11 November 2006

Your Money or Your Life

Financial awareness remains rather low among Singaporeans. In money matters, many of them still make quite basic errors. This article illustrates.
ST Nov 11, 2006
Many S'poreans don't have the right insurance cover
A third of those surveyed can't tell what is sufficient level of protection

By Finance Correspondent, Lorna Tan

ALMOST nine out of 10 Singaporeans have an insurance policy but many of them remain grossly underinsured when hard times hit because they have not bought the right policy.

A recent survey by the Life Insurance Association (LIA) found that 35 per cent of 514 respondents had no clue about what constituted a sufficient level of cover.

The most popular policies in Singapore have long been whole life and endowment plans. They have costly premiums but offer some insurance protection and potentially bumper payouts.

The high premiums, however, tempt many people to settle for a lower level of insurance cover that in many cases is inadequate.

According to the July survey, which covers households with a monthly income of at least $3,000, 73 per cent of respondents bought whole life policies, while 59 per cent have endowment plans.

LIA figures also show that the average death payout this year has been just $39,700.

And the average claim payout - anything from policy maturities, death and critical illness to total and permanent disability - was a mere $29,000.

Experts like Mr Christopher Tan, chief executive of financial advisory firm Providend, believe that many people would be better off investing in more traditional term life plans.

These offer pure insurance protection but have no savings element, which means there is no payout when the policy expires or is surrendered.
You don't need to be an expert like Christopher Tan. All you need is buy a basic book on personal financial planning and you will quickly understand that the advice "buy term, invest the rest" is good advice for most people. Not all people, but most people.
To give an idea of costs, a 20-year term plan with a sum insured of $100,000 costs $391 a year for a 35-year-old non-smoking male.

This is much lower than the annual premiums of $1,990 for a whole life policy and $4,559 for a 20-year endowment plan.

LIA deputy president Mark O'Dell recommended term plans, with their high protection at a relatively lower cost, as 'the most affordable way for families with dependants to close the protection gap'.

Yet these plans are not big sellers here and one reason, said Mr Tan, is that agents reap higher commissions selling whole life and endowment plans.

He said: 'At the end of the day, if the main compensation is commissions, there is a high chance that whatever product is sold depends on the commissions derived.'
This is one important reason why we all need self-education on how to manage our own money matters. Financial advisers and insurance agents, first and foremost, sell you products and policies that are good for themselves. That's often not the same as what's good for you.
The LIA cited another reason. 'Singaporeans, like many people in Asia, like combining protection with investments, knowing that there will be a cash value when a policy matures,' said LIA president Jason Sadler.
Well, let me perform my public-service good deed for the day and explain a couple of things.

Suppose you want life insurance, so as to protect your loved ones from financial disaster should you unexpectedly die. At the same time, you also want to invest your money. So you buy some kind of investment-linked policy which achieves both objectives at the same time. Your insurance agent collects a big commission and both of you are happy.

In practice, this is usually not the optimal approach for you (although your agent will be happy). In most cases, the better approach for you is to buy term life insurance and separately invest your money.

Term life insurance is basically a kind of insurance where you pay a small premium every month for a very large payout if you die. You usually cannot buy term life insurance beyond the age of 65. If you don't die by then, you don't ever get any money back.

If/when you pass the age of 65, chances are that your dependants are not very dependent on you. Your kids will probably be grown up. By then you will also hopefully have built up your savings and you can pass it all to your beloved spouse after you're dead.

The monthly premium for term life insurance is very cheap, compared to, say a endowment plan or a whole life policy. Thus for most people, buying term and investing the rest works better. That way, you get a lot more protection. You also get an excellent chance of achieving better investment returns in the long run.

That's because the nature of many endowment plans is that they have to be very conservative about how they invest your money. Low risk translates into low returns, which is unfortunate because these plans run on for years and years. With a long timespan, people should logically take higher risks - another basic financial concept.

Of course, I've assumed above that you are willing to put in some effort to learn how to invest your money elsewhere in a sensible way.

