high upfront commission

At this point, it is an excellent question to ask “high commissions, so what”? The following paragraph will clear this doubt.

These are the questions to ask, from a transparency perspective, if you are at the receiving end of this pitch:

What is the IRR of this product that is guaranteed without projections? Compare this figure vs savings bank account and FD returns
What is the premium for a realistic income replacement coverage amount, like one crore, that should be calculated using the HLV method
What are the commission amount and surrender charges in the first three years? You may not get anything if you cancel since the agent receives a large upfront commission from the premiums paid in the first few years in such plans. That money is already paid to the agent, and the insurance company will not return it to you.

A few suggestions to circumvent the usual emotional tricks that are played to ensure the sale happens:

“you will save tax”. This statement is technically true, but better tax saving options exist
“you don’t know anything regarding finance”: This could be technically true, but the Internet, including this blog, has enough information to explain, even to the most layperson, why insurance-cum-investment plans are not a good option for most people
‘in our days, we used to invest in insurance’: There are additional products available in the markets today, and so is a plethora of information regarding the right way to manage a portfolio and its associated risks. So lack of knowledge is not an excuse anymore.

However, at times it is better to focus on losing the battle to win the war. The premium of the insurance policy that the agent pitches is a small price to pay to get an agreement in place that the young earner is able to limit outside interference in their finances for goals that are decades away.

After all, and they should internalise this sooner than later, it is impossible to plan for any goal without investing in products, like equity, that can counter goal inflation. Of course, retirement can be possible with savings account returns, but few people will realistically reach the corpus for such a feat.

Here are some practical suggestions to circumvent the push:

identify the motivation for the investment. Are the parents feeling insecure that they will not be cared for if something happens to their child? In such a case, simply take a term plan of one crore or more and make the parents the nominee
assume that 70-80% of the first-year premium is the commission and offer a gift to the agent’s family of the same value to get them off your back

Mutual fund distributors

A common argument in favour of choosing Regular funds offered by distributors goes like this. The distributor is supposed to advise which funds will perform better in the future in advance. The claim is that investing in “best performing” funds makes the TER difference between Regular and Direct funds (which is due to the distributor commission) immaterial. However, since the distributor makes this claim, the investor must examine the distributor’s track record of future prediction of finding such funds. Then there is the taxation cost of switching frequently. Direct funds give guaranteed extra returns over Regular without needing any attempt to predict the future.

Identifying low or zero commission products

Golden rule: do not approach your bank for investment products

There are sayings in multiple Indian languages that mean something along the lines of: “today the prey itself walked into the predator’s den”. If you approach a salesperson, you will have course be pitched a product that

first makes the most money for the salesman
as a secondary consideration, it may or may not be suitable for you

A good product does not need to be sold.

The single most important criteria for evaluating if a product is suitable for investing is evaluating the sales channel used for obtaining the product:

the investment can be DIY if you can understand it
the product is well established with at least 10+ years of history
no one is chasing you to buy it. On the contrary, if you ask for more information, your question may be deflected

Some common examples of investment products that should be considered (vs those that you should reconsider) are:

life insurance: term plan instead of endowment, whole life, etc
health insurance: family floater with a super top-up plan
a personal accident insurance coverage to safeguard against accidents where you do not die but cannot earn
investment: direct plan mutual funds instead of regular MF plans, direct stocks (via advisory services), baskets (like smallcase), or ULIP
bonds: RBI gilts instead of corporate bonds, NCDs or covered bonds:
Real estate: REITs instead of commercial real estate or investment properties
gold: SGB or mutual funds/ETFs instead of digital gold

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