When can Whole Life Insurance be better than Term Insurance?

The topic of buying Life Insurance popped into my mind again recently when the Straits Times covered a topic of how Insurance Product options have expanded online and how it can be purchased without the need of going through agents. So perhaps it is a good time to re-evaluate when Term Insurance is better; and when Life Insurance is better.

Previously, I did a short write up of the common types of Insurance shown which can be read here. Hence if you need a basic understanding of how Term and Life insurance works, you may read it before continuing this post.

The "Money Psychology" associated with Term and Whole Life Insurance

My conversations with others on the topic of Term and Life Insurance has unveiled an interesting observation. Many individuals do not consider the value of their Whole Life Insurance policy when calculating their net worth or for retirement. This is intuitive because you yourself will never get to see the sum of money since... oh well you know. Hence many people view life insurance as an expense, whose premiums unfortunately form a significant portion of their take home salary.

Conversely for Term Insurance, as the premiums paid is so much lower than that of a Whole Life, one is able to save more. Currently, the premiums for a term insurance is approximately s$150 per year for a $100,000 coverage, while the premium for whole life insurance is about s$2,200 yearly. This means a savings of about s$2,050 yearly. 

This is one of the reasons why you see a few bloggers possessing a 6 figure investment portfolio despite being in their late 20s or early 30s. It is simply due to the fact that they (we) use term insurance to insure ourselves instead of Whole Life (and also our high propensity to save ratio). As a result of this, society seems to think we are in a better position to retire early and better.

Let's show it mathematically through two individuals who plan to insure themselves for a $200,000 coverage - Mr T (who will utilize Term insurance) and Mr WL (who will use Whole Life). In a short span of 10 years, assuming a return of 4% earned on the difference, Mr. T will be ahead of Mr. WL by $49,225.
                              

Savings over 10 years at 4% Average Returns

To summarize, individuals do not view Whole Life Policies as part of their retirement fund despite the premiums paid being much higher than that of Term. On the other hand, those who purchased Term insurance are able to see the tangible difference by a faster rate of accumulation in their bank balance; and if they were to invest wisely this difference, they will have a higher net worth compared to individuals on Whole Life. This sums up the "money psychology".   

When can Whole Life Insurance be better than Term Insurance?

So the question beckons? When can Whole Life be better?

The answer boils down to the individual - i) when the individual is ill-disciplined in savings or ii) the individual is not very good in managing his money/savings.

Following from my above example, an individual will have an extra $4,100 yearly. He can either a) Save this amount or b) Spend it away. An individual who is indiscipline at saving or poor in managing his money will do exactly b); spending it away for present consumption and not saving for retirement.

Seen in this light, one will notice that Whole Life Insurance is in fact a form of "Forced Saving" scheme. This is because it takes a significant amount of your take home pay now, locks it away until the end of your life to help you benefit from the magic of compounding. Unfortunately, the downside is that you will not enjoy the maturity sum, only your beneficiary.

The Returns from Being Locked Away

So what do I mean by saying an individual is not good in managing his savings? Well it means not knowing how to put the money saved from term insurance into good use (returns). While Whole Life publishes that their projected returns are 4.75% etc, readers will know that the true returns for many such policies are approximately 4% per annum.

If an individual has the discipline and is able to make use of schemes such as POSB-invest saver or ETF to invest in a basket of  shares belonging to companies of credible financial strength, achieving a long term average of 4% is achievable and feasible.

Similarly, if an individual is terrible in investing such that he is always making negative returns annually, then Whole Life might be a better option of locking away his savings for accumulation. However, an altering of his psychology has to be done to come to the realization that the maturity sum from his whole life is part of his retirement plan. Alternatively, he can try to surrender his policy near his 70s to use the proceeds to fund his retirement. 

However surrendering a life policy is not the best option because it reduces the returns to the region of 2-3% per annum; which is pretty achievable if you had started by putting money in your CPF special account at the beginning (CPF SA provides 4% annual returns). 

