Should you terminate your Investment Linked Policies?

Last Updated on 2, May 2014

Now that you realised you bought a lemon, the next question is whether should you terminate your investment linked policies.

What is the impact of terminating the ILP? What should you do if you are faced with the decision to terminate the investment linked policy?

I have many clients who bought unsuitable products and as a result have to postpone their retirement for many years. Let’s say if they had just bought simple products, they would have retired at age 55. But because of the unsuitable products, they have to postpone their retirement to age 70.

Most of the time the unsuitability arises due to two reasons:

1. The product has an extreme high expense ratio and thus much of the returns are taken away through effect of deductions and
2. The long-term contract nature of the product contractually bind the client to pay for the premiums all the way into retirement years. For example, if the maturity date is in 70 years old, this means a high cash flow is required to support the premium when they are old. Effectively they have to postpone their retirement in order to "support" the product manufacturer.

Many people were shocked when I shown them that they cannot reach their financial goals as a result of these wrong purchases. So the most nature thing they would ask is which product or products to terminate. Most advisers on hearing this will use this opportunity to tell their clients to terminate the product and buy a new one from them so as to earn a quick commission. Clients are also willing to do this because usually the previous advisers don’t service them anymore since the commissions are paid upfront. If the previous adviser resigns, the new takeover adviser don’t earn any recurring commission (because it was paid upfront to the previous one) and thus there is always a temptation to tell their clients to terminate and buy new one. In the industry, this is called churning which is morally, ethnically wrong. It is also illegal.

However, there is a reason why this is usually wrong to switch product like this. For me, I will almost never tell my clients to terminate their existing long-term contract products like ILP because of mathematical reason. Here is a mathematical example why it is usually too late to terminate a lousy product and buy a new one:

Let’s say you got cheated to buy a product with an expense ratio of whopping 4% per annum. Let’ say that the product has 100% surrender penalty if you terminate it within 2 years. Say you are at your 25th month. If you terminate the policy, you’ll incur 100% lost for that two years worth of capital. Assume the regular saving every month to the lemon product is $1000.

Scenario 1 - You terminate the product and buy a new one: Assuming that the market return before cost is 5%, how long will you take to breakeven when you buy a new product with an expense ratio of 1%? Working as follows:

PMT=1000,
R = 4%/12 (because net of expense ratio, the new product’s return is 5-1=4%)
Where N is to be solved such as the future value of the new investment equal to FV= N*PMT + 24*PMT

Using an iterative method, N = 112 months or 9.342 years.

As it can be seen from the above, it takes nearly 10 years just to breakeven. Don’t forget that this is the breakeven point. The client still has not even make any money. After netting inflation, he is still at a lost. How many 10 years period does a person has? Moreover, the rate of return is not even guaranteed. So the breakeven point could even be longer.

Scenario 2 – You terminate the product and buy a new one hoping to encash it 10 years later. Question: How much should a market perform if the desired rate of return is 4%? Working as follows:

N=10*12
PMT=1000
FV=1000*12*10 + 1000*24 (assuming two years of lost)
Breakeven R = 0.293% per month or 3.52% per annum.

Therefore the market must perform at least: 3.52% + 1% +4% = 8.52% per annum.

As you can see that the desired rate of return is just 4% but the market is required to perform 8.52%. This increases the risk of the portfolio significantly and as good as putting all money into the equity market. But with such a high risk, there is a high chance of losing 50% or more of the capital just like in year 2008.

Thus, for these reasons, it is almost always not advisable to terminate long-term contracts like ILPs.

So given the situation of clients who have to retire at age 70 (instead of 55), what can I do to help them? I cannot do magic for damages already done. However, financial planning is a subject that is very broad. Most financial advisers only deal with 30% of the entire subject because the rest of the subject earns no commission. There are many other problems which a person will face (financially) which I can help to resolve. Also I might be able to shift their retirement age say from age 70 to age 65 by teaching my clients good saving habits and what is really means to be prudent. I am actually very surprised that most people these days have very poor saving habits. I think Singapore is becoming like Americans which just borrow everything to buy this and that (properties) but save nothing. We should not adopt western culture blindly.

Of course, most of my clients hate what I have to say about what they should do because nobody likes to listen to what is meant to be prudent. But I am not bothered if clients do not listen to such advice afterall I am paid by them to tell them the prudent things to do.

This blog article also appeared at CPF Board's IM$avvy / IMSavvy: http://www.cpf.gov.sg/imsavvy/blog_post.asp?postid=209641116-70-579339861

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