A loan for one is an investment for another. And vice versa. Your loan (liability) is an investment for the bank. Your investment in a bank FD is a liability for the bank. Similarly, your insurance investment is a liability for the insurance company (in cases where the returns are guaranteed).
We have seen how the incidence of processing fee and ancillary not only increases the cost of loan, but also makes it difficult for borrowers to figure out the effective cost in the first place.
And this happens not just with loans. Happens with investments too. Obfuscation is an art. Data points are selectively hidden and revealed. For instance, if an investment has done well over the last 3 years but done badly over the last 10 years, a seller can focus on the short-term performance. Alternatively, if the long-term performance was better, the seller can focus on long-term returns.
In this post, I will write about a category of investment products where the product manufacturer can easily help investors to figure out eventual returns but chooses not to.
Planning for Retirement
With my limited experience, investors start getting serious about retirement planning as they touch 40.
There are many ways to construct a retirement portfolio.
- You can build a diversified portfolio (equity, debt, gold, real estate) and hope that the portfolio will be sufficient to meet your retirement expenses. OR
- You can purchase products that provide assured cashflows during retirement. OR
- You can use a mixed approach. Use both (1) and (2).
If you belong to the category of investors that prefers assured cashflows during their retirement, do note that only insurance companies can offer such products.
Mutual funds cannot provide guaranteed returns. Yes, you can consider long-term bank FDs or long duration Government bonds. However, since you are still working, taxes on interest income will make your life complex.
Now, insurance companies can offer multiple types of investment products.
- Unit Linked Insurance Plans (ULIPs): Market-linked. Returns not guaranteed.
- Participating plans: Returns not linked to market performance. Predictable but not guaranteed.
- Non-participating plans: Guaranteed returns. Annuity plans would also belong here. You can calculate annualized returns upfront.
Since we are talking about guaranteed returns and assured cashflows, we will focus on non-participating plans in this post.
Let us consider a hypothetical non-participating plan. For a 40-year-old. Looking for a product that provides income after retirement at 60.
- Pay Rs 1.5 lacs for the next 20 years. Age: 40 to 60
- You get Rs 15 lacs lumpsum at the end of 20 years. At the age of 60.
- And you get Rs 3 lacs per annum from the 21st to the 45th year. From 60 to 85 years.
Looks good, no?
If you are worried about how you will fund your retirement, this is a very comforting product. There is a surety that you will get Rs 3 lacs per annum for up to 25 years after retirement. At this point, you don’t care much about how inflation will rip into these cashflows over decades and let’s ignore this aspect in this post.
The product is simple. Easy to understand and relate to. It satisfies a financial concern.
The product is complex. The policy document is covered with jargon. Guaranteed additions, bonuses, and much more. Sometimes, there is a deliberate attempt to give you an impression of a higher return. You can understand the product only through a custom illustration (and I did that for you). Even in the illustration, it is not clear whether the insurance company will pay at the beginning or at the end of the year. There is no mention of your net return anywhere in the illustration.
Surprising, isn’t it? Not really. It is in fact quite smart on the part of the insurers.
The insurance company knows you may not buy the product if you know the annualized returns. It also knows that you will not calculate the returns on your own. Hence, it is better this unsaid.
IRDA, the insurance regulator, can easily force insurers to disclose XIRR (annualized returns) in each illustration so that the investors can make an informed decision. It does no such thing. I cannot understand why.
Nothing works like obfuscation. Here is the playbook.
- Make things so complex that people wouldn’t even try to calculate the returns. AND
- Make things so simple that people wouldn’t care to calculate the returns.
If you survive the policy term (up to the age of 85), your net returns from this product will be 5.59% p.a.
Please note this is just an example. The cashflows for an insurance product can be structured in any way. Different non-participating products will offer different returns. In insurance products, the returns also depend on your entry age i.e., everything else being the same, the net returns will depend on your entry age. A 35-year-old will earn better returns in the same product than a 45-year-old.
What Do You Do?
I do not mean that non-participating plans are bad investments. There are quite a few merits in non-participating plans. For instance, you can calculate XIRR (good or bad) upfront. You can lock in returns for the long term. No risk.
Moreover, while I believe that 5-6% p.a. is not a handsome return for a 45-year maturity product, you may be OK with such returns.
Not all investors think the same way. While I am harping about annualized returns, you may focus more on cashflows, comfort, security, and how a particular product alleviates a particular concern in your life. Hence, I leave this to your judgment.
However, I believe in making informed decisions.
I have no issues in buying a non-participating plan because you find the cashflow security comforting. But would you have bought the product if you knew you would earn 5-6% p.a. over the next 45 years? If yes, then there is no problem. However, if the answer is in the negative, then we have a problem. Such analysis must be done before buying any product. And not after buying.
Therefore, work out these numbers before you finalize any investment. The insurers will not make it easy for you to figure out. If you can’t do it yourself, seek help from a friend, colleague, or an agent/advisor.
Do not rush. Do not make emotional financial decisions. Reason and make informed decisions.