Summary

If you lack the financial discipline to save or is an individual who is unable to control one's own expenditure, Whole Life may perhaps be a better option scenario. This is because it acts as a form of "Forced Savings" that locks away part of your income for the future. Similarly, if your savings is generating less than 2% interest per year, utilizing a Whole Life policy to help in retirement planning may be an option as well.

It is at this juncture, that I would suggest to tap on another form of forced savings - topping up into your CPF Special Account. This is because it earns a close to risk free 4% returns with the benefits of a one-time tax deductions. However, there is a cap to how much you can top up into your CPF-SA.

Related Link: http://investmoolah.blogspot.sg/2015/09/this-is-better-than-singapore-savings.html

Portfolio Update & Open Challenge to Insurance Companies

Portfolio Update

I have sold one of my main holdings in Fischer Tech at 0.90. It has been a wonderful company which I discovered two years back. While the wonderful management has remained, the outlook of the automotive industry Fischer is so dependent on has not. China automobile inventories are building up and this may lead to lower orders. 

While Fischer is debt free and will survive the downturn, the prospect of declining share price due to declining revenue is why I have opted to cash out.

My DIY Challenge

Readers will be aware of my love for the "buy term invest the rest" concept vis a vis the whole life products offered by insurance companies. Blogged here

To actualize it, I will be starting a hypothetical insurance. It will be a whole life plan where one pays the premiums for 20 years. The sum assured is $100,000 and annual premiums are $2153.60. $153.60 will be for a term coverage of $100,000, while $1000 will be each channeled into the SPDR STI ETF and CPF SA. CPF SA will act as the "bond component". For queries on what happens to money when it enters the CPF SA, please read here. (under "100% of what is saved equally into STI ETF and CPF")

Let's see how I will stand against the titans of the industry over the long run. For those who have just bought whole life policies, feel free to compare your returns against it. It can be found under my "Challenge" Tab. Results will be updated yearly as long as this blog lives.

Getting to know: Home Protection Scheme (HPS)

The Home Protection Scheme (HPS) is a mortgage-reducing term insurance which covers an individual’s liabilities on home loans in the event of death or permanent disability. Its premiums are affordable and is a government initiative. For every $100,000 coverage under HPS, the annual premium is about $76; that is cheaper than most term insurance.

Eligibility

Currently home owners making HDB loan repayments through CPF-OA have to be enrolled into HPS. Exemptions from HPS is allowed if one shows proof of other forms of insurance coverage. However, in my opinion, the HPS is the most affordable plan and it is difficult to find a similar plan at a lower dollar to coverage rate. It is good too for HDB owners servicing their home loan through a bank to consider the HPS.

Why it is important to learn about HPS

Often, financial planners may unwittingly advise to obtain more coverage (through whole life plans) on the pretext that you are now a home owner with a housing liability (home loan). As many may not be aware that they are covered under HPS, as the funding of premiums is through CPF savings, they may land up in a situation of being double covered - under HPS and a more expensive insurance plan recommended by the adviser. Hence knowing if you are covered under HPS reduces your insurance expense.

To summarise, the HPS covers an individual’s home liability loan. You have to be insured under HPS if the servicing of your housing loan is through CPF-OA, following this reasoning, one can safely presume many new HDB owners are in fact covered by HPS (I wonder how many are aware of this). Furthermore, HPS is one of the best dollar for coverage term insurance, being priced at approx. $76 per $100,000 coverage.

For majority of Singaporeans, it is important to be aware if we are covered by HPS before embarking on insurance planning. It ensures optimal planning and prevent us from falling prey to purchase seemingly more expensive private insurance. To know if you are covered under HPS, do check your CPF statements to see if an annual HPS premium is deducted from your CPF savings. Alternatively, feel free to email CPF to make an inquiry.

Has an entire generation been ill-advised on Financial Planning? (Part 2)

In the previous post, I have talked about the steps to create our own insurance which has an investment component comprising 60% “CPF bonds” and 40% “STI ETF”. For this post, I will touch how it generates a better return.

