Are you able to tell the difference between a whole life and an investment linked policy?

One of the common misinterpretations folks totally not versed in money and finance is that if you invest, you are automatically well versed in other areas of personal finance. The two are are not well correlated all the time.

I do have many experience investors around me, that while they can astutely spot good businesses and make consistent money, personal finance is something that they have to learn or picked up.

Insurance is a whole different monster to them all together and it is especially tough for young folks who are just starting out working. If you do not have good resources that provides a primer to the dos and don’ts, what the adviser sells you, it will look like value for money.

My friend was asked to provide a second opinion whether this policy is better than a whole life policy. One thing to note is that my friend who is going to start working soon, is also figuring this insurance stuff out, but he is sharp.

The friend of his was recommended this better than whole life policy by his insurance adviser friend (very confusing, there are about 3 friends nested here!)

The premium is $300 per month and you get a coverage of $450k death and TPD protection and $150k critical illness protection.

The alarm bells start ringing in that, a typical level term life insurance would cost $155 per month. A whole life should cost much much higher than this $300 for the same coverage, since whole life comes with cash value.

It turns out to the layman, when you don’t know whether you are buying term life, whole life, limited whole life, investment linked policies, you get very very easily waylaid by your adviser that you do not ask the finer questions if you know how these products are categorized.

In this case, this better than whole life policy is actually an investment link policy.

Basically its an apples to orange comparison. The adviser did not even go into a financial planning overview, then matching this product to his needs.

My friend found some notable red flags in the benefits illustration document provided. My advise is that you read through the benefits illustration document provided which will shed more light on what you are really buying.

The freaking problem is that these benefits illustration isn’t always human readable.

When we talk about an investment linked policy, most would be looking at it for your investment and protection needs. For investment linked policy, you pick out 1 or 2 unit trusts in this wrapper policy and these unit trust’s performance decides if your policy will make money or lose money.

There is no guaranteed value like the whole life policy since under ILP, you do not participate in a participating fund.

If your unit trust underperformed badly, they might lose money over the long run.

The above illustrations show the surrender value  accumulated that the policy holder can get if he or she decides to liquidate. The projected investment returns used is 4% and 8%, but in truth, will depend on what unit trust you chose  for the underlying.

We will come back to this return later.

One thing you notice is that for the 4% project investment return, from age 61 to 66 the surrender value actually went down from $102,200 to $100,400. Not so if your projected return is 8%, as it grew from $277,000 to $380,000.

In fact at age 75 onwards, your nested egg, or the surrender sum, is projected to become $0 at the 4% project investment return.

Why is this the case.

This second table is similar to the first, the only difference is An Effect on Deduction column is added to show how the surrender value is derived.

According to the benefits illustration,  Effect of deductions to-date refers to the accumulated value of the deductions for the cost of insurance, distribution cost, expenses, surrender charge, expected tax payments, and expected transfers to shareholders (for participating policies). It represents the difference between “Value of premiums paid to-date” and “Total surrender value”.

That is a serious number of costs for managing this insurance policy.

Mortality Costs

The biggest cost among the effect of deduction have to be the cost of insurance. If we deconstruct an investment linked policy, it is made up of

1. an increasing term life insurance
2. some unit trust
3. a wrapper to wrap these 1 and 2 together to provide flexibility
4. riders of additional protection

1 is interesting because its an increasing term insurance. If  you look at the term life insurance plans provided by CompareFirst and DIYInsurance, they are generally 5 year renewable term or level term insurance.

Basically the premiums that you pay is equal or straight over time. You basically pay a little more when you are younger so that you pay a little less when you are older. This is advantageous if you are holding the plan for long to 65 years old.

The increasing term life insurance in the investment linked policy is not equal and starts of very cheap, which is why very little of the $300 per month goes to the insurance portion.

As you reach 50 to 60 years old, the mortality probability increases, and so do the corresponding premiums, more of your $300 per month premium, if not all of it goes to paying for the term insurance portion.

Over the age of 65, the mortality charges are so expensive that the plan are likely to sell units from the investment part to pay for the protection part.

Normal term insurance is not feasible to use over age of 65, as the premiums to insure are very very high.

And the illustration tells as over the age of 65, the premiums from the protection eats away whatever returns the 4% investment returns have generated.

The lesson learn here is that, if you purchase this plan:

1. You better make sure you have a good overall strategy what this plan is for and to what age it should be in service for.
2. Your investment returns of unit trust better perform very well, else come 55 to 65 years old, the policy may lapse if you do not have enough units to pay.

The Actual Returns on the Unit Trusts in the ILP

While we are on the topic of returns, the 4% and 8% projected returns are on the investments, but they have not factored in much costs.

According to the benefits illustration:

Projected Investment rate of Return (PIRR)

The illustrations are based on projected investment returns of 4.00% p.a. and 8.00% p.a. The two rates of return used are before deducting the annual management charges of the funds. They are purely for illustrative purposes and do not represent lower and upper limits on the investment performance. They also do not reflect potential volatility over the short term resulting in potential sharp movements, up or down, of the underlying assets of the
funds. The actual benefits payable will depend on the actual performance of the underlying assets of the funds.

The performance of the funds is not guaranteed and the cash value may be less than the capital invested. Please note that if you select a money market fund or a fixed income fund, the returns of 4.00% to 8.00% could be considered high in many cases and unlikely to be achieved if the current low interest rate environment persists. You are strongly encouraged to speak to your distribution representative who would be able to provide further information on these funds – both for your initial fund selection and subsequently.

So this means that this projected returns is before management costs. In case you think that the management cost is low like the 0.3% for an STI ETF, they are likely to be closer to 1.25%.

This more or less means that to earn that 4% return, the manager have to earn 5.25% return to equate to that 4% return if cost is factored in.

And you can see that the cost is a drag on performance:

1. 40% of the fund go to this unit trust that was started in 1999 and generated a 3.24% per annum return versus the benchmark of 3.31% per annum
2. 40% of the fund goes to this unit trust that was started in 2001 and generated a return of 1.46% versus the benchmark of 3.52% per annum
3. 20% of the fund goes to a bond unit trust started in 2002 and generated a return of 3.64% versus  the benchmark of 3.71% per annum

In this same period since 2002, the STI ETF, an exchange traded fund whose aim is to follow closely to the Straits Times Index, a basket of blue chip, earned a return of 8% per annum.

You will notice that all 3 funds underperform the benchmark over the 14 to 16 years and they are far below the 4% projected in the illustration.

In this case is it safe to use the 4% projection at all?

At the end of the day in investing, your cost matters. (Read this article to go into detail why cost matters)

Summary

Investment Linked Policies in this case have more variables than the traditional whole life policies and may work if you fully understand how they work, or have savvy advisers who know how to weave into your overall protection and investment strategies.

However, my take is that, more often than not, insurance protection and investment should be kept separate.

Some feel that Financial Education is rather important. To a certain extent yes, but it takes some upfront time cost to be invested to build up this body of knowledge to think critically on this.

Many felt that its too much work and they are disinterested in it. If that is the case, you can always purchase the products and hope that in the future things will work out. When they don’t, we have to live with the consequences of not investing enough effort, or not engaging the right advisers to help us make the fundamentally sound decision.

For those who are willing to take it up to empower themselves and make their own evaluations, you can compare and review protection, savings and retirement plans at DIY Insurance, where you get 30% rebate off the commissions for plans purchase through the platform.

** This post is sponsored by Providend, Singapore’s Fee Based Retirement Planners and Investment Managers **