18 July 2005

Savings Plan & Insurance

Aha! Mr Wang earlier invited his readers to ask him questions about financial planning. Mr Wang has now received his first question. KiddyBoy said:
    "... I had someone telling me "I want to buy this Savings Plan Insurance Policy because I want to save money". I find two things wrong with this. One, why do I have to pay people money to help me save money? Two, why mix up insurance with all sorts of other things (unit trusts, savings etc etc)?"
How does a regular savings plan work? After you sign up, a fixed sum of money will be deducted from your bank account each month and invested somewhere. This will go on for years. RSPs can be tied to a unit trust or, as in KiddyBoy's example, to an insurance policy.

RSPs are helpful for many people. In money matters, people are often their own worst enemy. Lack of discipline is a common problem. We all know that we need to save and invest, but knowing something, and actually doing it, are two separate matters. An RSP helps you to beat the discipline problem because it automatically deducts money from your bank account each month and parks it somewhere beyond the reach of your shopping urges.

RSPs also achieve what we call the dollar-cost averaging effect. By investing a fixed, relatively small amount each month (instead of investing irregularly and in big lump sums) you spread out the timing of your investments and protect yourself from the effect of a sharp, sudden market downturn.

Whar are the costs of signing up with an RSP? Well, if your RSP is tied to a unit trust, you pay the costs of investing in unit trusts. If your RSP is tied to an insurance policy, you pay the cost of the insurance agent's commission, plus the costs of investment (which arise when the insurance company takes your money and invests it elsewhere - it could well be in another unit trust).

Whatever you invest in, you will incur investment-related fees and expenses. If you invest in a condo apartment, you pay the property agent's commission, the stamp duty and the legal fees. If you invest in shares directly, you pay brokerage fees. Investment-related fees and expenses are important considerations, whatever you're investing in. In insurance, a significant amount of the money you pay, at least in the initial years, actually goes towards the insurance agent's commission. So you have to be careful about that.

KiddyBoy's second question is - "Why mix up insurance with all sorts of other things (unit trusts, savings etc etc?)"

Well, the simple answer is that you generally shouldn't. If you know enough about personal financial planning, you will know that there are probably cheaper and more effective ways to achieve your financial aims than by buying one of those products that mix insurance and investment.

What's the history behind all this? Once upon a time, the lines between the different types of financial institutions were very clear. Banks were banks, insurers were insurers and stockbrokers were stockbrokers. Each type of institution was permitted to do only certain types of businesses. However, over time, all the institutions tried to get innovative and so the lines got blurred as they started crossing into each other's territory.

The insurance companies traditionally sold protection against risks like death, critical illness, fire, motor accidents and so on. Then they began to see opportunities to make money by selling investments. However, because they were licensed to do insurance business only, they couldn't just go out there and say, "Hey, let me help you to invest your money." No, the rules wouldn't allow that. They were insurers, so they had to sell insurance. The way to get around this obstacle was to create investment products, add some insurance elements into it, and call the product "insurance". This would allow insurers to legally get into the investment market.

Thus the term "investment-linked policy" is actually a misnomer. If you understand how ILPs really work, you see that the more appropriate term would be "policy-linked investment". An ILP is fundamentally about investment, and the insurance aspects of it are secondary. However, when you mix investment and insurance, you usually can't get a product that meets your needs in an optimal way. As a general principle, if you need insurance, you should get a pure insurance product, and if you want to invest, you should get into pure investment products. For many people, the problem of course is that they do not know enough about financial planning to pick the correct "pure insurance" products and appropriate "pure investment" products for themselves.

Enter the insurance agent, who offers what seems to be a comprehensive package that solves all your problems. He sells you something which will fund your child's future university education; and which will auto-fund itself even if you die (thus your child can afford to go to university even if he is orphaned early); at the same time, you get medical coverage for your child; AND you even get a free gift from your insurance agent!

None of what the insurance agent says is actually untrue. It's just that there are cheaper and more effective ways to achieve all the same goals (except that you don't get the free gift). However, to find out what those ways are, horror of horrors, you would actually have to educate yourself on financial planning. Perhaps many people would just prefer to pay the insurance agent's hefty commission and be done with it. That could be why ILPs sell so well in Singapore. Many people are afraid to think too hard about their money.

If you see it that way, ILPs are perhaps not such a great evil. Perhaps you can do a mini-survey among your own friends and relatives. Look for those who have young children. Ask them: "Have you started savings and investing for your child's future university education yet?". Three possible replies:

1. "No, I haven't done anything, although I know I should."

2. "Yes, I bought an investment-linked policy."

3. "Yes, I'm saving and investing regularly into a diversified portfolio adjusted to my own risk appetite. I've done my calculations and I have some rough idea of how much I need for my children's education in 16 - 18 years' time. I've also got traditional insurance against catastrophic events, like if I should die unexpectedly."

The third answer shows the best situation. However, it is also the least likely answer you'll get. The second answer shows the next best situation. As I've said, it's not optimal - far from it. But it is still much better than the first answer. Unfortunately, I think that the first answer would still be fairly common among Singaporeans.

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Anonymous said...

Mr Wang, you seem to have been pretty successful in your personal financial planning. I have yet to start work, but would eventually like to be able to pay for my children's college education, if ever I propagate my brood. Unfortunately I am clueless where to start. I know you have included some of your books in the picture of an earlier post, but if I were to start on just one book, could you kindly recommend a good one? A financial planning for dummies?

Gilbert Koh aka Mr Wang said...

Well, if you are single & without kids, then it may be a bit premature to start planning for your children's future college education.

However, you may have other financial goals to work towards. Marriage; supporting your aged parents; buying an apartment; saving up for further education; or just building up some reserves to deal with any emergencies -

these are possibly some goals which are more relevant to you.

If I were to suggest one book for beginners ... hmmm, there is this book by Singaporean writer Andy Ong. I can't remember the exact title, but it covers the full scope of financial planning - it talks about credit cards, mortgages, retirement savings, children's college education, medical insurance, life insurance, and the rest of it.

Beware of reading books by foreigners, eg Americans, because what they write about doesn't necessarily apply in the Singapore context. This is due to differences in the tax laws and the financial industries etc of different countries.

Anonymous said...

ok, fire second salvo at Mr Wang!

I have a friend, just married and lives in a lovely but huge HDB flat. Just two of them. Price of flat stunned me, almost 300K. Friend tells me loan is for 30 years (no choice leh, he says), and by my quick calculation, total interest payment can buy a Subaru WRX (My dream car!) at today's prices. I also have a colleague, about to buy flat. He has PhD in Engineering, and tells me, "I did my calculations and it seems to me that I should take the smallest loan, or to put it in another way, buy the smallest flat. Then I can slowly upgrade along the way when I have kids etc etc". PhD-colleague says, "unlike buying shoes, buying flat is not a decision you can reverse easily".

I think - I am inclined to agree with PhD-colleague, and hope that if I do get a wife, the wife is not the sort who wants big flat.