Projected returns

From the SPDR STI ETF’s track record, the annualised return is 7.11% as of end August 15. While for the “CPF bonds”, we have to assume under two scenarios: i) 4% returns or ii) 5% returns. This is because while the Singapore government guarantees 4% for the CPF SA, the first combined $60,000 yields an additional 1%. Also as some will purchase whole life when young (25 to 30), the voluntary contributions may result in “CPF bonds” that are likely to yield 5% instead of 4%.

Assume “4% CPF Bond return” scenario

The formula is simple where the weight of each asset class is multiplied by its returns and then added up to calculate the projected returns

Hence projected is 0.04*0.6 + 0.0711*0.4= 5.24%

However like most insurance products, despite the projected returns stated in the benefit illustrations (i.e. 4.75%), the actual returns we receive will be lower because of distribution cost.

Hence for the DIY plan, the annual projected returns is $1200*0.04+ $800*0.0711=$104.88

The returns in percentage will be $104.88/$2153.60= 4.87%

Assume “5% CPF Bond return”

The projected return will be 5.84% and actual returns will be 5.43%.

This return is higher than the bonus projections of any whole life!

While people may note after the age of 65, there is no longer term coverage. A reason for it is because after 65, you would have accumulated more than $100,000 in savings through CPF and STI ETF which can be withdrawn anytime. Furthermore, at the age of 65, it is likely there are no dependents/housing loan obligations. Therefore insurance for dependents is not required.

Back testing the strategy

Using the period of April 2002 (SPDR STI ETF’s inception) till now, and comparing between the returns of our DIY plan and whole life. The DIY plan has returned 5.24% annually. On the contrary, many whole life have difficulty meeting their projected returns [4.75% (from 2013) or 5.25%] stated on their benefit illustrations table. 

Conclusion

So there you have it, a replicated DIY insurance plan offering a matching/better returns. This was achieved mainly through investing in AAA rated sovereign CPF bonds yielding a 4-5% annual return and equity investing through STI ETF.

Furthermore, it’s worth noting should Jerome fall in financial hard times, he has the option of cashing out the STI ETF proceeds anytime. Similarly, he could cash out his “CPF bonds” anytime if he is above age 55. This is unlike whole life where if we are to surrender our policy, it results in a drastic reduction of our cash bonus returns (probably in the region of 1-3%).

I have provided the projected return of this plan below. Do note this plan assumes that the policy starts from age 27. You may compare it to the benefit illustration tables of insurance products you will receive in the future but just remember the starting age will be different.

Has an entire generation been ill-advised on Financial Planning? (Part 1)

Whole life insurance is a financial product which many of us own or are recommended by banks and financial planners. Recently, I came across a 15 year premium whole life product with a sum assured of $100,000. Its annual premium is in the region of $2,155. It got me thinking: Are there ways to obtain better returns, at lower risk but with the same amount of sum assured?

For whole life insurance, it is a combination of term insurance and an investment component. And while the benefit illustrations of this product states the projected returns are 4.75%, the actual return calculated from the table will be slightly lower, around 4.2% to 4.5%.

Creating the Common Man’s DIY Insurance

Jerome (age 27) decides to create his own product which replicates a similar 15 year premium whole life. To replicate the components of whole life, he does the following:

Term Insurance

Jerome buys the AVIVA NS Term which covers him for a sum assured of $100,000. The plan costs $153.60 per year (for public servants, you can use the POGIS which costs $60 per year for every $100,000 of sum assured).

Investment component

As mentioned, most insurance consist of an investment component where majority of funds are allocated for investments in different asset classes- bonds, stocks etc. This is to generate the projected returns.

Jerome mirrors this and creates a portfolio with two asset classes, bond and equities. He will put $800 in the STI ETF and $1200 into “CPF bonds”, to form 40% equity and 60% bond portfolio. To buy these “CPF bonds” for his bond component, Jerome does an annual voluntary contribution to his CPF SA. As the “CPF Bond” is backed by the Singapore government, his bond component is triple A rated of very low risk. The returns of these "CPF bonds" are guaranteed ( 4%/ 5% for the first $60,000 combined).

