Death Care Law Blog : Kansas Death Care and Preneed Lawyer & Attorney : Stalter Legal Services Law Firm : Funeral Law, Elder Law : Kansas City

Not that close, even from the 30,000-foot view.

That’s our assessment of the Morningstar analysis of preneed and its impact on the death care industry. In “Dark Clouds for the Death-Care Industry”, a stock analyst attempted to explain the preneed transaction, and then provide an assessment of the impact of preneed on the profitability of the death care industry. Such attempts to generalize preneed are often misleading, particularly by an outsider looking in.

While the analyst raises a number of issues regarding preneed, only one can be described as generally accurate: there is a growing reliance on preneed sales. But then, operators in the smaller or rural communities may disagree because they do not face the competitive pressures that drive preneed sales. For the majority of the industry’s operators, competition has made preneed a necessity.

The article suggests that all preneed sales end up in trusts, and that the trust exposes the operator to investment risks. While this generalization has some merit, it completely ignores insurance funded preneed, and how those sales provide a background to assess the analyst’s preneed conclusions.

A majority of the states have preneed funeral laws that impose trusting requirements of 90% or more. The costs associated with a preneed program force larger operators in the 100% states to use insurance funding for the commission that will pay salesmen. The complaint currently heard from these operators is that the return on their insurance proceeds is not keeping pace with inflation.

The analyst states he would feel more comfortable if the industry turned to insurance companies for underwriting of the industry’s massive trust portfolios. Excuse me? The main problem with preneed trusts is that they are saddled with expenses, and are often ‘parked’ in fixed income investments. So, Wall Street’s solution to preneed would be to add a layer of expense through underwriting? Ignoring the state law issues, aren’t you suggesting to the operator that he should sacrifice the upside of his trust for the stability of a lower, more consistent return? How would that recommendation achieve the growth that you state is lacking for this industry?

The analyst also states that the industry must rely on preneed because of the lack of overall deaths in the marketplace. Perhaps the analyst meant to say there is too much competition for the current death rates in our communities. If so, then yes, preneed is becoming as important as heritage in maintaining (or growing) the operator’s market share. If the investment community believes preneed is bad for us, how would Wall Street propose funeral homes and cemeteries respond to competition in the market place?

Wall Street concerns over preneed are driven in part by misconceptions about the operator’s costs, and his exposures to trust funding liabilities. The analyst fails to make a distinction between the cost to perform a preneed contact and the prices listed on a general price list. The amount paid out of a trust when a preneed contract may not equal the current at need prices, but the trust proceeds do generally exceed the costs of the services and merchandise. Depending on the age of the contract, and the state’s trusting requirements, the older contracts may not be very ‘profitable’, but there is a profit, just not as profitable as the comparable at-need service.

The analyst also expresses concern the operator’s liability to fund the trust when the investment markets decline as they did in 2009. What state law requires that? Operators are not required to make ‘capital injections’ into their preneed trusts for investment declines. Such conditions may affect their authority to make income withdrawals, but not to require additional contributions.

Wall Street would prefer the death care industry to return to the day where at-need revenues constitute the base of operations. Most death care operators would share that desire, but most know better. Contrary to the analyst’s conclusion, operators are finding that it is the at-need service that is exposed to downturns in discretionary spending. Tight times make it easier for the consumer to choose cremation. If the preneed contract is paid in full, the family isn’t forced to come out of pocket to pay for the traditional service.

In conclusion, I have to concede that the analyst is somewhat correct about preneed exposing the operator to investment risks. Preneed has become a business reality, requiring many operators to make a decision between insurance or trust. Should the operator take the lower, but safer, rate of return of the insurance policy, or keep the upside of the trust (and its risks)?

Large funeral operators in 100% trusting states don’t have much choice but to use insurance.  For the funeral operator who wants growth and control over the direction of the preneed fund, then there is little choice but to assume the investment market risks that accompany the preneed trust. Cemeteries have no choice but to use the trust, and assume its investment risks. Cemetery preneed can be distinguished from that sold by funeral homes in that some merchandise (and services) is delivered prior to death, precluding the use of insurance.  