Moving on. Now here comes a little bit of bullshit, [sales pitch] piece of advice that Mr Wang disagrees with:
But to have sufficient protection, he said the 'international rule of thumb' for insurance cover for an individual should be at least 10 times his annual earnings.
Whenever you hear any piece of advice about anything concerning money, first ask yourself - what is the source of this piece of advice, and what agenda would this source have?

The international rule of thumb for insurance is that you should have "at least 10 times his annual earnings" - so we're told. This "rule of thumb" is created by insurance companies, whose agenda is to sell you insurance. That's how they make money. So you can be quite confident that their rule of thumb has probably been heavily overstated.

Firstly let me explain the rationale behind this rule of thumb. Suppose you are the sole breadwinner of your family and you earn $5,000 a month or $60,000 a year. Then you die. The idea is that your insurance payout should be sufficient to allow your family to sustain approximately the same lifestyle for the next 10 years. That will give them plenty of "cushion" to adjust to your untimely demise. So the insurance agent will say that you need to have $60,000 x 10 = $600,000 worth of coverage.

Now, as you can see, there is some "rationale" behind the rule of thumb. On the other hand, it also glosses over many variables, which are collectively so significant that I, for one, think that the rule of thumb is largely useless.

Firstly, if you were earning $5,000 a month today, you wouldn't have spent it all on your family anyway. Suppose in fact that on average, you had been spending $1,500 a month on yourself (food, transport, clothes, entertainment). Well, when you're dead, you don't need any more food, transport clothes or entertainment. In fact you've been sustaining your family on only $5,000 - $1,500 = $3,500 a month, or $42,000 a year. Reapplying the adjusted rule of thumb, you only need $42,000 x 10 = $420,000, not $600,000 worth of coverage.

Secondly, receiving the full sum of $420,000 immediately upon your death is very different from receiving $3,500 a month, 12 months a year, over 10 years. Don't forget the time value of money. The immediate $420,000 is much more valuable. If what you want is for your family to receive the equivalent of $3,500 every month for the next 120 months after your death, and you therefore proceed to pay for the right to immediately receive $420,000 upon death, you are basically overpaying.

Thirdly, consider the hypothetical Mr Jin Jia Kiam and Mr Ai Kai Lui, both of whom are about the same age, currently earning $5,000 a month and spending $3,500 a month on their respective families (one wife and two young kids each). Suppose both men die. Mr Jin dies leaving $300,000 in his bank and investment accounts. Mr Ai dies leaving $300,000 in credit card and loan shark debts. Obviously, they leave their families in very different financial circumstances. Thus what constitutes adequate insurance coverage would be very different for Mr Jin and Mr Ai. Since individuals can be vastly different in their financial circumstances even though they earn the same salary, the "10 times annual earnings" insurance rule of thumb is quite useless.

Fourthly, even if you had not died at that critical moment, your salary would not have remained the same (at $5,000) for the next 120 months anyway. Do you actually know anyone whose salary has actually stayed the same for the past 120 months?

I could give more examples, but by now you get the point. I'll say it again - there are so many significant variables that this insurance rule of thumb is pretty much useless. What people need is some basic level of financial understanding, so that they can consider the variables in their own individual lives, and plan accordingly. The rule of thumb SUCKS. And everyone should educate themselves on how to manage their own financial matters.

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20 comments:

Rowen said...

Dear Mr Wang,

I am grateful for your illustration of the illusions of the insurance world.

True. Agents are out to sell things. They do representations in insurance plans which do not guarantee returns. Even if it is a guaranteed return, the return may not be the same when you first bought the insurance and what you may get 10 to 15 years down the line.

My experience is as a young boy of 18, i got myself a Life insurance policy with my allowance in NS and my savings due to part time work which i did in my school holidays. The stated guaranteed interest and return was about 7% per year with a large jump in return in the 20th to 25th year of the policy. However years later, they sent a letter stating that because of XXX reasons, the interest rate will be decreased by 0.5%.
Having paid at least S$200.00 a month type of premium for over 10 years. I see that the companies are backing on their word.
I wanted the "protection" and surety that my parents will not need to worry in the event of my death, i did not stop the policy.

As a result i did not take any more policies after this event.

