It was the year 2001, I was a few months into my first job out of college, just getting used to the idea of being able to make discretionary purchases with a magical piece of plastic. Hoping to address my obvious lack of awareness of concepts like compounding and investing for the future, my dad introduced me to an old friend of his, ‘S Uncle’.
With his salt and pepper hair, ramrod posture and polished leather briefcase, ‘S’ uncle was a successful agent for India’s only life insurance company at the time and so equipped to guide a financially illiterate 21-year-old. He sat me down and told me the importance of saving part of my salary and making it work for me. He then snapped open his briefcase, rifled through a stack of multi-coloured brochures and pulled one out with a flourish saying “This is the perfect investment for a young man like you!” It had “Jeevan” in its name and had terms like “sum assured”, “tax benefit”, “annual bonus” in it. I nodded along as if to imply I understood.
A few minutes later, feeling like a responsible adult for the first time in my life, I had signed the pre-filled form S Uncle had ready and handed over a cheque as the annual premium for my first LIC policy. A 17-year endowment policy, that for 14 tax-exempt annual payments of Rs 14,506, assured me a lump sum payment of Rs 2.5L and an unspecified bonus at the discretion of LIC. A mind-boggling IRR of 2.7% that jumps to almost 4% if you include the tax saved.
The same amount invested annually in the NIFTY would’ve been roughly worth about Rs 5.9L, or 2.4X the “smart” investment S Uncle had me sign up for. As an insurance instrument, had I picked a term life policy (that Uncle S forgot to mention was even an option), the same premium would have bought me life cover of several times the 2.5L. So what gives?
The power of incentives
If I had probed S uncle’s advice even a little bit, I would’ve learned that for the product I was signing up for, he would receive close to 40% of the first year’s premium as commission, 25% for the next 2 years, and 10% for 12 years after that. Compared to that, for a simple term-life policy, his commission would’ve been less than a quarter of what he made from the product he sold me.
To be clear, “S uncle” did not do anything illegal, and he didn’t think he was doing anything unethical. He believed it to be sound financial advice which also happened to work well for him. Even though it’s logical that young professionals are better off buying adequate health insurance and term-life policies for far higher coverage amounts.
Imagine you work for a large global multi-business conglomerate that pays out performance-bonuses at the end of each year.
Scenario 1: Your business shines while the rest of the company has a ho-hum year
Scenario 2: The company shows decent growth while your business degrows
Your answer to the question “Should bonuses be specific to business unit performance or company-wide performance?” will be different in each case. What’s more, each answer will have rational supporting arguments.
Incentives warp even the most well-meaning minds to convince themselves of the objective superiority of their point of view. Now consider that not all minds are well-meaning and you recognize the importance of healthy scepticism when receiving advice.
What’s in it for you?
The examples are all around us
- the “hot tip” SPAM SMS announcing some unheard of stock is about to move up
- the expert on CNBC talking of the opportunity in <sector> stocks
- the star fund manager on twitter forgoing subtlety to say “XYZ stock is about to gain big from <govt / macro factor> push. Go buy!”
- the wealth manager recommending churning your mutual fund portfolio for “better” returns
- the online brokerage offering “no charges on F&O positions squared off within 5 minutes”
What stock manipulation looks like… pic.twitter.com/fVnp0CuaeO
— The Calm Investor (@CalmInvestor) October 5, 2017
The point is not that advice is bad just because the giver has something to gain. Acting out of self-interest is our most fundamental trait. It’s when the nature and extent of self-interest are not known clearly when bad things happen. Being aware of the incentives also helps identify potential blind spots the advisor might have.
So, when you hear / read advice of any kind, ask the question “What’s in it for you?”
A dependable advisor will calmly and clearly spell out her incentive. The other kind will typically give themselves away by expressing outrage, throwing out jargon, blocking you or all of the above.
For more on cognitive biases that sabotage investors, click here
The distorting power of incentives farnamstreet
Benefits illustration from LIC policies LIC India
Why some agents pay your first year premiums jagoinvestor
More commissions for insurance life agents livemint