A reader recently commented on an article we wrote which discussed about Investment-Linked Policies (ILPs), and why we are not fans of it.
Here’s the comment.
Question Asked – Some Pros Of ILPs That Were Not Mentioned
“I would like to point out two pros about ILP-life policy that were missed out in the article. Firstly, ILP is mainly an insurance product with a savings and investment portion to it. You could actually mimic ILP yourself by buying a term insurance policy and buying regularly in a basket of unit trusts.
So let’s compare the difference between the two. Sales charges for ILP are higher in the first 3 years, however that that is offset in the long run by higher allocation rates of up to 107% by the 10th year onwards.
In contrast, regular premiums into unit trust will always occur a fixed sales charge of 1% which means that your allocation rate is at 99% throughout. In a life insurance policy, say over a period of 40 years,
ILP will actually give higher returns than your term-unit trust combo because of the allocation rate difference. Let me give an example on this. John buys an ILP for $1200, which $200 goes for protection and $1000 for investment.
His return each year from the 10th year onward assuming that his investments made an average of 3% p.a would be 3% of total NAV + 7% of $1000. If John were to buy a term insurance ($200) and unit trusts ($1000), his return each year on the $1000 would average out to be 2.97% after paying for sales charges (1%).
Over the span of 40 years, it is clear that ILP will give a higher return of the two. At the age of 55 and above, if John feels that he do not need coverage anymore, he can choose to terminate the protection portion and convert his ILP into a full investment which gives a return of 3% total NAV + 7% of $1000 put in that year.
The second benefit of ILP as compared to a term and unit trust combo is that in an ILP, at different milestones in life, (marriage, first child, second child) you can increase your sum assured without any underwriting. This benefit does not extend to term insurance.”
Summary Of The Pointers Raised
(1) Reader (rightly) pointed out that an ILP, which comprises of insurance and investment, could be mimic by buying a term insurance policy and a basket of unit trust (i.e. mutual funds).
(2) User pointed out that while ILPs have lower allocation rates in the first few years, it is offset by higher allocation rates in the long run.
(3) Conclusion from reader at this point is that given the higher allocation rate for ILPs in the longer run, it’s likely that ILPs would give higher returns in the long run.
How Did The Calculation Work Out?
To keep the comparison simple, here are the assumptions we will be making. Most of the assumptions we are making will be based on what our reader have proposed.
An investor spends $14,400 per year ($1,200 a month) on his insurances and investments needs. He contributes an equal amount ($7,200) into two portfolios.
|Insurance expenditure||Investment Made||Total|
(Buys a term insurance, invest the rest in unit trusts)
(Buys an ILP)
|$1,200 (this is the amount allocated to insurance)||$6,000||$7,200|
As proposed by our reader, we will keep it simple and ignore the insurance charge as we are assuming the amount to be the same for both portfolios.
He makes a $6,000 investment annually into each portfolio. We will also assume an annual return of 3% for both portfolios.
Returns For Portfolio A
Portfolio B is harder to calculate since allocation rate into the investment is not equal throughout. For the first 3 years, allocations rates are much lower based on the product we are looking at.
What this basically means is that in the 1st year the policy is in effect, only 25% of our premiums will be invested. This subsequently increases as the years go by.
In addition, there is also a monthly policy fee of $5, or $60 per year.
Returns For Portfolio B
|3 Years (assuming average allocation of 55% for first 3 years)||$10,015|
|10 Years (assuming average allocation of 103% between 4 and 10 years)||$59,211|
|20 Years (assuming average allocation of 107% between 10 and 20 years)||$152,485|
|30 Years (assuming average allocation of 107% between 20 and 30 years)||$277,838|
|40 Years (assuming average allocation of 107% between 30 and 40 years)||$446,301|
Our Analysis – An ILP Still Under-performed
Despite the much higher allocation it enjoyed from its 4th year onwards, we were surprise that portfolio B (the ILP) still underperformed against portfolio A.
This is particularly unexpected since we have already assumed a 40 years investment timeline, which should have rewarded policyholders who have stick to the ILP for a long time.
Yet, it appears that the higher allocation rates in later years were still unable to cover for the reduction in allocation during the first three years. One of the contributing reasons for that is because of the monthly $5 policy fee.
There are other assumptions we have not taken into consideration. For example, our calculation for both portfolios did not include fund management expenses, which would significantly reduce the overall returns for both portfolio A and B. There may also be differences in the returns depending on whether you invest annually or monthly.
Our calculations are theoretical and for the purpose of addressing this specific question asked. It’s simplistic and we could be missing out on other hidden costs. It’s not to be used to make an investment decisions. If you need further advice, we suggest you speak to a trusted advisor.
We also did not discuss much about the other details pertaining to the pros and cons (mainly cons) of an ILP. If you are interested to find out more on this, you can read up more in the other articles that we have written.
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