26 smart money
THE BUSINESS TIMES WEEKEND SATURDAY/SUNDAY, MAY 25-26, 2013
The ins and outs of endowment plans
Some policyholders have been disappointed by their maturity values. Here are some things you should watch out for.
By Genevieve Cua
gen@sph.com.sg
AN insurance endowment plan is likely to be one of the
first things that comes to mind when one wishes to embark on a medium- or long-term savings plan.
Endowments are widely seen as an efficient form of
savings. You may put it on an auto-payment plan so that
you don’t run the risk of any lapse in payment. You need
not fret about what assets to invest in, and it appears to
have little volatility.
Yet for some policyholders, endowment plans have
disappointed in terms of their maturity values, causing a
shortfall in their savings objectives. What can typically go
wrong, and what should you watch out for?
Endowments are a type of bundled insurance product
offering savings plus protection. They are a staple in
Singapore’s insurance market. They are typically
marketed to parents with young children as a form of
savings for future university fees.
There are two broad types of endowments: “participating” and “non-participating”. A participating or par plan
is a “with-profits” type of insurance plan where premiums are pooled together by the insurer and collectively
invested to achieve a rate of return.
A non-par plan is designed to pay fixed or guaranteed
benefits. The insurer typically will invest the premiums
in bonds whose maturity profile matches that required
by the policy. The funds are managed on a segregated basis – that is, the funds are not co-mingled with the participating life fund. Non-par endowment returns are typically lower than those of par endowments.
What you should know:
Understanding bonuses
With par endowment plans, there are two components
to the return: guaranteed and non-guaranteed. The
non-guaranteed portion of returns is expressed in terms
of bonuses. Sometimes a plan can also feature cash dividends, although a bonus structure is the most common.
A plan may have an annual or “reversionary” bonus,
as well as a terminal (TB) or maturity bonus. As the name
suggests, an annual bonus is accrued annually. The maturity bonus is typically a one-off bonus in the final year of
the policy. It is typically expressed as a percentage of the
accumulated annual bonus to date.
Some insurers may also give a one-off “performance”
bonus which is paid when the policy matures or is surrendered, or when a claim is made.
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In par policies, returns are “smoothed”. This means
that in a good year, the insurer may choose to pay out its
normal bonus rate and retain more surpluses. In a poor
year, it may distribute more of the retained surplus as bonuses to maintain the bonus rate. The effect is a fairly
smooth rate of return, which masks any volatility that the
life fund may experience.
Under the Insurance Act, shareholders receive up to a
tenth of the bonus allocation, and policyholders get up
to 90 per cent.
What you should always keep in mind is the nonguaranteed nature of the bonuses. In fact, over the last
two decades, policies’ bonus rates have steadily declined. While a number of factors may affect bonuses
such as unexpectedly large claims including death
claims, the largest factor is the fund’s investment experience.
The bulk of insurance monies is invested in fixed income assets where yields have steadily fallen. Yet another challenge is that the bond market may not offer maturities that match insurance policies’ maturities. This
means that insurance funds often incur re-investment
risk and have to re-invest their funds at steadily lower
yields.
Even equity returns expectations have become more
muted compared to 10 to 20 years ago. Life funds’ equity
allocation tends to vary between 10 and 30 per cent. Equities are typically expected to provide the kicker to
long-term portfolio returns, hence enabling insurers to
quote fairly generous maturity bonuses. But in recent
years, for older generations of policies, TBs have been
substantially cut.
In short, insurers may cut bonus rates and this typically happens for the cohort of policies whose previously
quoted rates of return at inception have become unsustainable because of increasingly depressed yields. Insurers do try, however, to avoid cutting rates as this causes
disappointment among policyholders. Instead, newer
policies are quoted with lower rates of return.
Projected investment rate of return
All with-profits BIs carry two projected investment rates
of return: 5.25 and 3.75 per cent. The Life Insurance Association (LIA) sets an upper limit to projections at 5.25 per
cent, and insurers have to present a second scenario
1.5 percentage points below the maximum projection.
The cap is currently under review and may be adjusted.
The rates represent what insurers’ life funds are expected to achieve, net of the life funds’ investment expenses. The BIs carry two rates to show policyholders
that volatility can occur and there can be a range of outcomes. As LIA says in its guidelines, the rates are only for
illustration and do not represent the upper or lower limits achievable by the life fund.
