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Don’t Buy Investment-Linked Policies (ILP) for the Right Reasons (Not just based on reasons your friends also cannot explain well).

If my memory serves me well, I don’t think I have written anything specifically about investment-linked policy or ILPs for short, on Investment Moats before.

I guess it is not because I am disinterested in it, and it is more because I think it is a policy structure that is more complex, and I need more time to digest and understand it better.

But I have noticed that for the past few years, I have been seeing this comment in the social space more and more:

“Hi all, I think I might have made a mistake. I met up with my financial adviser. He/she recommends this {insert the name of a fancy ILP}. I decide to invest $XXXX of my monthly income into it.”

“When I talk to my friend, my friend says that ILP is shit and that I made a grave mistake.”

“Now, should I cancel and surrender my ILP? What should I do?”

The comments may be in a different form, but the general idea is someone panicked after some friend made them feel like they just bought a one-way ticket to level 6 in hell.

This Reddit post was shared internally:

I dunno man. I wonder if the friends of these people are scaring them so much that these folks will make rash decisions to the detriment of their wealth.

I have a more balanced view, but I don’t think many should invest in something with an ILP structure. Let me try to lay out some of my thoughts.

ILPs have come a long way…

I am quite sure many who dissuade their friends from investing in ILP are parroting the “hearsay” or the narrative they heard online about ILPs reputation.

I wonder how many can differentiate the different kinds of ILP structures.

Investment-linked policy is basically a structure created by insurance companies to achieve a certain financial planning purpose. This can be different types of protection.

Investment funds such as unit trusts are the type of securities to fulfil the financial planning goals. ILP differs from other cash-value policies in that the value of the policy is driven less by the direct investments of insurance companies, but more of the fund manager.

In the past, ILP was marketed or sold as a flexible structure to fulfil a combination of your protection and wealth-building needs. The sum assure is a combination of the market value of the underlying investment funds and death benefit from term riders.

But nowadays, these plans are less common.

The ILPs today are more investment wrappers. They are known as 101 ILP. 101 is closely connected to the degree of maximum coverage of these plans, which is 101% of the policy value. Sometimes, the death benefit is 105% of the policy value.

The policy is less boosted by term policies but solely based on the investment fund’s value. So the financial planning objective of the ILP of today is mainly for wealth-building purposes.

With that the line item of fees is also different from the past.

Let us say that some portfolios are named as ILP that have Roboadvisers-like fee structure. If you are okay with recommending your friend to invest in a Roboadviser, why are you making so much noise with your friends to invest in an ILP?

An ILP Structure is how an Adviser and his Partners are Renumerated, just like other Compensation Structures.

Through an ILP structure, the insurance company, the advisory firm and then the adviser get paid.

I had coffee with a prospect who didn’t come on board a few months ago.

He told me about the three advisers he was considering putting his money with. These three advisers, one of which is our firm’s adviser, proposed three different advise structure to him. The one that surprised him the most was an adviser who could take on his case for an upfront planning fee with no recurring advisory fee.

Not having any recurring, ongoing fees charged sounded too good to be true until later on, he shared the adviser recommended him to invest in FundSmith through a certain ILP.

As I reflect upon this, the adviser already gets paid through the ILP structure, and this is why the adviser do not need to get paid a recurring advisory fee because the ILP contains a different remuneration structure that keeps him/her well compensated already.

The wealth advisory firm where I work uses an upfront and recurring fee structure, while an adviser on an ILP gets renumerated mainly upfront.

If you wish your adviser to have your best interest throughout your investment journey, a recurring fee structure is more equitable. If the adviser do not deliver good advise, you can cut off the renumeration. If you pay so much upfront, then what is the adviser’s motivation to help you if there isn’t any financial repercussions?

Ultimately, if you say ILPs are costly, I wonder what are you comparing the ILP against? Is it a fee-only adviser or a plain stock-broker?

Each of those three offer different price but the breath and depth of what they can do for you is also different.

I Wonder How Many NaySayers of ILP Really Know What They are Talking About…

I think most of those folks who say that ILPs are costly are just parroting based on some articles, or some narrative mentioned in the media.

In those discussions, I tried to see if anyone can tell me specifically what makes the structure costly. Most of the time, I cannot find any.

If not, they say it is costly based on incorrect reasoning.

I roughly know why this is the case.

These ILPs have a set of costs and benefits that is complex enough that few people can make sense of the net result!

Typically, an ILP has

  1. Some bonus units given upfront or if you stay invested long enough. These are positive cash inflow boosts.
  2. Some limited-period costs and recurring costs as you keep the policy running. These are negative cash outflows.

Here are the general cash flow considerations:

  1. Initial Charge – Negative cash flow
  2. Policy Charge – Negative cash flow
  3. Initial Bonus units – Positive cash flow
  4. Loyalty Bonus units – Positive cash flow
  5. Additional Bonus units – Positive cash flow

I did not include the underlying fund’s total expense ratio or management fee under this set of considerations because I don’t consider that part of the structure. If you say that the funds in ILP are high-cost, I only need to use index funds or Dimensional funds to break down that argument.