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A few months ago, a stock analyst issued a critique warning against investment in the industry’s public companies. A few weeks later, the critique got a second wind when chat pages and social media forums picked up on the critique’s conclusion, and circulated the article as proof that certain trends will ‘haunt’ all funeral homes and cemeteries for years to come. Several weeks later, the critique’s attempt to assess or explain the industry’s key issues continues to haunt me. If a professional who makes his living from investment assessments has difficulty grasping and explaining the intricacies of the death care industry, consider the difficulties our regulators and legislators may have understanding the business.

The critique identified “the” three issues impacting the industry’s revenues and profitability: cremation, preneed and longer life expectancies. This post will focus on cremation.

The analyst opens with the statement that ‘several unfavorable secular trends’ are hampering long-term growth and profitability in the death care industry. But, the critique concludes with sticking the “unfavorable secular trend” label solely on cremation. There is no doubt that cremation is turning the industry on its head, but is the “secular trend” label important? It is when you view the history of the business, and need to convey the depth of the cremation issue, and that it will continue to grow.

The American way of death was shaped by the Christian funeral and burial. Theology professor Thomas Long has written several insightful books and articles regarding the Christian funeral and the role of the body. Another excellent work is Paul Irion’s “The Funeral: Vestige or Value?” The growth of death care business can be traced to the fact funeral homes profited by establishing a good relationship with the local church. That fundamental relationship served the funeral home well for several generations. But as our society became more pluralistic and secular, the acceptance of cremation grew.

For theologians, cremation represents a challenge to long standing beliefs about the funeral ritual. But, the emerging message to clergy is one of education and adaptation. As a follow up to his seminal work on the funeral ritual, Paul Irion wrote a book simply titled “Cremation”. This blog has previously discussed this issue, and one form of adaptation by churches: the columbarium.

For the funeral director, a church’s shift to embrace cremation sends a mixed message. The families from these churches view the funeral as having value as a ritual, but a ritual that does not require the purchase of a casket. If the funeral home does not own a crematory, the director will have to compliment the church’s pastoral care, or risk losing the church’s business altogether.

Operators must also market to a public that has become more secular, and view the funeral home as providing a utilitarian service. As the analyst alluded to, once the body is disposed of, all other services are ‘auxiliary’ in nature. The secular public is more likely to purchase a cremation, and forego any type of memorial service.

While cremation has taken away casket sales and cut into the purchase of services, is the critique accurate in its warnings about the death care industry? Keep in mind that the analyst was assessing the industry for profitability and growth, and that growth is difficult for a mature industry to achieve. The death care business has all the characteristics of a mature industry: limited or declining markets, intense competition, and evolving consumer demands. Individual companies may be able to achieve growth, but the industry as a whole may not until the Baby Boomer generation ages another 10 years.

Some mature industries do wither and eventually die away. But in contrast to industries that produce a product with a definitive life cycle, death care is based on a service that will always be needed. Funeral homes may have been guilty of having allocated too much of their profit to the sale of a casket and too little to their services. But, they have the ability to adapt their pricing strategies. For the small operator who cannot afford a crematory, alkaline hydrolysis may provide a less expensive investment. And, there is the green burial alternative to explore.

Next: Dark Clouds and Preneed
 

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Many state preneed regulators share the point of view that the payments made toward a preneed contract belong to the consumer until the prearranged funeral is provided. This perspective was adopted by the California Attorney General in its Eighth Cause of Action brought against the California Funeral Directors Association and its Master Trust. The AG criticizes the CFDA for investment decisions that are fairly representative of those taken by the industry as a whole.

Early on, the CMT relied upon bond funds that specialized in zero coupon government bonds. The AG points out that U.S. Treasury Bonds and similar bond funds outperformed the CMT at less risk and with lower fees.

When the bond market crashed in 2001, the CMT experienced substantial investment losses and changed investment course. The CMT began diversifying, and purchasing mortgaged back securities, foreign bonds and notes, corporate asset-backed securities and other types of securities. The AG criticizes these investments by stating “these types of investments are not insured bank accounts, are not bonds that are legal investments for commercial bank (sections 1001 et seq. of the Financial Code lists certain legal investments for commercial banks), are not government bonds, and do not comply with the Uniform Prudent Investor Act (as discussed below).”

