Over the past few years, we've been regularly covering Investment Linked Policies. Our position on Investment-Linked Policies (ILPs) has always been very clear.
If you are ready enough to want to take control of your own personal finance, or interested enough to be looking over this article, then chances are, you do not need an ILP.
Following our newest article on 5 explanations why Singaporeans continue to be buying ILPs today, we receive questions from some readers about what they ought to do if they have already bought an ILP. Would it better to continue, in order to surrender the insurance policy?
Sunk Cost Fallacy
Sunk cost fallacy refers to how individuals are not willing to stop with an investment simply because of the items they have allocated to an investment (i.e. the sunk cost).
Think of it from a business perspective. Imagine if a company spent $10 million dollars creating a factory overseas. However, business didn't go as planned.
To keep the factory operating, the company has to spend $200,000 every month while only recuperating 1 / 2 of it in revenue, thus sustaining an additional loss of $100,000 every month.
A sound business decision at this time could be to close the factory, and perhaps salvage back the gear, that are still worth $2 million. Sunk cost fallacy is necessary when a clients are reluctant to close on the factory not because it believes that the turnaround is appropriate around the corner, but simply because it does not wish to realize the $8 million loss on its investment.
Overcoming Sunk Cost Fallacy In ILPs
The same logic pertains to ILPs. Often, individuals are not willing to give up their ILPs as they do not want to terminate it baffled. Instead, they continue paying their payments, hoping they can breakeven by using it later on.
They fall under the trap of sunk cost fallacy. They continue investing due to the things they had previously place in, rather than investing due to the returns they be prepared to get.
It's similar to getting a bad hand for poker, but still playing, not since you are confident you are able to win the round, but since you already committed too much towards the pot, and think it's past too far to exit. The end result more often than not? You wind up losing more.
How Should You Assess If you should Continue Your ILP?
Here is a real life scenario based on an ILP plan that one of our readers has kindly distributed to us.
ILP Monthly Premiums
|Premiums That really Get Invested Each Month||$310|
|Premiums That Are Used For Insurance||$178|
Despite paying $488 a month, our reader is only investing $310, using the remaining amount used for insurance costs (more about that later).
Our reader has been make payment on premiums since December 2009.
|Total Premium Paid To Date (Since Dec 2009)||$40,504|
|Total Premiums Invested||$25,730|
|Current Surrender Value||$26,207|
|Net Estimated Return Per Annum||0.6%|
Pretty depressing huh-
The numbers look pretty bad therefore we probe just a little further into the investments our reader made. He was forthcoming enough to share the details of the 2 funds he had committed to.
|Type Of Fund||5-Year Annual Return||Benchmark|
|Asian American (equities and bonds)||1.8%||5.4%|
|China India (equities)||0.7%||3.7%|
Actual returns in the two funds were really that bad. Both the funds significantly underperformed against their respective benchmark. Average go back to our reader was 1.2% per annum, before further transection cost.
The Big Question – Are you currently Best By Yourself?
Our reader may have paid a total premium $40,504 since 2009. However, you need to bear in mind that only $25,730 were invested, with the remainder used for insurances.
If he terminates his plan today, he'd receive $26,207 he can pick to reinvest elsewhere. He'll also provide an extra $310 every month to take a position. If he simply invests all these money and generate a return of 4% per annum, he would have about $168,000 in Two decades time.
If he sticks to his current plan, he would have to continue paying the same premiums each month, and hope the funds he is purchasing would fare better than it had in the last Five years.
The reason for this illustration isn't for us to incite a witch-hunt to discover what these bad money is, and also to encourage people to pull their money out, and to place it into good funds instead. Nobody can predict the near future. Today's best performer can become the worst performer the coming year, and the other way around.
Rather, the point here is to remind people who if you have an ILP, and therefore are considering taking out, you need to know what the other investing options are. There isn't any point in pulling out of the ILP simply because it is not faring well, only to understand that you've got no other plans in mind.
A 2% return from an ILP would look bad if you can obtain a 5% return elsewhere. Exactly the same return could be great, if the alternative would be to keep your money in your saving accounts, and to end up spending it for any holiday.
Before you take out, ask yourself that which you plan to do with the surrender value you receive, and the future premiums that you can now use at your discretion
Find Out What Health Insurances Are Tagged To Your ILP
There is a great chance that your ILP might be offering you insurance policy. Go discover what these coverages are. You don't want to cancel your ILP, simply to understand that you've also cancelled your insurance policy simultaneously.
In the case in our reader, he's an earlier stage critical illness and a disability income insurance that is associated with his ILP. If he promises to cancel his ILP, he should first determine if this coverage is still important to him.
If it is, he then is deserving of himself covered first, before terminating his existing ILP. This ensures that his health insurance needs are not compromised by the termination of his ILP.
Generally speaking, we advocate for individuals to keep their investment and insurance needs separated, as it could be simpler to manage.
To end off, the question of whether you should cancel your ILP really boils down to what other better plans you have, and what you intend to use the additional money you have. To get a full picture of the options, you need to talk to multiple agents to find various viewpoints, in addition to some financially savvy friends that you can trust to provide you with independent advice.
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