AN insurance endowment plan is likely to be one of the first things that comes to mind when one wishes to embark on a medium- or long-term savings plan.
Endowments are widely seen as an efficient form of savings. You may put it on an auto-payment plan so that you don't run the risk of any lapse in payment. You need not fret about what assets to invest in, and it appears to have little volatility.
Yet for some policyholders, endowment plans have disappointed in terms of their maturity values, causing a shortfall in their savings objectives. What can typically go wrong, and what should you watch out for?
Endowments are a type of bundled insurance (BI) product offering savings plus protection. They are a staple in Singapore's insurance market. They are typically marketed to parents with young children as a form of savings for future university fees.
There are two broad types of endowments: "participating" and "non-participating". A participating or par plan is a "with-profits" type of insurance plan where premiums are pooled together by the insurer and collectively invested to achieve a rate of return.
A non-par plan is designed to pay fixed or guaranteed benefits. The insurer typically will invest the premiums in bonds whose maturity profile matches that required by the policy. The funds are managed on a segregated basis - that is, the funds are not co-mingled with the participating life fund. Non-par endowment returns are typically lower than those of par endowments.
What you should know:
- Understanding bonuses
With par endowment plans, there are two components to the return: guaranteed and non-guaranteed. The non-guaranteed portion of returns is expressed in terms of bonuses. Sometimes a plan can also feature cash dividends, although a bonus structure is the most common.
A plan may have an annual or "reversionary" bonus, as well as a terminal (TB) or maturity bonus. As the name suggests, an annual bonus is accrued annually. The maturity bonus is typically a one-off bonus in the final year of the policy. It is typically expressed as a percentage of the accumulated annual bonus to date.
Some insurers may also give a one-off "performance" bonus which is paid when the policy matures or is surrendered, or when a claim is made.
Once a bonus is paid, the amount becomes part of the guaranteed value. You will find details on the annual and other types of bonuses in the product summary that should accompany the BI.
In par policies, returns are "smoothed". This means that in a good year, the insurer may choose to pay out its normal bonus rate and retain more surpluses. In a poor year, it may distribute more of the retained surplus as bonuses to maintain the bonus rate. The effect is a fairly smooth rate of return, which masks any volatility that the life fund may experience.
Under the Insurance Act, shareholders receive up to a tenth of the bonus allocation, and policyholders get up to 90 per cent.
What you should always keep in mind is the non-guaranteed nature of the bonuses. In fact, over the last two decades, policies' bonus rates have steadily declined. While a number of factors may affect bonuses such as unexpectedly large claims including death claims, the largest factor is the fund's investment experience.
The bulk of insurance monies is invested in fixed income assets where yields have steadily fallen. Yet another challenge is that the bond market may not offer maturities that match insurance policies' maturities. This means that insurance funds often incur re-investment risk and have to re-invest their funds at steadily lower yields.
Even equity returns expectations have become more muted compared to 10 to 20 years ago. Life funds' equity allocation tends to vary between 10 and 30 per cent. Equities are typically expected to provide the kicker to long-term portfolio returns, hence enabling insurers to quote fairly generous maturity bonuses. But in recent years, for older generations of policies, TBs have been substantially cut.
In short, insurers may cut bonus rates and this typically happens for the cohort of policies whose previously quoted rates of return at inception have become unsustainable because of increasingly depressed yields. Insurers do try, however, to avoid cutting rates as this causes disappointment among policyholders. Instead, newer policies are quoted with lower rates of return.
- Projected investment rate of return
All with-profits BIs carry two projected investment rates of return: 5.25 and 3.75 per cent. The Life Insurance Association (LIA) sets an upper limit to projections at 5.25 per cent, and insurers have to present a second scenario 1.5 percentage points below the maximum projection. The cap is currently under review and may be adjusted.
The rates represent what insurers' life funds are expected to achieve, net of the life funds' investment expenses. The BIs carry two rates to show policyholders that volatility can occur and there can be a range of outcomes. As LIA says in its guidelines, the rates are only for illustration and do not represent the upper or lower limits achievable by the life fund.
But what you should note - and this is very important - is that you should not think that your own policy actually earns 3.75 or 5.25 per cent.
To get a sense of your policy's net rate of return, you have to net out policy expenses such as mortality costs, management expenses, and distribution costs which include commissions and other costs.