The AG goes on to argue that the investment policies of the CMT should be set by the risk and return objectives of the preneed contract beneficiaries, and faults the defendants for having set investment policies based on their own needs.

Other states’ preneed regulators (and cemetery regulators) share the California AG’s point of view. It is common to hear a regulator characterize the preneed trust as a depository account or to express the belief the industry would be better off if preneed funding were left to the insurance companies. These regulators need to take the blinders off.

The CMT, like so many preneed trusts, went into tax exempt investments after 1988 because of Revenue Rul. 87-127. The Internal Revenue Service pushed for an income reporting method that proved impractical and burdensome. To compound the situation, the IRS applied the ruling retroactively to certain states. California was one of those states. Prior to the ruling, funeral homes had no reason to require the consumer’s social security number when selling a preneed contract. Consequently, many California trustees could not comply with the ruling with regard to existing contracts.

The ruling required grantor statements to be sent to consumers, and the consumers complained. So, funeral homes instructed their preneed fiduciaries to go into anything that didn’t require a grantor statement. While the CMT went to zero coupon bonds, the IFDA went into the poorly conceived key man insurance. Other trusts went into annuities. Various approaches were taken because the IRS could not provide reporting guidance once it changed the rules.

In stating that the preneed funds must be invested pursuant to the contract beneficiary’s objectives, the California AG has ignored the fact that a majority of these preneed contracts are probably guaranteed. Under that arrangement, the funeral home has assumed the investment risk. From a practical approach, how would the investment advisor determine the objectives of the thousands of preneed beneficiaries? In a prior post, this blog reported about an Illinois contract beneficiary’s complaint about the IFDA Master Trust. In contrast to the losses suffered by the member funeral homes, the beneficiary experienced a modest return on her non-guaranteed contract. Her complaint was that the return was not enough to keep up with rising funeral costs.

The California AG argument that the CMT must comply with the Prudent Investor Rule in a way that does not expose trust principal to risk is the equivalent to handcuffing both of the investment advisor’s hands behind his back.

Of the investment complaints made by the California AG, the one which would seem to merit the most attention would be the relationship between the former investment advisor and a CFDA board member. That CFDA board member also served as a trustee for one of the advisor’s funds, for which he received compensation. That relationship warrants an inquiry whether the relationship was disclosed and the compensation appropriate and reasonable.

The AG’s argument that the investment advisor must be independent from the seller is one shared by Missouri regulators. The Missouri regulators are quick to point to the abuses committed by NPS and its investment management firm. (See our post titled “The Zeal for Independence”). Those abuses were so bad that the Missouri legislature passed a provision prohibiting a relationship between the seller and the fund manager. This author thought the provision went too far. (See our post titled “Regulating Out of Context”). With the passage of SB 325, the Missouri Funeral Directors Association has convinced the Missouri legislature that it did go too far.

Regardless of whether the fund manager is a fiduciary employee or an independent investment advisor, that fund manager should appropriately look to the preneed seller for input about investment objectives. For the larger trust, the fiduciary and fund manager should adopt a written investment policy that, among other factors, considers the trust’s mix of guaranteed and non-guaranteed contracts. If the fund manager is an independent investment advisor, the relationship should be documented with an agreement that discloses all forms of compensation. Consistent with the SEC efforts to reform mutual funds, the disclosure should address any 12b-1 fees. The agreement with the fiduciary should also disclose all relationships the investment advisor has with the preneed seller.

To the extent the preneed contract is guaranteed, the regulator needs to recognize the seller’s economic interest in the trust’s performance. But, fiduciaries and sellers need to consider the growing number of non-guaranteed contracts and the possibility that the guaranteed contract may be serviced by a different funeral home. While the seller may have the prevailing economic interest, not all of the trust may be considered his for investment purposes.

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The Wall Street Journal has long been viewed as a leading source of business and investment news. But last weekend, the WSJ ran a short article on preneed, and demonstrated its lack of understanding of the transaction.

The article attempts to characterize preneed as an investment, and then explores issues such as cash surrender charges, cancellation penalties and the NPS failure. This is all very misleading because preneed is not an investment, or a security, but rather the purchase of funeral goods and services.

Those who are considering the purchase of preneed should not view the transaction as an investment. The Securities Exchange Commission determined decades ago that the transaction is a purchase of goods and services, not an investment. While the transaction may be entered as a ‘hedge against rising costs’, there are forms of preneed that do not provide such protections.

