A friend who hasn’t talked to you in years hits you up for coffee, and surprise! They want to sell you insurance. Don’t worry it’s more to help you earn money, they might add, as they start to ask which bank you deposit your money in and whether you know about the poor interest rates given.
This dear friend, really, really wants to help you grow your wealth, and I don’t doubt their sincerity (then again some of them are really dodgy) because most insurance agents and self-styled financial consultants themselves don’t understand fully what they’re selling nor know any better way to grow their own wealth. Aside from the fat commission they get by selling such plans of course.
But here’s why you shouldn’t commit yourself to a long-term insurance savings product.
What are such plans?
Such plans go by many names, such as “retirement plans” or “education plans”, and come in different tenures from 5 to 25 years or even up till age 80. Most follow the same structure of having you pay (or they would like to say – save) a premium regularly, and you will receive a lump sum payout when the plan matures, or provide income for your retirement.
When you see their benefit illustrations (if the agent sends them to you at all), they typically have two columns of projections at 3.25 and 4.75% pa.
Here are some reasons why they’re a bad idea for most young working adults:
High upfront commissions
Here’s a fun question I always ask people when they want to buy a savings plan – how much of your first-year savings go to your agent as commission?
20%? Nope. 40%? Go higher. Surely it can’t be more than half?
Try 100%. For plans that are some 20 years or longer, all of your first-year “savings” are paid to your agent, your agent’s manager, and sometimes your agent’s manager’s manager as commissions and bonuses.
Over the next few years, as much as another year of premium is paid as such, which means you are giving up as much as two years of “savings” as commissions. I hope you like your friend a lot, because he/she will like you better. At least until the sale is complete and the free-look period is over.
Overly conservative portfolio greatly reduces your potential returns
The bonkers commissions aside, another major reason why such plans are a bad idea because the underlying investment assets are overly conservative for an investment horizon of decades.
Such plans are invested in the insurer’s Participating Fund, and such funds usually have at most 30% in equities with the remaining 70% in safer assets like bonds and other lower-risk asset classes. If you are setting aside money for the long term, this is simply too conservative which greatly limits your returns.
The Rule of 100 states that you should subtract your age from 100, and the resulting number should be your percentage exposure to equities. Hit the big 30 this year? Put at least 70% of your investible savings into equities. Some even think that the number should be closer to 120, and you can always use 80 if you are a more risk-conservative person.
Equities may be riskier and volatile in the short-term, but it is the smarter choice if you have a long time horizon
Poor risk-adjusted returns
Now some may say that they are indeed conservative and fearful of losses, which is why they are attracted to the safe nature of such plans which offer guaranteed values.
Even if you fall under this category of people, you must recognise that there is still risk when you commit to a plan like this since the underlying assets are after all still exposed to investment risk.
There is no stopping you from undertaking similar investment risk by getting an investment portfolio with 30% equity exposure with the rest in safer asset classes, and this is easy to do with ETFs and unit trusts. Or simply pay someone a few hundred dollars to set it up for you – a way cheaper endeavour than the hidden cost you incur through commissions.
In the long run, you will come up ahead of buying the savings plan because you did not incur a mind-boggling high amount of cost by contributing 2 years of your savings to line your agent’s pockets.
And the risk level is similar. Those guaranteed amounts the insurer promises you? You get them from the same place the insurer gets it – the 70% in safe asset classes like bonds is the reason why the insurer is confident to guarantee a certain level of returns in the long run.
Pay up or else
On the topic of risks, such plans have risks that other forms of investment usually don’t – pay you premiums or your plan will lapse, or go into a state where you have to loan from your own policy at a hefty interest rate.
When your financial situation gets tight and you cannot afford to invest, your plan runs the risk of lapsing and you will suffer losses as a result.
Speaking of tight financial situations, such plans also offer poor liquidity. If you want to make use of the cash value, you often have to loan from your own policy, as mentioned above, at a interest rate of about 6% or so.
Compare this to other more liquid investments where you liquidate your holdings at the prevailing market value if you wish.
Now even if you still want a savings plan, make sure to do a comparison. For something that’s such a long-term commitment, you should probably do a little bit of research before diving in.
Have you been considering an insurance savings plan, or been proposed one by your agent? Let me know in the comments below!
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