With only 40% of portfolio subjected to market risk, Jerome’s portfolio is far less risky than any insurance’s. You can read here about voluntary contribution to the CPF SA.

Total Premiums paid

The annual premium Jerome pays for his own DIY is $2,153.60

Premiums paid

It is worth noting, Jerome still has to pay premiums of his Aviva NS term insurance from the age of 42 to 65 unlike for a 15 year premium whole life. In my analysis, Jerome’s premiums are covered during this period for the following 2 reasons. Firstly, the NS Aviva term provides returns during good years (about 1-2 month premium is returned). Hence during good year, Jerome receives 1-2 month rebates which he invests into the SPDR STI ETF. Since inception in April 2002, this ETF has generated an annualised return of approximately 7.11% as of end August 2015. This includes the market rout witnessed during the past two months.

Secondly, as Jerome had been topping up $1,200 yearly into his CPF SA, he received a tax savings of $84 annually. Similarly, he invests the tax saving proceeds into a STI ETF (annualised 7.11% returns) and then start depleting it from age 42 to 65, hence covering his premiums. In fact, Jerome still has $2,352 leftover from this method after paying the premiums until 65.

So it seems our very own DIY product is viable and less risky. In my next post, I will explain how this plan generates a higher projected return. 

Click here to continue.

For Young Singaporeans, For Financial Freedom: Basic things to know about Insurance

Besides seeking to insure yourself before investing, young individuals (just starting out in their careers) may seek financial advisers to set up a retirement program. However, we will often be presented a few products which may seem complex and daunting due to the thick pages and jargon. Hence to help readers understand some of these common products, this article will seek to do a basic explanation and define how they work. As this article uses examples of death, I will like to warn of the post’s bluntness which may offend readers.

The Different Products

Term, whole and endowment are the most common products recommended by financial advisers for our retirement planning. So let me illustrate them with a simple matrix.

Product	Provides funds to dependents fordeath during coverage	Term of Coverage	Does it have an Investment component?	When are the investments paid?
Term	Yes	Typically 5 to 40 years	No	Not applicable
Whole	Yes	Entire Life	Yes	When you die
Endowment	Yes	Mature after a fixed period	Yes	At expiration of  policy

For term insurance, it is a plain insurance which covers you for the term of period opted. For example, if you purchase a term insurance to protect you until the age of 65, should you die on the day after your 65^th Birthday, you do not receive any pay-outs. However dying anytime from now till the age of 65, your dependents will get a “death pay-out”. In addition, it does not have an investment component.

In endowments, it is a combination of term insurance and an investment component. There is a maturity for endowment plans where you will receive a lump sum pay-out. For example, if I were to buy an endowment plan which matures in 20 years’ time; should I die within these 20 years, my dependents will receive a “death pay-out” and “cash bonus”. However should I live beyond the maturity; and because the investment component of my endowment will have accumulated a sum of money, I will only receive the amount of “cash bonus” at the end of maturity, and not the “death pay-out” amount.

Whole life is similar to endowment. The only difference is whole life does not have a maturity period and covers for your entire life. Hence once you die (you can’t live forever), your dependents will receive a “death pay-out” and “cash bonus”.

Lastly, I will like to highlight for both endowment and whole life, we may opt to surrender the policy anytime and receive a sum of cash bonus. However, this will result in us obtaining only a small sum, which is undesirable.

How does the investment component work?

Projected returns vs Actual returns

In our policy document, there is a benefit illustration table which informs us how much we will receive upon death. The death benefit is the sum of “death pay-out” plus “cash bonus”. In the benefit illustration page found in very policy, there is a guaranteed amount which is the death pay-out while the non-guaranteed portion is the “cash bonus” accumulated. You may wish to review these benefit illustration page in your policy.

In the benefit illustration table, the non-guaranteed amounts are projected to have returns of either 3.25% or 4.75%. Do note the 4.75% projection is not the actual annualised returns you will obtain. For whole life, the returns under a 4.75% projection will in fact yield you about 4.2% to 4.5%. This is because some of your premiums are used to pay for the product’s distribution cost etc.

