Over the past couple of years, we have been regularly writing about Investment Linked Policies. Our position on Investment-Linked Policies (ILPs) has always been very clear.
If you are serious enough to want to take charge of your own personal finance, or interested enough to be reading this article, then chances are, you don’t need an ILP.
Following our most recent article on 5 reasons why Singaporeans are still buying ILPs today, we receive questions from some readers about what they should do if they have already bought an ILP. Would it better to continue, or to surrender the policy?
Sunk Cost Fallacy
Sunk cost fallacy refers to how people are not willing to give up on an investment just because of what they have already spent on the investment (i.e. the sunk cost).
Think of it from a business perspective. Imagine if a company spent $10 million dollars building a factory overseas. However, business didn’t go as planned.
To keep the factory operating, the company has to spend $200,000 each month while only recuperating half of it in revenue, thus sustaining a further loss of $100,000 each month.
A sound business decision at this point could be to close the factory, and perhaps salvage back the equipment, which are still worth $2 million. Sunk cost fallacy comes into play when a company is not willing to close down the factory not because it believes that a turnaround is right around the corner, but simply because it does not want to realize the $8 million loss on its investment.
Overcoming Sunk Cost Fallacy In ILPs
The same logic applies to ILPs. Many times, people are not willing to give up their ILPs because they do not want to terminate it at a loss. Instead, they continue paying their monthly premiums, hoping they can breakeven with it in the future.
They fall into the trap of sunk cost fallacy. They continue investing because of what they had previously put in, instead of investing because of the returns they expect to get.
It’s similar to getting a bad hand for poker, and still playing, not because you are confident you can win the round, but because you already committed too much to the pot, and think it’s too late to exit. The outcome most of the time? You end up losing more.
How Should You Assess Whether Or Not To Continue Your ILP?
Here is a real life scenario based on an ILP plan that one of our readers has kindly shared with us.
ILP Monthly Premiums
|Premiums That Actually Get Invested Each Month||$310|
|Premiums That Are Used For Insurance||$178|
Despite paying $488 a month, our reader is only investing $310, with the remaining amount used for insurance premiums (more on that later).
Our reader has been paying the premiums since December 2009.
|Total Premium Paid To Date (Since Dec 2009)||$40,504|
|Total Premiums Invested||$25,730|
|Current Surrender Value||$26,207|
|Net Estimated Return Per Annum||0.6%|
Pretty depressing huh…
The numbers look pretty bad so we probe a little further into the investments our reader made. He was forthcoming enough to share the details of the 2 funds that he had invested in.
|Type Of Fund||5-Year Annual Return||Benchmark|
|Asian American (equities and bonds)||1.8%||5.4%|
|China India (equities)||0.7%||3.7%|
Actual returns from the two funds were really that bad. Both the funds significantly underperformed against their respective benchmark. Average return to our reader was 1.2% per annum, before further transection cost.
Read Also: The Ugly Truths Of ILPs
The Big Question – Are You Better Off By Yourself?
Our reader may have paid a total premium $40,504 since 2009. However, it’s important to bear in mind that only $25,730 were invested, with the rest used for insurances.
If he terminates his plan today, he would receive $26,207 that he can choose to reinvest elsewhere. He will also have an extra $310 each month to invest. If he simply invests all these money and generate a return of 4% per annum, he would have about $168,000 in 20 years time.
If he sticks to his current plan, he would have to continue paying the same premiums each month, and hope that the funds he is investing in would fare better than it had over the past 5 years.
The purpose of this illustration isn’t for us to incite a witch-hunt to find out what these bad funds are, and to encourage people to pull their money out, and to put it into good funds instead. Nobody can predict the future. Today’s best performer may become the worst performer next year, and vice versa.
Rather, the point here is to remind people that if you have an ILP, and are considering pulling out, you need to know what the other investing options are. There is no point in pulling out of your ILP just because it is not faring well, only to realize that you have no other plans in mind.
A 2% return from an ILP would look bad if you can get a 5% return elsewhere. The same return would be great, if the alternative is to keep the money in your saving accounts, and to end up spending it for a holiday.
Before you pull out, ask yourself what you intend to do with the surrender value you get, and the future premiums that you can now use at your discretion
Find Out What Health Insurances Are Tagged To Your ILP
There is a good chance that your ILP may be providing you with insurance coverage. Go find out what these coverages are. You do not want to cancel your ILP, only to realize that you have also cancelled your insurance coverage at the same time.
In the case of our reader, he has an early stage critical illness and a disability income insurance that is tied to his ILP. If he intends to cancel his ILP, he should first decide if this coverage is still important to him.
If it is, then he should get himself covered first, before terminating his existing ILP. This ensures that his health insurance needs are not compromised by the termination of his ILP.
Generally speaking, we advocate for people to keep their investment and insurance needs separated, as it would be simpler to manage.
To end off, the question of whether or not you should cancel your ILP really boils down to what other better plans you have, and what you intend to do with the extra money that you have. To get a full picture of your options, you should talk to multiple agents to seek various viewpoints, as well as some financially savvy friends whom you can trust to give you independent advice.
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