When I started out my career as a financial adviser with an insurance company many years ago, I was taught that insurance products are a good instrument for accumulating one’s wealth. Not only do they generate returns that are higher than bank interest rates and offer protection against death and disability, but they are also a systematic and organised way of saving for the long term. It was not until many years later that I found out it was only half the truth.
Today, I still hear many preaching this distorted gospel. Even financial advisers make this same mistake. In this short article, I hope to dispel this myth.
Here are some reasons why people advocate the use of life insurance as a savings tool:
1. Higher returns than the interest on bank deposits
Currently, bank interest rates are at an all-time low. Instead of leaving your money in a bank, you could park your money with insurance companies and earn a higher return on your funds.
2. Additional protection
Besides getting a higher return on your money, you also get additional protection. In the event of your death, disability or even if you are diagnosed with a critical illness, you can still achieve the financial objectives that you were working toward with the help of a lump sum pay-out from a life insurance product.
3. Safe
Besides accumulating your money at higher interest rates and having the protection element, life insurance is a safe instrument.
To be fair, there is some truth in what is being said about using insurance products as a savings tool. It does give a higher interest rate than that which is given on bank deposits. It does provide you with some protection. It does, to a certain extent provide a safer haven for investing. However, they are only half-truths. Before you decide to put your hard-earned money into it, you should consider the full picture.
The downsides of using insurance as a savings tool:
1. No liquidity
Yes, insurance products do offer you a higher interest rate than that of bank deposits. However, as the saying goes, we are not comparing apples to apples. Bank deposits are meant for short-term parking of your monies. They are meant to be liquid, withdrawable without any loss of capital in the shortest possible time. They are also flexible in that there is no commitment to continue depositing monies into your account. And thus, they naturally come with lower interest rates. Insurance, on the other hand, is a long-term instrument. It is not as liquid as cash at bank. If you need money suddenly, or you need to stop your contributions (premium payments) you most likely will have to suffer a loss if you cash out. Of course, instead of surrendering the policy, you could instead take a policy loan, but it comes at a cost. You need to put back what you take out plus interest of 7-8% depending on the insurance company.
2. Protection comes at a cost
Yes, insurance products can provide you with additional protection against death, disability and critical illness. However, it does not come free. You end up paying for it. Do you know that parts of every dollar that you pay for your insurance policy goes to your agents as commissions and to the insurance companies as mortality charges (the cost of insuring you) before whatever is left is invested? It is not that I am against paying for insurance, but the crucial question we need to ask ourselves is: Do we need that additional coverage in the first place? And if so, is this the best way to do it?
3. Exposure to market risk
Yes, insurance does, to a certain extent, provide you with some safety as part of your maturity benefit is guaranteed. But, most of the time, the guaranteed component is only a small portion of the overall illustrated benefit. Given what you pay, and your opportunity cost, you lose out big time. Besides, your monies placed with insurance companies are also deployed, by investment managers, to the stock market, bond market and so on. They are also subjected to market risk. It is no surprise that over the last few years, when the market was bearish, that many insurance companies adjusted their bonus rates downwards. Insurance being a safe instrument may be an illusion after all.
4. No flexibility
Besides all the above, if you decide on using insurance as your investment strategy, you must accept the fact that you will have to forgo. the flexibility to stop saving if your circumstances change, the flexibility to switch investment manager if they are not producing the results you want, and the flexibility to cash out all your savings if there is an emergency. If you do end up having to do any of these, you will lose either coverage or your hard-earned money.
So, What Are Your Alternatives?
Armed with the whole truth, what can you do? First, decide whether you need insurance in the first place. If you do, separate your need for such insurance from your need to invest or save. Buy an insurance plan that is without profits, non-participating or a term plan according to your needs. Simply put, whether you need insurance to cover you your entire life or for a fixed number of years, pay only for the protection and nothing more. Then, invest your money directly using unit trusts or equivalent instruments. If I have not been clear, let me illustrate it in another way. Instead of using a dollar to buy an insurance policy to save towards your goal (of twenty cents is insurance cost and eighty cents is invested it for you), buy twenty cents of insurance and invest the eighty cents yourself.
Two Caveats
One of the problems with buying a “without profits” insurance policy and investing the difference yourself arises if you do not invest the difference! In that case, it may be better off letting the insurance companies invest it for you.
Another problem is if you do not invest your money properly. And by that I mean, buying stocks when you do not really understand the stock market, buying flavour-of-the-month unit trusts and so on. If you do not create a diversified portfolio with a suitable asset allocation, monitor your investments closely and constantly rebalance your portfolio, investing yourself can do more harm than good. (Find out how you can build a successful investment portfolio here.)
And if you are engaging an adviser to help you, you should look for an adviser who is able to help you construct such a diversified portfolio and monitor it for you.
Conclusion
If one depends solely on using insurance as a savings tool to reach your financial objectives, you will find them hard to reach. While insurance promise higher interest rates than bank deposits do, the returns are not exciting. This is because, insurance is primarily for protection, and is not a savings tool. Unfortunately, putting money into life insurance and investments is a zero-sum game. The more you put your money into life insurance, the less you have to invest. If you use the correct instrument for the correct purpose, you stand a better chance of achieving your financial goals.
The writer, Christopher Tan, is Chief Executive Officer of Providend, a Fee-only Wealth Advisory Firm. Besides being financially trained, he is also an Associate Certified Coach with the International Coach Federation.
For more related resources, check out:
1. Why Buy Term and Invest the Rest Is Not the Whole Story
2. Uncovering the Sales Ideas behind Whole Life Plans
3. Are Investment-Linked Policies (ILP) And Unit Trusts A Good Way To Invest?
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