The traditional financial planning technique used by professional financial planner is to assume that one’s dependents are not permanent. The most common are children as dependents. When they finish school, they are not supposed to be a liability to their parents anymore. That is why a term insurance covering for a short period of support is most suitable. However, there are cases in which a person has permanent dependents such have having children with permanent disabilities. In this case, the equation is very different. Regardless of how one juggle with the figures, a very large capital outlay is required. By my estimate, a person who does not have $1500 extra cash every month will need government support to help his family. In the following example, I demonstrate how I come up with this figure with the various assumptions of course.
Let’s assume that a parent is aged 30 years old having a child of 5 years old with a permanent disability. Assuming the life expectancy of the child is 82 years old, the time horizon to support this child is 82-5 = 77 years. For easy calculation, I compute all figures in real terms. We assume that the annual support for this child is $30,000 inclusive of special school, special training, special drugs and special accommodation and as well as all the cost payable to special trustees and special insurance. The present value of the liability is 77 x 30000 = $2,310,000 which is also the insurance required on the parent. This assumes the real investment return is 0% which is reasonable because it is common for parents to disallow the trustees of the children’s monies to be invested in high risk instrument. So we assume the trustees of this amount will only invest in low risk instruments that merely provide a return equal to inflation rate.
Now, assuming that the parent retires at age 65, it means that 35 years have lapsed. The age of the child is now 40 years old. The time horizon to support this child is now shorter which is 82-40= 42 years old. The present value of liability is 42 x 30000 = $1,260,000 in real terms.
Traditional financial adviser will recommend a whole life policy covering $2,310,000. Actually I tried to key in this figure into a famous whole life product only to receive an error from the software. It appears that this amount is just too large. The maximum allowed from this product is just $1m sum assured. So I will use this and extrapolate. According to my extrapolated whole life product, $19,763 of annual limited premium payable from age 30 to age 65 can buy a whole life policy that covers $2,310,000 from age 30 to age 65. Beyond age 65, the sum assured drop to $1,283,333 plus bonuses. At the end of age 65, the projected nominal death benefit and nominal cash value are $2,218,954 and $1,271,244 respectively at 5.25% investment nominal returns. In real term it is 2218954/1.02^35 = $1,109,538 and $635,657 respectively. I assume inflation is 2%. Thus, it appears that the death benefit even at age 65 of this product matches the liability.
If we would to purchase a term and invest the rest, what kind of returns will we see? A $2,310,000 term insurance from a cheapo-insurance-company-that-pays-negative-commission-and-takan-the-adviser-with-all-sort-of-difficult-underwriting-requirements-only-to-get-scolding-from-client that covers from age 30 to age 65 will cost $3105.4 per year at preferred rate (meaning superman’s rate). The difference between the whole life and term is 19763-3105.4 = $16,658 if invested in an instrument that gives a real growth of 3.25% (= 5.25%-2% inflation), the future value of this at age 65 is in $1,091,756.91 in cash and in real terms.
Thus from this exercise, it appears that buy term-invest-the-rest is the superior choice. The advantages of buy term and invest the rest are:
- Flexibility – in the event the payer losses his job, he is still able to service his term insurance because of low annual commitments.
- Suitable for those with extremely low budget. An immediate estate can be created with low cost.
- The invest-the-rest person accumulate cash of $1.09m and as the saying goes, cash is king. On the other hand, the whole life person accumulates a death benefit of similar amount but he must die to realize this benefit.
The disadvantages of buy-term-invest-the-rest are:
- All investment returns are not guaranteed and major losses can wipe up all gains. For example, the impact of a say 30% lost at the final year is more detrimental than say an investment lost in the middle years. For whole life, the bonuses are locked. Life insurance companies are able to meet its liabilities through an efficient asset-liability-matching (ALM) approach which is a tool not possible for man-in-the-street mainly due to lack of expertise and discipline.
- I haven’t come across anyone who really ‘invest-the-rest’ all the way. All my clients who claimed to buy-term-invest-the-rest panic during the 2008 financial crisis. They either liquidated their holdings or stop their RSP since then. These tend to be the more knowledgeable clients. My buy-term-invest-the-rest clients became a chicken when the going-gets-tough. The practice of buy-term-invest-invest-the-rest only exists in the Neverland world. On the other hand, those who are blur-like-sotong and has no clue what on earth is happening stayed on their RSP course when I told them just continue when Lehman brothers collapsed.
Regardless of the approach, what happens if a person does not have an annual $19,763 spare cash to do the above planning for his or her permanently disabled dependent? First, buying whole life is out of the question. Second, he or she can still buy a term insurance like the above cheapo-will-get-shouted-at-by-manager-type-of-cannot-meet-api-term-product. However, there will still be issue on what to do beyond age 65 because the person does not have money to invest the rest. That is why the only solution I see is that Singapore must step in the help these individuals. In order for tax payers’ monies to be used wisely, I suggest that:
- That the country mandate such individuals who are seeking for financial assistance to go through a proper financial planning to ensure they do not buy rubbish insurance and ensure they are spending wisely. If found that insurance agents have sold rubbish insurance to these individuals, the country should take legal action through penalties and fines which are to be used to reduce tax payers’ liabilities.
- Second, make sure they get a suitable term insurance at low cost. Perhaps the authorities can call for a tender for insurance companies to bid for such a project.. and please make sure it is not another group insurance that can be terminated any time. I am OK that it is another group insurance with the master contract policyholder the government of Singapore but there must be an explicit guarantee that no policyholder will be disadvantaged by any changes to its benefits. Disclaimer such as the Aviva SAF Group Term insurance is not good.
- Third, to setup an Endowment fund something like Medifund which can be tap upon by those who are truly needy.
- To prevent abuse of the Endowment fund (which afterall comes from taxpayers’ monies), parents such as above should be means-tested so that only the true needy can use the Endowment’s monies.
- Finally, we may wish to introduce estate duty again to target high networth. Perhaps they can place a high exemption limit of say $10m and tax them at say 20% of their estate above this limit. This tax revenue can be use for social purpose such as contribution to the Endowment fund. I am always against the abolishment of estate duty as it is the means in which the rich’s wealth are redistributed to the poor. A person who is already dead cannot enjoy his wealth. Why not redistribute his wealth to those who are in need?
This article also appears on http://www.cpf.gov.sg/imsavvy/blog_post.asp?postid=557714523-243-1888391971
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