But what you should note – and this is very important
– is that you should not think that your own policy actually earns 3.75 or 5.25 per cent.
To get a sense of your policy’s net rate of return, you
have to net out policy expenses such as mortality costs,
management expenses, and distribution costs which include commissions and other costs.
Older BIs used to have a section to spell out the “reduction in yield” (RIY). This explicitly shows the net return to the policyholder assuming that the life fund
achieves 3.75 or 5.25 per cent. You’ll find that the actual
net rate of return is significantly lower. For a 3.75 per
cent assumed return on a 20-year policy, the net return
may be less than 1.5 per cent. For 5.25 per cent, the net
annualised return for the policyholder could be less than
3 per cent.
For some shorter endowments, net returns may be
even lower. On a 10-year plan seen by this writer, using a
financial calculator, the net return to the policyholder
was just 0.2 per cent for the 3.75 per cent assumed return. For the 5.25 per cent column, the net annualised return was 1.8 per cent. The policy was incepted in 2011.
Of four BIs perused by this writer from different insurers, only one firm spells out the RIY – and it does so
based on the two headline rates of return of 3.75 and
5.25 per cent. The RIY ceased to be part of most BIs since
2008. Prior to 2008, it was quoted based on a single assumed rate of return.
The RIY is arguably one of the most important pieces
of information as it illustrates the total expense ratio of
the policy. It also helps to you to compare projected returns among insurers as expense ratios can vary significantly. And, particularly if the death benefit is minimal,
you are able to compare the policy net returns against
other investment options such as a balanced fund or a
portfolio of bonds. If your BI does not spell out the RIYs,
do ask your agent to calculate it for you.
Flexible withdrawals
Most plans are designed to give policyholders the flexibility of making some withdrawals, which may be called a
coupon or cashback. This type of policy is traditionally
called the anticipated endowment. Today, the withdrawal feature is built into the endowment plan. In the past,
withdrawals could only be made at three-year intervals;
today, you can make withdrawals as frequently as annually.
Typically, you can withdraw 5 per cent of the death
benefit annually. The total withdrawal over the life of the
plan may be up to 120 per cent. If you choose not to withdraw, the coupons or cashback is then deposited with
the insurer at a certain interest rate. The rate is not guaranteed and may be cut.
Do take note of these two points: One, there is a potential here for misunderstanding and mis-selling. This is because the cashback is sometimes mis-represented as a return on your capital. This is wrong. As mentioned earlier,
the coupon or cashback is actually a portion of the death
benefit.
Two, when you make withdrawals, you affect the policy’s rate of return and defeat the purpose of savings in
the first place. If you withdraw every year, the final maturity value will of course drop and the net rate of return
based on the lower maturity value will be negative.
Deductions
All BIs will reflect a table of deductions. Under the respective projected rates of return, you’ll see a column, “Value
of premiums paid to date”. This reflects the assumption
that you are able to invest the premiums without incurring any expenses and earn the headline rate of return.
Another column shows “Effect of deductions to date”.
This shows the accumulated value of expenses such as
the cost of insurance, distribution costs, surrender
charge, and expected transfers to shareholders. The difference between the two columns is reflected in the “surrender value” column, which represents what you will receive should you choose to terminate your policy before
maturity.
You will find that on most policies, there is no surrender value in the first year. The breakeven point of the policy – the point at which you recover your premiums
should you surrender – is also typically very long. On a
25-year policy, the breakeven point assuming a 3.75 per
cent return may be some time after the 20th year. Assuming a 5.25 per cent return, you may break even some time
after the 15th year.
The BI will also show you “total distribution costs” ,
which includes commissions and overrides paid to the
adviser. On a long-term policy of 20 or 25 years, all distribution costs may be paid out by the sixth year.
Asset allocation and insurer’s track record
Life funds are invested in market assets. It is a mistake to
assume that because your returns are smoothed, the
fund does not experience volatility. Life funds are typically invested in a very diversified manner. The bulk is invested in fixed income assets to provide a stable profile
of returns. A relatively modest portion is invested in equities, usually less than 30 per cent. Other assets may include real estate and loans.
