What to Do With An Investment-Linked Policy (ILP)

Investment-linked policies (ILP) have been sold a lot over the past decade or so, and as people become increasingly knowledgeable about the pitfalls of such policies, questions are starting to mount about what to do with one’s ILP. Here is my take and personal opinion on what you should do with your ILP, though do note that as with everything else on this site, it does not constitute personal financial advice.

I’ve talked about why ILPs are bad multiple times before, but here is a quick recap:

  1. High upfront costs – ILPs have high upfront costs which are mostly incurred as commissions paid to the agent and their manager
  2. High ongoing costs – ILPs invariably involve high ongoing costs like policy fees, annual management fees etc. which eat away at your investment returns

High fees are paid

The high costs are primarily why ILPs deliver poor value. An excessive amount of fees and charges are taken away from the policyowner not only from the start of the policy, but also over the years and even decades of the policy.

In the past, insurance companies were a little more honest about the high upfront commissions, showing a low allocation rate at the start of the policy. After putting in your 1st or even 2nd-year premium, your investment value would show zero dollars in the first couple of years because the bulk of it had been used to pay your agent.

However, in recent years, insurance companies – creative and profit-driven entities – have created a new type of ILP that doesn’t show you zero dollars. In fact, they even claim to give you bonus units and show you that once you put in $10,000, you have $16,000 or something in your account now. But if you actually look at the surrender value of such policies, you still find that it’s still zero in the first one or two years of the policy owing to “termination fee” or some other penalty. The simple fact is that commissions have been paid to your agent, and the insurer is unable to give you anywhere near the amount you have invested.

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Seth

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The illusion of breaking even

We need to recognise the existence of the “sunk-cost fallacy”. This is where someone continues with a particular course of action even though it may not be the most favourable because they’ve already invested a lot of time and money into it.

Similarly, after buying an ILP, some people think that the solution would be to hold the ILP for 15 to 20 years because terminating it would incur a loss. Once we hold the policy to a point where the policy “breaks even”, it seems as if there was no loss at all. This is a prime example of the sunk-cost fallacy, because the loss was incurred from the start of the policy, regardless whether you continue with the policy or not.

There’s no magic to what’s happening here when your policy “breaks even”. After deducting amounts from your premium to pay for the agent’s commissions and other marketing expenses, the remaining amount is invested, and over the long run, your returns from the amount investment should ideally cover the loss made by paying the agent. This makes it appear as if no loss was made. It’s a comforting illusion, but an illusion nonetheless.

The real question is if there is a better way to recoup your losses

The better question to ask is, if I were to look at an alternative investment, would that actually help me recoup my losses better? Remember that aside from the high upfront costs of an ILP, there is also high ongoing costs that eat away at your investment returns. It is quite likely that the ILP will not be as good as finding something else with lower ongoing costs in helping you recoup that loss.

It can be quite telling why insurers pay agents high commissions to sell the ILP in the first place. After the agent gets their share of the lucrative product sold, the insurer itself needs to make a profit, and ILPs are laden with ongoing costs to help achieve that aim.

Very new policies – try to free look or cancel

If you have very recently bought your policy, you are able to exercise the free look option and get your money back. It might not be your entire capital if markets go down, but it is far better than being locked into a long-term fee-laden commitment.

For policies that are only a few months old, you may still try to write to your insurer for a free look. Since it is longer than the 14-day period, they have every right to reject you, but I think there is no harm checking since some insurers may do it out of goodwill.

If that is not an option any more, cancelling your policy and giving up the premiums paid so far may still be a wise option. In the first couple of years, every premium you put in goes largely to commissions, and the more you are able to avoid this cost, the better off you will be.

Longer-term policies – look for better alternatives

Policies that are older than the first couple of years have already incurred most if not all of the upfront costs, but they are still subject to the high ongoing costs of an ILP. For such policyowners, I suggest summing up all the fees involved, and this could come from the policy itself as well as the underlying fund that it is invested in (also known as an annual management fee).

Many ILPs can have a total expense ratio of 2% p.a. or even higher, and that is an expensive way to invest. If you can find something of 1% p.a, it sounds like a small difference, but the absolute difference in returns can be staggering.

All things equal, something with a lower expense ratio will also help you to “break even” sooner than something with higher fees. Between the many trading apps we have and roboadvisers, It is not difficult to find lower cost investments that let you keep more of your returns. ILPs also do not have magical funds that can outperform the markets.

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Conclusion

At the end of the day, owing to innate feelings of loss aversion and the sunk-cost fallacy, it can be quite difficult for us to make a rational decision with bad investments. It is, however, important to try to separate emotion from our financial decisions. The best thing to do was to avoid buying the ILP in the first place, and now that one has bought it, the next best thing to do would be to deal with it properly.

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