Investment-Linked Policies Look Very Attractive These Days

Judging by their online notoriety, one would imagine that investment-linked policies (ILP) would eventually go extinct, becoming a forgotten mistake of the past as agents move on to the next big hot thing to sell. I mean, just look at any local online forum that discusses about personal finance and you would readily see numerous posts discussing the poor value of ILPs.

On the contrary, insurers and their “financial consultants” have done something that is as insidious as it is impressive – they’ve somehow managed to make new ILPs that look attractive. It’s actually a bit scary how well they have achieved this feat.

Old ILPs are bad… but are at least a little honest

The gig is up for older ILPs which are called “front-loaded” policies because of the nature of how commissions are handled. Premiums of the first few years are subject to an “allocation rate” of typically 15% for the first year, 30% for the second year, then increases progressively until it reaches 100%. The allocation rate is essentially how much of your premium is invested. In year 1, only 15% goes towards buying investment units, with the rest going to “distribution costs” which is a really professional-sounding euphemism for “commission”. The process repeats each year where the allocation rate is under 100%.

Agents tend to gloss over the allocation rate since it is rather unpalatable for a huge chunk of your commissions to be taken out upfront like this, but these numbers are found in the benefit illustration for a prospective customer to read. These facts aren’t readily understood by laypeople, of course, but they’re there at least and we can say that there was a feeble attempt at trying to be transparent about how your premium is handled.

“100% allocation! Bonus units!”

One of the ways newer ILPs try to make themselves a lot more appealing is to move away from being front-loaded. They now declare themselves to have “100% allocation” or that all your premiums are invested in from Day 1.

In fact, many policies these days even claim to give you more than 100% allocation by offering you “bonus units”! Let’s take a pause here and ponder if it is financially feasible for you to put $10,000 into a policy and receive $16,000 in value.

Even if we set aside the fat commission that the policy offers the agent, this is an untenable product for a profit-making company. Add in these distribution costs and you can see why this magical product’s bonus units are more bait than actual bonus.

Say hello to “back-loaded” ILPs where insurers have shown just how creative they are. Instead of making a better policy, they have created the illusion of a better product.

Fees, fees, fees

To be perfectly clear, these bonus units are indeed awarded at the start of the policy. There is a big hitch though – terminate the policy before a certain year and you will incur high penalty fees that essentially takes away most if not all your capital in the first couple of years. You won’t get back your capital until a certain “break-even” year which could be at least 10 to 15 years away from the start of the policy.

The termination fees serve one purpose – to get policyholders to hold onto the policy. Having a commitment to a long-term investment is not a bad thing by itself, but the policy wants to lock you in simply because it needs to recoup the bonus units given to you.

It doesn’t stop at just recouping the bonus units. Insurers are profit-seeking businesses after all, and they can’t possibly pay you bonus money for your investment capital, commission to your agent, management fees to the fundhouse managing the investment, and call it a day without generating profits for their stakeholders.

The “magic” here is that through a series of ongoing fees, they will not only recoup the bonus units, but even reap good amounts of profits from such policies, and there is no prizes for guessing where the money comes from.

This is achieved through a variety of fees you’d find in the policy contract, and such fees are the hallmark of a “back-loaded” ILP. I can’t say any it clearer than how MoneySense has briefly but accurately put it:

Although the premium allocation structure differs for front-end and back-end loaded ILPs, the overall effect of the charges will be similar.

MoneySense’s guide to ILP fees and pricing

The investment fund looks fantastic…! Or does it?

The second major way the industry does window dressing for these policies is to emphasise on how good their fund of choice is performing.

Only accredited investors of a certain networth can invest in the fund, they’d say, creating this air of exclusivity. Conveniently, retail investors and the everyday person on the street now have the exciting chance to participate in this investment through an… you guessed it – an ILP!

More than 15% p.a. returns in the past decade sounds so spectacular, some agents even haughtily say that all the high fees of the ILP is worth it. Since you are reading this, let’s be clear about two things:

Does past performance guarantee future performance? No.

Can you invest in similar funds outside of the ILP? Yes.

The fund popularly hailed (by agents) as this wonderful investment opportunity is mostly vested in large growth companies like Microsoft, Estée Lauder, Pepsi etc. If you are convinced in the continued growth of such companies, there are plenty of exchange-traded funds (ETF) that invest in very similar things with comparable returns. Comparable, until you factor in the fees of the ILP and realise you’d do so much better investing outside of the policy.

Same poor value in new clothing

Unfortunately, the way these products are packaged and sold is unsettlingly compelling. You buy the policy and immediately see an account value that looks good. The underlying fund has had a great last decade and you’re convinced by the agent’s story of above-market returns. You might even get this warm fuzzy feeling of helping out your agent.

The reality is that everything looks fine and dandy on the surface until you look deeper to examine the product’s fees, and better alternatives you can easily find these days. Little has changed since ILPs were first created and they continue to deliver poor value to people who buy them. Between your agent and yourself, such ILPs are certainly great for someone’s retirement… and it’s probably not yours.

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