Every year, you will receive an annual bonus update
which will show you the bonus that your policy has accrued. You will also receive a par fund update which
gives a snapshot of the insurer’s life fund performance.
The update will tell you the asset allocation and returns
over one year and the past three years. There may also be
commentary on the experience of the past year and the
near term outlook. Some insurers also include top five or
10 holdings.
What all this shows is that by investing in an endowment, you are buying into the insurer’s asset allocation.
If you have a horizon of 20 or 25 years for your savings
plan, you may want to consider investing in funds where
you can control the asset allocation. While endowments
are seen as instruments that allow you to sleep at night
because of their apparently low volatility, they are not
without risk to your savings goals especially if the insurer
cuts bonuses substantially. Net returns may also not
keep pace with inflation.
smart money 27
THE BUSINESS TIMES WEEKEND SATURDAY/SUNDAY, MAY 25-26, 2013
Benefit illustration
Highlights to watch for
Basic sum insured: $20,000
Annual basic premium: $1,662.56
Term: 25 years
Male, non-smoker
Age last birthday: 25
END OF
POLICY
YEAR/
AGE
TOTAL BASIC
PREMIUMS
PAID
TO-DATE ($)
GUARANTEED
($)
1/26
2/27
3/28
4/29
5/30
20/45
25/50
1,663
3,325
4,988
6,650
8,313
33,251
41,564
20,000
21,000
22,000
23,000
24,000
39,000
43,000
END OF
POLICY
YEAR/
AGE
TOTAL BASIC
PREMIUMS
PAID
TO-DATE ($)
GUARANTEED
($)
1/26
2/27
3/28
4/29
5/30
20/45
1,663
3,325
4,988
6,650
8,313
33,251
0
1,000
2,228
3,251
4,275
19,217
0
0
288
465
693
10,863
25/50
41,564
24,000
25,605
DEATH BENEFIT
PROJECTED AT 3.75% INVESTMENT RETURN
NON-GUARANTEED ($)
TOTAL ($)
340
686
1,057
1,455
1,880
16,510
25,605
PROJECTED AT 5.25% INVESTMENT RETURN
NON-GUARANTEED ($)
TOTAL ($)
20,340
21,686
23,057
24,455
25,880
55,510
68,605
A
400
808
1,259
1,755
2,297
22,713
36,113
20,400
21,808
23,259
24,755
26,297
61,713
79,113
SURRENDER VALUE
PROJECTED AT 3.75% INVESTMENT RETURN
NON-GUARANTEED ($)
TOTAL ($)
PROJECTED AT 5.25% INVESTMENT RETURN
NON-GUARANTEED ($)
TOTAL ($)
0
1,000
2,515
3,716
4,968
30,080 B
0
0
351
585
891
15,869
0
1,000
2,579
3,836
5,166
35,086
36,113
60,113
MATURITY VALUE
49,605 C
Table of deductions
END OF
POLICY
YEAR/AGE
TOTAL BASIC
PREMIUMS
PAID
TO-DATE ($)
1/26
2/27
3/28
4/29
5/30
20/45
25/50
PROJECTED AT 3.75% INVESTMENT RETURN
VALUE OF BASIC
EFFECT OF
TOTAL
PREMIUM PAID
DEDUCTION
SURRENDER
TO-DATE ($)
TO DATE ($)
VALUE ($)
1,663
3,325
4,988
6,650
8,313
33,251
41,564
1,725
3,515
5,371
7,298
9,296
50,052
69,464
1,725
2,515
2,856
3,581
4,328
19,972
19,859
0
1,000
2,515
3,716
4,968
30,080
49,605 D
PROJECTED AT 5.25% INVESTMENT RETURN
VALUE OF BASIC
EFFECT OF
TOTAL
PREMIUM PAID
DEDUCTION
SURRENDER
TO-DATE ($)
TO DATE ($)
VALUE ($)
1,750
3,592
5,530
7,570
9,717
59,413
86,452
1,750
2,592
2,951
3,734
4,551
24,327
26,339
0
1,000
2,579
3,836
5,166
35,086
60,113
Compiled by BT
Total distribution cost
END OF POLICY
YEAR/AGE
TOTAL BASIC PREMIUM
PAID TO-DATE ($)
TOTAL DISTRIBUTION
COST TO-DATE ($)
1/26
2/27
3/28
4/29
5/30
6/31
20/45
25/50
1,663
3,325
4,988
6,650
8,313
9,975
33,251
41,564
1,617
2,075
2,258
2,349
2,441
2,532
2,532
2,532
E
‘
By investing in an
endowment, you are
buying into the
insurer’s asset
allocation.