In addition, Investment moats did a review of endowment plans in Singapore and found the actual annualised returns for endowments range from 2.7% to 4%, with one giving an exceptional 5.25% and another a negative 11.65% return. So one can safely assume endowment annualised returns are 2.7% to 4% which is below that of whole life. Investment moat's article can be found here.

Achieving the returns

So how are our premiums invested? The insurance company will have a fund who will seek to achieve the projected investment return stipulated in your policy while controlling the risks. The fund will do so through active management of a mix of asset classes. Below is a mocked up example of a fund’s asset allocation table.

These funds are in the wealth management industry and often have links to the insurance company. 

Which is the best?

The choice among these 3 financial products is hugely dependent on the financial circumstances of individual. And because this is unique across individuals, I am unable to give a broad stroke comment on what to choose. I can only say, due to my own financial circumstances, term insurance is my best option.

Insure yourself before Investing

Before investing, it is always important to insure yourself. This is because you are the most important asset with the ability to generate income. Therefore, it is vital we insure ourselves against unfortunate events which may render us unable to earn income, in turn deplete our savings.

Hence what are some of the insurances we should purchase at the various stages of our life cycle?

Studying Years (Infants to University Undergrads)

During this stage, the first thing to buy is a health insurance. This is because illnesses or accidents may strike us at any time and the medical cost to treat you can be costly. Should you be uninsured with a health insurance, the medical expenses may deplete your savings/investments and perhaps even your loved ones.

For Singaporeans, we will soon be covered under a health insurance scheme called the Medishield Life. It provides us a basic coverage for our medical expenses and should be sufficient. However, if we wish to have more coverage for hospital treatments due to illnesses/accidents or stay at a better ward, one may consider upgrading to the various health insurance policies provided by insurance companies. It will be good to get the best coverage for health insurance plans when one is young because the premiums are cheaper then. If it gets too costly when one is older, the coverage can be reduced to pay lesser premiums.

I will like to stress that health insurance is essential throughout all stages of our life.

As for life insurance, I will strongly advise against it at this stage of life. This is because the purpose of a life insurance is to bequeath a pay out to dependents that are reliant on your working income for their living expenses. Hence if you are a child, who is studying, it is unlikely you will have dependents and be without much earning power. To put it bluntly, there is no income loss should the child pass on and hence buying insurance to insure against such event is irrelevant.

Starting out at work

At this stage, a medical insurance will suffice. As for life insurance, you will have to assess if there are any dependents (e.g parent not working) that are now reliant on your working income. Often, there will be none during this stage of your life; hence life insurance is not needed yet.

Married Life /owning a home

At this stage, this is where other forms of insurance are needed. Upon owning a home, one should get insurance. This is because should you be permanently incapacitated or die prematurely before your housing loan is fully paid, your partner will be burdened with paying the outstanding housing loan amount alone. For HDB flat buyers, the government has a mortgage reducing insurance which protects against such events; it’s called the Home Protection Scheme (HPS) and can be funded by your CPF savings or cash.

In addition, with your spouse or child now part of your life, there are dependents reliant on your income for sustenance. Hence a life insurance policy is needed. Some common examples of life insurances are term, whole and endowment policies.

How much to cover?

There is no definite number because it depends on the expenses of your dependents. Generally, it will be good to be covered for 3 years of your working income, rounded up to the nearest $100,000. If your child is relatively young or you have many dependents, it may be wise to insure up to 7 years of working income. This is because the key purpose of having life insurance is to cover the living expenses of your dependent. Protection against liabilities such as housing loans should have been covered by the HPS or similar housing insurance.

Retirement Years

See “studying years” life stage. Furthermore, your child by then would be independent and have started working. No life insurance should be bought at this stage.

A Disclaimer when buying Insurance

While it is tempting to just sign on the dotted line to purchase insurance, one should read carefully the policy document that comes with it. This is because each policy may have different sets of exclusions and coverage. Some policies may not insure you for example, accidents arising from competitive racing or have conveyance limits. So please read these documents before signing.