Investment-linked Policy: Stay Away Before You Understand These
Client A: Hey HauEng, a friend of mine has just bought an ILP plan and according to his agent, this plan is going to give him the possibility of achieving high investment return, and the flexibility of withdrawing cash for urgent needs. Sounds attractive, but is it true?
Me: Well, nothing is wrong with the saying, but there are so much more about an ILP that we need to know!
Client A: What do you mean by that?
Me: Insurer is a business, and they too need to make profit. So, surely they wouldn’t allow you to freely withdraw the premium paid into the policy at any time, without imposing some T&C. Also, whatever that gives high return also comes with high risk. Are you ready to take on a plan that gives absolutely NO guarantee on the returns?
Client A: Not my cup of tea. But who then are the people that you will recommend an ILP to?
Me: Long story, let me first explain to you how does an ILP work.
Ever since it was first launched, ILP has always been in the centre of the limelight because of the way it is structured differently from other life insurance. Numerous debates have been going on, while people try to conclude if ILP is an effective product to improve our financial shape.
It is not uncommon for us to hear news about someone who has regretted buying an ILP because he/she was not aware of all the features and limitations, and now either the wealth invested is not growing as quickly as he/she thought, or he/she will have to sacrifice the insurance coverage someday down the road. All these conflicts will boil down to one simple reason: The product was not positioned properly when it was first bought.
To help you visualise an ILP quickly, here is a simple analogy to compare it with another two traditional insurance products, a whole life policy and a term policy:
Imagine that we are now looking for a residential property.
A term policy is just like a rented property, with low upfront capital required and easily sustainable monthly rental. However, when the contract ends and we have yet to make a claim, we will receive nothing back eventually.
A Whole Life plan is just like buying a HDB/Condo. Though the upfront capital is higher, we do own the property for life(or long enough) and enjoy the right to sell it someday in the future in exchange for cash.
Lastly, an ILP is just like buying a piece of land and build your own house. The capital required is the highest among the three, but you can enjoy the freedom of designing the unit however you like it, to suit your needs and wants, and to make adjustment along the way.
Let us bring the discussion further, to break down the mystery of ILP into smaller, easily understandable pieces.
How exactly does an ILP work?
ILP is a type of insurance product specifically designed to help us achieve both wealth accumulation and insurance protection in one policy. Premium paid for the policy will first be invested into the selected funds for wealth growth. Periodically, insurance costs will be charged if there is an insurance protection component.
Account value is the total worth of your policy at any point in time. The initial account value is equal to all initial premiums paid less any charges, and the fluctuation of account value over time is directly dependant on the investment performance and any cash top-up thereafter. Account value also represents the maximum amount that you can receive from surrendering the policy.
Insurance cost is for the coverages such as death benefit, disability benefit, and/or critical illness lump sum pay-out. The cost varies depending on your age and the actual amount of insurance coverage. The older that we get, the higher the insurance costs will be, since we are more likely to make a claim due to the deterioration of our health condition. Insurance cost will usually be paid from the account value directly (through the deduction of investment units of equivalent value).
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What are the common charges in an ILP?
Initial sales charge – Upfront charges that will be directly deducted from the premiums paid, before investing the rest into the selected sub-funds. This is usually applicable to all premiums paid into the policy.
*note that some policies will apply initial sale charge through units deduction after the premium is allocated for funds purchases.
Premium allocation rate – Represents the amount of premium paid that will be allocated into funds investment. This is commonly used in policies that allow partial cash-out or surrender of policy in the first few years without additional charges. Premium allocation rate will usually be low in the first year(typically 30~50%), and gradually increase to 100% premium paid after a few years.
Annual policy charges/maintenance fee – These are the routine charges to cover the administration cost of keeping the policy in force. Again, it is most commonly charged through units deduction.
Insurance charges – This is the cost for the insurance component to protect us from major health events in life by paying out the sum assured in addition to the account value to us.
Surrender charges – Some policies will impose a surrender charge for cashing out the policy fully or partially if the withdrawal were to be made within the first few years after policy inception.
Fund Switching charge – Some policy will impose a fund switching fee for every switch of sub-funds. It is also common for the policy to allow the first few switches at no cost, before imposing the fee on subsequent switches.
What is the bonus component in an ILP?
Most policies will give out bonuses in the form of additional fund units as an incentive to the policyholder. “Welcome bonus” is a common type of bonus given as a percentage of the first-year premium paid into the policy. Another common type of bonus is the yearly bonus that is distributed routinely as an encouragement for the policyholder to continue staying invested with the policy.
It is important to choose an ILP not only based on the bonus distribution, but also to take into consideration of the embedded charges.
The timeline below puts together the bonuses and charges at different stages of an ILP policy term for better clarity.
