Monday, June 09, 2008

A Study of Transamerica

The Company
Last year, a friend of mine introduced me to a financial planning firm by the name of Transamerica. To take the description from their own webpage:
The companies of Transamerica offer a wide array of innovative financial services and products with a common purpose. Regardless of the distribution method, our mission is to help individuals, families, and businesses build, protect, and preserve their hard-earned assets. With more than a century of experience, we have built our reputation on solid management, sound decisions, and consumer confidence.

The Transamerica companies are members of the AEGON Group, a multinational insurance organization headquartered in The Hague, The Netherlands. AEGON is one of the world’s leading life insurance and financial services organizations.

As I spent more time on the job, I began to notice an interesting thing about their formula for success. (They are the fastest growing financial planning firm in the country)

Cialdini's Magic In Full Effect
I was luckily already well familiar with Cialdini's work by the time I began working there. For those who do not know, Robert Cialdini is a sociologist who has researched and wrote on psychological principles which can be used to influence a person's reaction. In his book Influence: The Psychology of Persuasion, he wrote about 5 particularly effective tools: liking, reciprocity, commitment, authority, and social proof. (For those who want to learn more about this, there are a few articles in my Online Archive "Cialdini, Robert.")

In my opinion, Transamerica's business formula had incorporated ALL of these methods. ( I'll disregard for now the many methods used to motivate the employees themselves within the company.) First, let me explain the process. As a new employee, my first "mission" was to make a list of one hundred friends and family members. I was then told to narrow down the list into two groups. The first, people who would potentially need financial advice. The second, people who would be interested in working for Transamerica themselves. After that, the calling began, and the goal was to set up a one or two hour meeting between the employee, the acquaintance, and a senior employee. During that time, senior employee would discuss the financial matters of the household and offer recommendations which could be helpful.

Now let me paint the picture of how I see Cialdini's principles in the process. It begins by using the "liking" which is already present between the employee and their friends. (Let's say Billy and John, respectively) Already, this inspires in John a sense of wanting to help his friend, and it makes him commit to something he would ordinarily refuse. That leads to the "commitment"- John has agreed to give up a few hours of time for this meeting. On the one hand, this means he will likely stick to the promise he has made to his friend. Even more importantly, after spending two hours on a meeting, John will likely feel the need to get something out of it.

Then, there is the presence of the boss. He represents "authority" because, face it, Billy's friends and family know Billy, and they've never known him for his financial expertise. But this senior employee is mysterious, and so John has no reason to doubt his financial accumen. As the boss is giving this speech to John, Billy is sitting complacently near by, making him feel comfortable about everything being said ("social proof"). After this long, personal meeting, John feels like he has just been done a huge favor by Billy and his boss. They have just given up their time trying to help him plan and save for his future. John feels the urge to want to "reciprocate" the favor, and implementing the recommendations seems like the least he can do. Besides, the recommendations will make him more money, so it is win-win, right?

To What End?
Cialdini mentioned in his book that these principles can be used on people for good or for bad. His goal was to reveal these principles to his readers so that they can spot these tactics and then decide for themselves. But as Charlie Munger pointed out, many sellers/advertisers picked up the book instead, and applied the principles in their business to the detriment of their customers.

Which side does Transamerica fall under? I am not going to say directly how I feel; rather, I will simply demonstrate an example in something I understand, mutual funds. Now as Transamerica makes clear:
Fund shareholders may incur two types of costs: (1) transaction costs, including sales charges (loads) on purchases, contingent deferred sales charges on redemptions and redemption fees; and (2) ongoing costs, including management fees, 12b-1 distribution and service fees, and other fund expenses.
So first, lets deal with transaction costs. You can find information for Transamerica's sales charges here. But as an example, if you were investing $50,000 in a Transamerica Equity Fund, it appears your sales charge as a percent of the amount invested would be 4.99%. To see how important that is, lets look at the value of that 50,000 invested for 10 years at 10%. With the charge, your final amount comes out to $123,216. Without it, it is $129,687. Some people might brush that off, but I surely don't, especially when there are an endless amount of funds out there which no longer charge upfront fees.

And then, there are the ongoing costs. Lets take the "TA IDEX Asset Allocation- Conservative Portfolio". In their financial report they state:
The average weighted annualized expense ratio of the underlying investment companies at April 30, 2007, was 0.83%.
That surprised me at first, because it is relatively low. And then I looked at the portfolio's composition: (Click on it below to get a closer look)

These are all affiliated funds, with their own expenses, which are not included. Essentially, you are getting charged .83% a year simply for them to put your money into multiple other TA IDEX funds.

It just so happens that I was writing this, news came out on Buffett's newest bet, which is completely relevant:
Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.

You can guess which party is taking which side.

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected...

Essentially, the issue boils down to a simple point which Buffett and John Bogle (founder of Vangaurd Funds) have long made. That is, the sum results of all participants in the stock market must average out to the stock market average. In any given year, some people will out-perform, some will under-perform, but their total can never average out to more than the returns of the market itself. Unfortunately, most people get hit with a variety of fees along the way- management fees, brokerage fees, trading fees, etc. Now, a piece of the market's total returns is going from investors to these third-parties, meaning that most people will actually end up under-performing the average return of the market itself. A passive investor's best hope is to minimize all of his fees and hope to achieve a return as close to the market average as possible.

Getting back to Transamerica's Conservative Portfolio, they are by my count investing in 36 other mutual funds. Each of those funds is probably invested in about a hundred stocks or bonds themselves, making it so diversified that it is hard to believe its results will be materially different than average. Yet, you are getting charged for two layers of fees and expenses along the way.

So let us now update our own example taking into account all of the fees. We're still investing $50,000 at 10% over 10 years. But in one situation, you are giving up 5% upfront and 1.5% (my guess) in total annual fees. That leaves you with a final amount of $107,408 in 10 years, compared with $129,687 with no fees. If you expand the time horizon to 25 years, the numbers are $365,160 versus $541,735. I'll let readers decide how much those differences mean to them.

P.S. If anyone sees any legal issues which may arise from this post, please do let me know so I can make any necessary changes. I really don't want to get sued.

1 comment:

oldye said...

Sounds a heck of a lot like Ameriprise and Northwestern Mutual..although I'm sure there are others out there. They all get college kids that are "interested" in finance to sell crappy funds (High Fee's and destined for mediocrity at best) to their friends and family. Once the friend list is dry, the new employ is put out there to sell products to strangers. It works a heck of a lot like a MLM scheme.