The WSJ article ends with advice that also misses the mark. An elder law attorney suggests that a simple trust, costing “a few hundred dollars”, could substitute for the preneed transaction. Unless the attorney is considering individual trustees who serve without compensation, the combined cost of the trust document and the initial corporate fiduciary fee could be several hundred dollars. The corporate fiduciary will then have a minimum annual fee that will be ‘a few hundred dollars’.  With a corporate fiduciary, this rather simple plan could end up costing 'a few thousand dollars'.

The next time the WSJ reports on preneed, it should do its homework, and not use the transaction as weekend filler.
 

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The ICCFA’s November Magazine included an article by Craig Martin that provides good advice for all death care trusts. Death care trusts are notoriously bad performers, and if operators are to improve investment performance they need to work more closely with their fiduciaries and portfolio managers. Mr. Martin offers 5 tips that are equally applicable to preneed trusts and endowment care trusts:

1. Know your investment guidelines (and statutory limitations)
2. Communicate with the investment manager on a regular basis
3. Use a professional fund manager
4. Include growth in the asset allocation
5. Explore the availability of a master trust

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Over the next year, Missouri will examine the various flaws of SB1. One of those flaws concerns the independent investment advisor and the ‘fix’ meant to preclude conflicts of interest.

Preneed trusts have a poor track record in terms of investment performance. Trustees often fail to appreciate the key factors that impact investment strategies for preneed. Those factors can vary substantially from trust to trust, making the fund manager’s job more difficult.

Consequently, it is not uncommon to see large trusts delegate investment authority to an independent fund manager. Missouri’s old preneed law took the practice an ill-advised step too far by relieving the trustee of liability for the advisor’s decisions. NPS exploited that provision by appointing investment advisors who handed the keys to the vault to Lincoln Memorial. Believing themselves to be exculpated from investment liabilities, the NPS fiduciaries became bystanders to the largest preneed fraud in history.

Section 436.445 of SB1 appropriately requires the fiduciary to remain responsible for the investment advisor’s actions. However, the statute goes too far in attempting to preclude any relationship between the advisor and the seller. The provision was lifted from Missouri’s Uniform Trust Code without adequate consideration of the relationships of the seller, fiduciary and fund manager.

In contrast to SB1, the Uniform Trust Code does not prohibit relations between the trustor/seller and the investment advisor (or any service provider to the trust). Missouri’s preneed industry would be better served if such relations were allowed if fully disclosed and subjected to a higher level of scrutiny.
 

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During the long and tedious Chapter 436 hearings, some Missouri funeral directors joined consumer advocates in using the NPS failure as reason for recommending that legislators impose 100% trusting on the preneed transaction.  Those funeral directors generally advocated the use of insurance or joint accounts as safer methods of preneed funding.  During regulatory meetings, comments were also made about how the insurance policies or joint accounts were 'guaranteed'.   The realities are that each of these forms of funding has its advantages and disadvantages, and that there are no absolute guarantees.

The AIG failure underscores that even the largest of insurers may be vulnerable to the current financial crisis.   While most life insurers are safe, the only guarantees offered by insurance are the rates of return promised by the policy terms.  As witnessed by the Texas insolvency proceedings for Lincoln Memorial life, the insurer's promises are only as good as the assets held in its reserve accounts.  After that, the policyholder must look to guaranty funds for assistance.  Consequently, funeral directors should periodically review the financial statements of the insurance companies they use for preneed funding.

With regard to keeping those preneed funds at the local bank, the funeral director is assuming risk (and liability?) when he exceeds the FDIC insurance coverage.   By holding the consumer's payments in a joint capacity, the funeral director is also exposing the funds to the claims of the funeral home's creditors.   Losing a lawsuit for damages that exceed the firm's casualty insurance put the consumers at risk. 

In contrast, the funds placed in a preneed trust are not the assets of the bank or the funeral home.   By virtue of the terms of the preneed contract, the funeral director usually has the risk of investment performance (and under the current circumstances, that's more risk than what some funeral directors want).  But in contrast to insurance and joint account contracts, the trust provides the death care operator some say in how investment risk should be handled.

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