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Note: This is just a general illustration. Not all ILP works the same. You are strongly encouraged to speak with your financial planner for a more accurate representation of your existing policies, or request for a review with us via the chatbox below.
Advantages and disadvantages of an ILP
“The Good”
1. High flexibility – Not only can we adjust the insurance coverage at different stages in life to suit our needs, but we are also allowed to withdraw the account value for quick cash, or even take a break from paying the premium when we face financial difficulties.
2. Leverage your money – With an ILP, your money is essentially multitasking to help you achieve multiple purposes all at once. “One dollar doing the work of many” allow us to keep ourselves on track in life before deciding which is more important to us, wealth accumulation or wealth protection?
3. Low insurance cost with flexibility – The insurance component in an ILP function just like a term plan, but with greater flexibility. The insurance cost is extremely low when we are young, and we also enjoy the freedom to increase/decrease the coverage as we wish.
4. Potentially higher return with full Control over funds invested – Unlike a participating plan (typically referring to an endowment plan or whole life policy), you will have full control over the investment decision in an ILP. Chasing after an aggressive portfolio for higher long-term growth or shielding your funds with a safer portfolio during the tough time to minimize losses, it is all on your call.
“The Bad”
1. Potentially high initial sales charge – ILP will usually impose high initial sale charge, thus rendering it unsuitable for people with short investment horizon as it could deeply affect your overall return in the first few years. The longer that we can stay invested with an ILP, the lower impact it will have to our overall portfolio returns.
2. High insurance cost when we age – Insurance cost for an ILP could rise quickly as we age, causing us to face the problem of having to reduce insurance coverage at old age when it is needed the most. These could also lead to having little or no growth in the account value due to the high insurance cost, despite having an excellent investment return.
3. Zero protection for the policy returns – Since we enjoy full control over the investing sub-funds, we are also exposed to the full investment risk with no guaranteed returns or downside cap. As such, it is 100% our responsibility for the portfolio’s performance and the choice of sub-funds. Having a poorly managed investment portfolio could be highly detrimental our financial position over the long run.
4. Limited choice of funds – Unlike the local fund houses or brokerage firm which can easily offer hundreds or thousands of fund choices, the range of unit-trust available for selection in an ILP is rather limited, typically less than 50.
5. Early partial withdrawal charges –Withdrawal or surrender of ILP in the first few years upon inception are usually either not allowed, or you will be charged at the pre-determined rate for the amount withdrawn. This is similar to the participating plans(savings plan or Wholelife plan) whereby the surrender value in the first few policy years will be extremely low.
Should you buy an ILP or avoid it at all cost?
After all these discussions on the features of ILP, we shall now determine the target audience of an ILP. Because of how it was designed, an ILP is never meant to be a versatile product that fits easily into anyone’s portfolio. In my opinion, these are the 3 groups of people that might find an ILP effective in helping to achieve their goals:
1. People with an extremely tight budget, needing some flexibility on cash flow, while also looking to get both insurance coverage and wealth accumulation at the same time.
2. People who have already gotten their basic insurance coverage done up(via traditional term/whole life policy), and is now looking for wealth growth with the flexibility to top up for more insurance coverage at the same time.
3. People who have yet to figure out which is more important (insurance protection or wealth accumulation) at the moment, thus considering and “one stone kill two birds” option.
If any of these categories describes you, I have prepared this Guide to Select Your Best Fit ILP here to help you understand the available ILP options in the market and each of their differences.
On the other hand, there are also some people whom I will never recommend an ILP to, because it simply does not do a job that is as good as other available options:
1. Those who are looking for pure insurance protection with high level of certainties.
2. People who are near retirement and looking for more insurance coverage(either for self-protection or as a form of inheritance) or wealth accumulation (to counter inflation etc) in a safer mean.
3. People who are risk-averse with low tolerance on investment volatility.
4. People with a relatively short investment time horizon (5 years or less).
If 1~3 describes you, plain-vanilla life insurance or an endowment plan (savings/retirement plan) could be right what you are looking for! For those with short investment duration between 3 to 5 years, investing directly with a local fund brokerage might help you to achieve better wealth preservation by avoiding the excessive upfront charges in an ILP. Either way, do not hesitate to share your concerns with me via the chatbox below!
Final note
Despite being commonly labelled as “expensive”, “complicated”, or “high charges”, statistic has shown that ILP still holds a strong position in the insurance market due to its popularity. I label no product as bad(or good), because they are designed to suit people of different needs. If you do not understand the product, chances are high that it is not suitable for you. But if you are ever considering for an ILP and wish to understand more, do drop me a message below and I will get back to you soonest!
Article by Moo Hau Eng
Email: haueng.moo@gen.com.sg
The writers are financial adviser representative representing GEN Financial Advisory Pte Ltd.