Already, some firms make a set of index funds available under the ILP structure. This means the underlying will have similar return outcomes to your equivalent DIY investments with Interactive Brokers. With the help of some providers, I don’t think we will have a problem using Dimensional funds within an ILP wrappers.

In order to see the net effect, you would need to build a cash flow model to see the net effect of these costs and benefits. I got so fed up with the arguments that I went ahead to build my own model to review the net effect of fees on performance returns.

The model allows us to compare the long-term return (in XIRR) for different ILP structures and also our advisory fee structure.

This is because the overall objective, be it an ILP or other structure is the long-term compounded returns.

A high fee structure will reduce the returns severely while a low fee structure will reduce the returns to a lesser degree.

I asked my colleague Mike to feed me a different set of ILPs so that I could put it through the model.

The result is:

  1. Some ILPs slightly reduce the long-term returns. The returns reduction is even less than our Providend fee structure.
  2. Some ILPs have the same effect as our Providend fee structure.
  3. Most ILPs reduce the long-term returns more than our Providend fee structure.

Which benefit enhances the returns the most? Which cost kills returns the most? If you have a strong argument that ILPs are very costly, then you should have the right answer.

In one ILP, they listed the long-term running cost if you stayed invested for 30-35 years. The cost per annum is closer to 0.30%. Can it be that low? It is stated explicitly in the benefits illustration, and I think these documents have to pass through some compliance before they can be shown to the public.

Better Reasons Not to Buy ILPs

Still, I would not recommend my friends buy any ILPs.

If you want to parrot and tell people why they should not buy ILPs, here are the reasons:

  1. The advisory structure does not give proportionate incentives to risk coach and advise you over the long term (30 years).
  2. The steep surrender costs lock you in, make it extremely difficult and costly to reallocate your capital when you make cash flow management mistakes, financial decision mistakes or when life changes.
  3. The cost structure is complex, while alternatives are available that have simpler cost structures. Why subject yourself to such a complex structure when you don’t need to?

I will elaborate on point number two.

Now… I don’t know how many people ask me, our advisers or others if they should surrender their ILPs. They could be asking for the right or wrong reasons, but the question is how much would they get back?

When you surrender an ILP, there is usually a surrender charge levied, equivalent to a large portion of the premiums paid.

Also, since most surrender charge is charged based on the initial units account, where your regular premiums AND initial bonus units are paid, you will also lose a large chunk of those initial bonus units.

The follow table is lifted from the benefits illustration of a certain ILP:

It shows us the surrender charge based on your contribution period, and the year you are considering to surrender.

Whichever contribution period, if you surrender within the first two years, you lose 100% of the amount in the initial units account, which likely is equal to the premiums paid and the initial bonus units. Whether the underlying funds made money or not, you will lose a chunk.

Given this kind of charge, it dissuades you from surrendering.

If you view it positively, they are forcing you to save. But in reality, if you made the wrong investment decision, would you still want to contribute to a fundamentally unsound investment?

Most likely not.

But you cannot easily reallocate your resources! There may be nothing much left for you to reallocate until the end of the policy contribution period.

When we are young (or even some that are older), we may not always make the right financial decision:

  1. We don’t need such a large monthly amount so we contribute a larger monthly sum to an ILP. Then we realize we got housing downpayment, renovation and furnishing soon. We need to save up for this short term goal but all our money is tied into this ILP.
  2. Many in their late twenties or early thirties began to take more control over their financial education. They eventually realize that the key to building wealth is to keep costs low and their ILP are very high cost. They regretted their decision to buy these ILP.

The high surrender charges and losing the initial bonus units severely punish financial late-bloomers.

Some viable investments can achieve better or at least the same returns without such lock-in. Robo-advisers and ETFs through a low-cost broker.

Why do you want to lock yourself in such that you are gravely punished if you make a financial decision-making mistake?

The costs of not being able to reallocate are more than any benefits of such lock-in.

What I find the Most Depressing About…

You know, what saps the most energy for me is that for the people that ask these ILP questions, or people who think they jumped into the wrong product… is that many of them never learn the true lesson why they got into this trouble in the first place.

For a few different reasons, they will not get themselves financially educated.

They just are less interested in putting one-time or a few time upfront effort to understand what are some of the fundamentally sound ways to build wealth, go deep enough to understand the matter so that they have a good investing basis not to be snooked again.

Because they are disinterested in putting in the effort, they will get into the same situation again and came back with similar questions.

Imagine if you do the same thing to your seniors at work.

Most likely, they will have a poor impression of you. They won’t just blame the clients or the vendors that you will deal with for getting the whole team in such a position.

They will wonder why do they hire you here if all you do is come to them with problems.

You will be out of the team in no time.

On a personal basis, you keep coming to us to “bail you out” because we are such a convenient avenue for financial advice.

Sometimes… this is an example of the consumers may really get what they are paying for.

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