I place my trust in my own judgement in stocks and shares in the US Stock exchange. Singapore shares are too volatile and very subjected to manipulation.

Just my 2 cents worth.

Philip said...

Well said Mr.Wang. I've seen so many Singaporeans fall for the trap of "insurance" and fail to see the real value of "term insurance". So much that i have seen the colour of the face of the insurance agent change when i mention to them that i want nothing but a term insurance.

They are disheartened cos they realise that they cant make any money out of me. That in truth shows how much of "false sympathy" they try to show towards us. Anyway, no point blaming them cos they are just doing their job. Its upto the individual to be more discerning and do some homework when it comes to something as important as "financial planning".

Keep up the great work. Thanks for sharing your valuable knowledge selflessly.

Dr Oz bloke said...

good post Mr Wang!

When SARS came, I was warded for suspected SARS. Upon discharge I was looking for protection for my family as being a doctor became a severe risk and I wasn't sure when the insurance companies would increase premiums for doctors or simply not cover doctors anymore (we didn't know when SARS would end or if it would end at all)

I settled on one of the cheapest term policies around. SAFRA NTUC term policy.

http://www.income.coop/insurance/
safraterm/premium.asp

They recently put an age band to it. Back in 2003 it was still the same premium regardless of age!

Nevertheless, I suggest people go check it out and compare with the prices for Whole Life and Endowment policies for the same compensation coverage.

Anonymous said...

Great article on financial planning. I admit I'm ignorant of such matters and would like to find out more as I have recently started working. Can anyone can recommend a good book on basic financial planning that is applicable to Singapore? I've read books like Rich Dad Poor Dad and they don't seem very credible to me.

Mr Wang Says So said...

This is quite good for Singaporeans' financial planning - Growing Your Tree of Prosperity - and I'm not saying that just because the author gave me a free copy. :)

Thr author Chris Ng happens to be a blogger and his second book on financial matters will be out in December.

ichtus said...

Indeed. How many of us were fearful and bought insurance during BMT in NS? Am now waiting for my annual statements to see which insurance I can terminate without a bad heartache.

Keep insurance as insurance, and not try to use it as a form of investment, hoping for the 3 5 or 7 percent projected.

Hopefully the moneysense initiative will help to raise awareness on financial matters and the need to manage your own finances properly.

To illustrate something about insurance too.

In good times, the bonuses the insurance companies pay out after already net of bonuses and other good stuff for insurance bosses. So you actually don't get the enjoy the full return they managed to earn on your premiums. In bad times, they can don't pay out.

So if you follow the advice of "buy term, invest the rest", in good times, you get to keep ALL that your money earned (no cuts to anyone). In bad times, you suffer the same as above anyway.

But of course, the assumption (and belief) is that we can invest our money correctly and enjoy a high rate of return more than the inflation rate.

Jason said...

Some comments:

* Why are endowment funds constricted to take conservative stands? I would have thought that since their liabilities have long maturities, they can afford to take some risks. But it doesn't seem to have been the case. Certainly with the downgrade of bonuses, the insurance companies are (wrongfully IMO) shifting the risks of investment to their clients, without compensation.

* What are the options of people who aren't yet financially savvy enough to play around with equities and mutual funds? Would life, endowment policies be ok for them, compared to, say, keeping their money in bank accounts, fixed-Ds?

Anonymous said...

Mr Wang, what it your advice for those who have already bought the whole life policy?

Indi said...

Of course insurance companies would like "to encourage" people to have more insurance coverage. After all, that's what they are selling, isn't it?

PS: This article does not say how much profit insurance companies have made over the past 10 years. Do you know?

hugewhaleshark said...

Just want make a few points, as usual, Mr Wang.

1. Agree that protection comes first. If you have limited resources, go for a the higher protection offered by a term policy.

2. I am not sure that $391 per year for $100k of coverage is for a LEVEL Term policy, i.e. where premiums stay fixed for the duration of coverage. If it is not a Level Term, premiums will rise drastically as the policyholder ages.

I have seen one quote where premiums rise from $300+ per year in the 30s to $3,000+ in the late 50s and $6,000+ in the 60s. Correspondingly, a Level Term is not as cheap, costing about $1,000+ per year.