Understanding the benefit illustration
A: Death benefit numbers.What this part of the BI shows is
that the value of the death benefit is progressively enhanced
by a non-guaranteed component.
Reading the data: By Year 25. the non-guaranteed portion
of the DB – assuming 3.75 per cent return – would come to
$25,605.
B: Surrender values. SVs have guaranteed and non-guaranteed portions. There is usually no SV in the first year or two.
Reading the data: By Year 20, the policyholder has paid
$33,251 in premiums. Assuming a 3.75 rate of return, his total SV – the sum of guaranteed and non-guaranteed returns
– will be $30,080. Should he choose to surrender at this
stage, he still does not break even on premium payments. If
there is a bonus cut, the projected SV may be lower.
C: Maturity value. This is the long-term goal. Again it comprises guaranteed and non-guaranteed portions.
Reading the data: By year 25, the total maturity value is
projected at $49,605 assuming a 3.75 per cent return. The
non-guaranteed portion of $25,605 makes up roughly half
’
the total maturity value.
D: Table of Deductions. This shows the magnitude of expenses and how that affects the SV. Expenses include distribution
and insurance costs, surrender charge and other expenses.
Reading the data: By year 25, the policyholder would
have paid total basic premiums of $41,564. The “Value of premiums paid’’ assumes that the premiums earn a rate of return without costs. Assuming a 3.75 per cent return, the total
premiums would grow to a value of $69,464. The column “Effect of deductions to date’’ represents total expenses on the
policy, which comes to $19,859. This would reduce the total
SV and maturity value to $49,605.
E: Total distribution costs. This section reflects each year’s
distribution costs without interest. Costs include commissions and costs of benefits and services.
Reading the data: The largest deduction for distribution
costs – in this case 63 per cent – occurs in Year 1. By Year 6,
all distribution costs are accounted for and there are no
more deductions in subsequent years.
Why you want
it, how to go
about it, and a
Fair assessment
BEFORE you make a commitment, here are a
few things to think about.
What are your objectives? An endowment
sets out to satisfy the twin objectives of
protection and savings. The protection value is
often relatively modest. Yet it still incurs a cost
and adds to the policy’s total expense ratio. If
your objective is purely to save towards a
long-term objective, you can consider putting
money aside in a diversified portfolio of stocks
and bonds. Make sure to commit to regular
investment, which helps to ride out volatility
and harness the power of compounding.
Consider term assurance for protection.
Cash flow. You should be able to afford
premium payments well into the future. In a
cash crunch, there are a few options. You can
opt for a policy loan or take a premium
holiday. These options carry costs. There are
also parties that can buy over your policy and
on-sell it to investors, turning it into a traded
or resale endowment policy. This option may
pay you a higher value than the insurer’s
surrender value.
Diversify. Many endowment policies’
return profile is just slightly better than a
long-term Singapore government bond.
Returns may disappoint due to bonus cuts,
and fail to beat inflation. It is prudent to
diversify into growth assets for your savings.
Shop around. Some insurers may offer
more attractive net rates of return – that is,
you could benefit with substantially lower total
expense ratios. For this, you will need to
compare each policy’s “reduction in yield”
which reflects the net rate of return after all
policy expenses. Insurers will also differ in
terms of their track record in bonus cuts.
Changes in the offing. Following the
Financial Advisory Industry Review (Fair),
some changes are in the offing in terms of
disclosure as well as remuneration structure
for insurance advisers.
The Fair report, for instance, recommends
that the benefit illustration and product
summary should highlight factors such as the
non-guaranteed nature of the illustrative rates
of return.
Insurers may also have to state the average
expense ratio of the par fund over the past
three years, reflecting management,
distribution and other expenses. On
remuneration, there may be a redistribution of
commission payouts, setting a lower cap on
the first year payout. – Genevieve Cua
This column on financial products
is sponsored by MoneySENSE,
a national financial education
programme in Singapore. Find out
more about other common financial
products at www.moneysense.gov.sg