Investment and insurance are the two things working adults should be concerned about, so a product that combines the two sounds exactly like what a prudent person needs, right? Not quite. Imagine buying a meal from your favourite fast food restaurant and it costs more than buying the burger, fries and drink separately. Doesn’t make sense? That’s basically what happens when you buy a regular premium investment-linked policy (ILP).
Double payment of fees
When you purchase a $1,000 per year policy, you incur fees mostly in form of distribution costs. These are charges that come out of your premium to pay your agent and their manager(s). Fair enough. When you invest $2,000 a year, you tend to pay sales charges or brokerage fees, and pay anywhere between 0.5 to 5%, depending on what exactly you’re investing in. That’s fair too.
When you buy a $3,000 annual premium ILP, as much as 80% to 90% of your first-year premium is used for distribution charges which are charges typical of an insurance policy. The remaining amount is used to buy investment units, which is subject to sales charges. Units are then sold off to pay for assurance charges (cost of insurance). This roundabout way of paying for assurance charges means that you incur sales charge typical of investments while paying for the cost of coverage.
The second year isn’t pretty too, with as much as 50% of your premium gone towards distribution cost. As with most long-term insurance plans, as much as two years of your premiums go towards distribution cost.
Essentially, you are paying for distribution costs and sales charges on your investment, and likewise for your insurance, rather than paying the typical cost for each.
The difference is stark when you compare it to someone who uses the $3,000 budget for a $1,000 term policy for $1,000 and invests $2,000. Assuming zero growth in the underlying investments, at the end of Year 1, the ILP has practically nothing, while the Term + Investment has $1,960 (subtracting a 2% sales charge). At the end of Year 2, we can expect the ILP to be around $1,500, while the Term + Investment has approximately $3,920.
Owing to the high upfront costs the ILP incurs, the difference is compounded over the long term and can snowball into a sizeable sum.
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High assurance charges at older ages
Almost every regular premium ILP is pegged to increasing assurance charges. Many people point to this as a flaw and disadvantage of ILP. This is problematic if one buys an ILP expecting whole of life coverage, because the exponential increase in assurance charges will make it untenable to keep the policy beyond one’s 60s or 70s.
To be fair, increasing assurance charges can be a good thing if you don’t intend to have coverage beyond a certain age. You pay less when you’re younger, and are thus able to optimise the time value of your money by diverting the savings towards investment during your younger years.
In an ILP, however, the time value advantage an increasing assurance charge affords you is wiped out by the high upfront costs we have discussed about earlier, so you end up having high costs at the start of the policy, and high costs after a certain age. Kind of the worst of both worlds, and if you do like increasing assurance charges, you can always buy an increasing term policy and invest the rest.
Agents peddling ILPs may point out features like “premium holidays”, but they are by and large pretty gimmicky. It’s like the toy they give with happy meals: of little value, and not something you really need nor want anyway.
A premium holiday works by liquidating your investment units in the ILP to pay for the assurance charges, so you won’t have to pay for your premium.
The same can be done when you buy a term policy and invest separately. Simply stop your regular investment if cashflow gets tight, and unlike insurance policies, most investments allow you to stop adding new funds whenever you decide. If you wish, you could also start liquidating your investments to pay your term premiums. There you have it, premium holiday.
Greater flexibility in investments
When you purchase an ILP, your choice of investments are restricted to the insurers’ offerings of funds. As a result, they also tend to be less competitive when it comes to the sales charges and fees they impose. You can easily find similar investments at lower cost, especially given how many roboadvisers and cheap investment products there are now in the market.
ILPs aren’t necessarily bad because they are ILPs, but the ones in the market now have unreasonable fee structures. I have always thought – and hoped – that a more reasonably priced ILP would be launched; something that charged distribution costs only on the cost of coverage, and sales charge rightfully on just the invested amounts.
Unfortunately, a quick calculation tells me that this wouldn’t be quite commercially viable; the agent would be paid even less than if he/she sold a term policy. Good luck getting something like that out into the market.
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