Of course one can reduce the amount of coverage as one gets older, as "liabilities" in the event that you pass on are reduced (children have fewer years to go before they hit working age).

3. I once did a present value calculation of the cashflows comparing a Investment Linked Policy, a Level Term and a normal Term (ever the analyst!). There is not a lot of difference in cost in today's dollars.

4. Many people who don't have the sophistication or discipline to invest on their own are better off investing through an insurance policy, after coverage needs are taken care of.

5. Agree that the 10x salary thing is bullshit. I performed a discounted cashflow of the "liabilities" should I pass on. The result is something like 2.5-3.5x, depending on assumptions.

The differences lie mainly in: i) we save a fair bit, so our expenses don't reflect our level of income, and ii) if I pass on, I expect my dependents to live a fairly modest lifestyle.

Of course, if my pay got chopped 30% tomorrow, the liabilities will still remain pretty inelastic, so the multiple will increase.

6. I am protected mainly through Investment Linked Policies, which take care of both protection and retirement needs. When I was making less money, I had a fairly large Term policy, which I converted at the same underwriting terms to ILPs.

One point I want to make is that even for an investment professional, investing your own money is a whole different ball game from investing your clients' money. The main difference for me is the emotional aspects of investing your own money. Think about it as a surgeon operating on his own child.

That's why my self-directed investment pool remains rather modest. Till I am sure I can handle the feelings.

Just my 0.02!

hugewhaleshark said...

Oh, either that or I am not sure the $391 per $100k also covers critical illness, which is the expensive part.

Critical illness planning is another ball game.

Mr Wang Says So said...

HWS:

I don't think it covers critical illness. For that kind of pricing, it probably covers death, TPD and possibly stuff like loss of hand, loss of toes due to accident.

Yes, agree that critical illness coverage is another ball game.

One thing about term is that the cost of dropping out halfway is much lower (actually, it's nothing) as compared to dropping out of an endowment plan or whole life policy.

I also have an ILP - problem is ILPs is the size of the agent's commission.

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Jason:

Your endowment plan will still beat your bank FD /savings plan. However, one big problem with the endowment plan is that if you feel like you want to pull out halfway, say, after 5 years or 8 years, because of some change in your circumstances, you don't get much back. The cashback value climbs sharply only in the final years when you're nearing the end of the plan.

Whereas you can get the full amount of what you put in the bank, anytime you want.

hugewhaleshark said...
This comment has been removed by a blog administrator.
hugewhaleshark said...

Agreed. Comms are an issue with ILPs. My cashflow study above was after deducting comms, though. Maybe the ILP's comms were balanced out against the Term plan's higher premiums near the end, and probably the Level Term's comms are pretty high too, in line with higher premiums (esp. with critical illness).

My feel is that the "buy term invest the rest" mantra is not a straightforward matter, and probably laden with vested interests as well.

ichtus said...

I have seen in SAFRA mag this month of NTUC's term policies for life and critical illness. Those interested might want to check them out.

moomooman said...

interestingly.....

I got a cold-call from one insurance firm last week. They are offering Term insurance of coverage of 100k for about $300 a year covering critical illness plus medical claims from minor accidents up to 1k per accident. If you buy straight for 5 years, at the end of the 5th year, they refund 50% of the premiums you paid for the 5 years back to you.

Of course, I'm still reviewing. But after reading this.... I thought it was a good deal being offered to me.

Mr Wang Says So said...

I think that was probably Aviva, right (though recently they changed their name).

moomooman said...

amendment to my last post.

No critical illness. Up to 100k accidental disability benefit.

As for the insurer. It's not aviva, thought previously it might be known as.

But I shall not reveal names, Unless they give me commission. Haha.

However, if anyone likes to know, you can always email me via my blog.

beartoes said...

It does not sound that different than things in the U.S. Most families here are under insured also. It is a sad fact that most people find that life insurance is a waste of money. The same as s'poreans. For more information on competitive life insurance rate just click the link

cecillia said...

Nice info. Thank you.
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