Older BIs used to have a section to spell out the "reduction in yield" (RIY). This explicitly shows the net return to the policyholder assuming that the life fund achieves 3.75 or 5.25 per cent. You'll find that the actual net rate of return is significantly lower. For a 3.75 per cent assumed return on a 20-year policy, the net return may be less than 1.5 per cent. For 5.25 per cent, the net annualised return for the policyholder could be less than 3 per cent.
For some shorter endowments, net returns may be even lower. On a 10-year plan seen by this writer, using a financial calculator, the net return to the policyholder was just 0.2 per cent for the 3.75 per cent assumed return. For the 5.25 per cent column, the net annualised return was 1.8 per cent. The policy was incepted in 2011.
Of four BIs perused by this writer from different insurers, only one firm spells out the RIY - and it does so based on the two headline rates of return of 3.75 and 5.25 per cent. The RIY ceased to be part of most BIs since 2008. Prior to 2008, it was quoted based on a single assumed rate of return.
The RIY is arguably one of the most important pieces of information as it illustrates the total expense ratio of the policy. It also helps to you to compare projected returns among insurers as expense ratios can vary significantly. And, particularly if the death benefit is minimal, you are able to compare the policy net returns against other investment options such as a balanced fund or a portfolio of bonds. If your BI does not spell out the RIYs, do ask your agent to calculate it for you.
- Flexible withdrawals
Most plans are designed to give policyholders the flexibility of making some withdrawals, which may be called a coupon or cashback. This type of policy is traditionally called the anticipated endowment. Today, the withdrawal feature is built into the endowment plan. In the past, withdrawals could only be made at three-year intervals; today, you can make withdrawals as frequently as annually.
Typically, you can withdraw 5 per cent of the death benefit annually. The total withdrawal over the life of the plan may be up to 120 per cent. If you choose not to withdraw, the coupons or cashback is then deposited with the insurer at a certain interest rate. The rate is not guaranteed and may be cut.
Do take note of these two points: One, there is a potential here for misunderstanding and mis-selling. This is because the cashback is sometimes mis-represented as a return on your capital. This is wrong. As mentioned earlier, the coupon or cashback is actually a portion of the death benefit.
Two, when you make withdrawals, you affect the policy's rate of return and defeat the purpose of savings in the first place. If you withdraw every year, the final maturity value will of course drop and the net rate of return based on the lower maturity value will be negative.
All BIs will reflect a table of deductions. Under the respective projected rates of return, you'll see a column, "Value of premiums paid to date". This reflects the assumption that you are able to invest the premiums without incurring any expenses and earn the headline rate of return.
Another column shows "Effect of deductions to date". This shows the accumulated value of expenses such as the cost of insurance, distribution costs, surrender charge, and expected transfers to shareholders. The difference between the two columns is reflected in the "surrender value" column, which represents what you will receive should you choose to terminate your policy before maturity.
You will find that on most policies, there is no surrender value in the first year. The breakeven point of the policy - the point at which you recover your premiums should you surrender - is also typically very long. On a 25-year policy, the breakeven point assuming a 3.75 per cent return may be some time after the 20th year. Assuming a 5.25 per cent return, you may break even some time after the 15th year.
The BI will also show you "total distribution costs" , which includes commissions and overrides paid to the adviser. On a long-term policy of 20 or 25 years, all distribution costs may be paid out by the sixth year.
- Asset allocation and insurer's track record
Life funds are invested in market assets. It is a mistake to assume that because your returns are smoothed, the fund does not experience volatility. Life funds are typically invested in a very diversified manner. The bulk is invested in fixed income assets to provide a stable profile of returns. A relatively modest portion is invested in equities, usually less than 30 per cent. Other assets may include real estate and loans.
Every year, you will receive an annual bonus update which will show you the bonus that your policy has accrued. You will also receive a par fund update which gives a snapshot of the insurer's life fund performance. The update will tell you the asset allocation and returns over one year and the past three years. There may also be commentary on the experience of the past year and the near term outlook. Some insurers also include top five or 10 holdings.
What all this shows is that by investing in an endowment, you are buying into the insurer's asset allocation. If you have a horizon of 20 or 25 years for your savings plan, you may want to consider investing in funds where you can control the asset allocation. While endowments are seen as instruments that allow you to sleep at night because of their apparently low volatility, they are not without risk to your savings goals especially if the insurer cuts bonuses substantially. Net returns may also not keep pace with inflation.