BEFORE you make a commitment, here are afew things to think about.

What are your objectives? An endowmentsets out to satisfy the twin objectives ofprotection and savings. The protection value isoften relatively modest. Yet it still incurs a costand adds to the policy’s total expense ratio. Ifyour objective is purely to save towards along-term objective, you can consider puttingmoney aside in a diversified portfolio of stocksand bonds. Make sure to commit to regularinvestment, which helps to ride out volatilityand harness the power of compounding.Consider term assurance for protection.

Cash flow. You should be able to affordpremium payments well into the future. In acash crunch, there are a few options. You canopt for a policy loan or take a premiumholiday. These options carry costs. There arealso parties that can buy over your policy andon-sell it to investors, turning it into a tradedor resale endowment policy. This option maypay you a higher value than the insurer’ssurrender value.

Diversify. Many endowment policies’return profile is just slightly better than along-term Singapore government bond.Returns may disappoint due to bonus cuts,and fail to beat inflation. It is prudent todiversify into growth assets for your savings.

Shop around. Some insurers may offermore attractive net rates of return – that is,you could benefit with substantially lower totalexpense ratios. For this, you will need tocompare each policy’s “reduction in yield”which reflects the net rate of return after allpolicy expenses. Insurers will also differ interms of their track record in bonus cuts.

Changes in the offing. Following theFinancial Advisory Industry Review (Fair),some changes are in the offing in terms ofdisclosure as well as remuneration structurefor insurance advisers.

The Fair report, for instance, recommendsthat the benefit illustration and productsummary should highlight factors such as thenon-guaranteed nature of the illustrative ratesof return.

Insurers may also have to state the averageexpense ratio of the par fund over the pastthree years, reflecting management,distribution and other expenses. Onremuneration, there may be a redistribution ofcommission payouts, setting a lower cap onthe first year payout. – Genevieve Cua

A: Death benefit numbers.What this part of the BI shows isthat the value of the death benefit is progressively enhancedby a non-guaranteed component.

Reading the data: By Year 25. the non-guaranteed portionof the DB – assuming 3.75 per cent return – would come to$25,605.

B: Surrender values. SVs have guaranteed and non-guaran-teed portions. There is usually no SV in the first year or two.

Reading the data: By Year 20, the policyholder has paid$33,251 in premiums. Assuming a 3.75 rate of return, his to-tal SV – the sum of guaranteed and non-guaranteed returns– will be $30,080. Should he choose to surrender at thisstage, he still does not break even on premium payments. Ifthere is a bonus cut, the projected SV may be lower.

C: Maturity value. This is the long-term goal. Again it com-prises guaranteed and non-guaranteed portions.

Reading the data: By year 25, the total maturity value isprojected at $49,605 assuming a 3.75 per cent return. Thenon-guaranteed portion of $25,605 makes up roughly half

the total maturity value.

D: Table of Deductions. This shows the magnitude of expens-es and how that affects the SV. Expenses include distributionand insurance costs, surrender charge and other expenses.

Reading the data: By year 25, the policyholder wouldhave paid total basic premiums of $41,564. The “Value of pre-miums paid’’ assumes that the premiums earn a rate of re-turn without costs. Assuming a 3.75 per cent return, the totalpremiums would grow to a value of $69,464. The column “Ef-fect of deductions to date’’ represents total expenses on thepolicy, which comes to $19,859. This would reduce the totalSV and maturity value to $49,605.

E: Total distribution costs. This section reflects each year’sdistribution costs without interest. Costs include commis-sions and costs of benefits and services.

Reading the data: The largest deduction for distributioncosts – in this case 63 per cent – occurs in Year 1. By Year 6,all distribution costs are accounted for and there are nomore deductions in subsequent years.

Understanding the benefit illustration

Why you wantit, how to goabout it, and aFair assessment

This column on financial productsis sponsored by MoneySENSE,a national financial education programme in Singapore. Find out more about other common financial products at www.moneysense.gov.sg

Benefit illustrationHighlights to watch for

1/262/273/284/295/30

20/4525/50

1,6633,3254,9886,6508,313

33,25141,564

20,00021,00022,00023,00024,00039,00043,000

20,34021,68623,05724,45525,88055,51068,605

340686

1,0571,4551,880

16,51025,605

400808

1,2591,7552,297

22,71336,113

20,40021,80823,25924,75526,29761,71379,113

END OFPOLICYYEAR/

AGE

TOTAL BASICPREMIUMS

PAIDTO-DATE ($)

GUARANTEED($) NON-GUARANTEED ($) TOTAL ($) NON-GUARANTEED ($) TOTAL ($)

PROJECTED AT 5.25% INVESTMENT RETURN

DEATH BENEFIT

Basic sum insured: $20,000Annual basic premium: $1,662.56Term: 25 years

Male, non-smokerAge last birthday: 25

PROJECTED AT 3.75% INVESTMENT RETURN

1/262/273/284/295/30

20/45

25/50

1,6633,3254,9886,6508,313

33,251

41,564

01,0002,2283,2514,275

19,217

24,000

00

288465693

10,863

25,605

01,0002,5153,7164,968

30,080

49,605

00

351585891

15,869

36,113

01,0002,5793,8365,166

35,086

60,113

END OFPOLICYYEAR/

AGE

TOTAL BASICPREMIUMS

PAIDTO-DATE ($)

GUARANTEED($) NON-GUARANTEED ($) TOTAL ($) NON-GUARANTEED ($) TOTAL ($)

PROJECTED AT 5.25% INVESTMENT RETURN

SURRENDER VALUE

PROJECTED AT 3.75% INVESTMENT RETURN

A

B

MATURITY VALUE

C

Table of deductions

Total distribution cost

1/262/273/284/295/30

20/4525/50

1/262/273/284/295/306/31

20/4525/50

1,6633,3254,9886,6508,3139,975

33,25141,564

1,6172,0752,2582,3492,4412,5322,5322,532

1,6633,3254,9886,6508,313

33,25141,564

1,7253,5155,3717,2989,296

50,05269,464

1,7503,5925,5307,5709,717

59,41386,452

1,7502,5922,9513,7344,551

24,32726,339

01,0002,5153,7164,968

30,08049,605

1,7252,5152,8563,5814,32819,97219,859

01,0002,5793,8365,166

35,08660,113

END OFPOLICY

YEAR/AGE

END OF POLICYYEAR/AGE

TOTAL BASIC PREMIUMPAID TO-DATE ($)

TOTAL DISTRIBUTIONCOST TO-DATE ($)

TOTAL BASICPREMIUMS

PAIDTO-DATE ($)

VALUE OF BASICPREMIUM PAID

TO-DATE ($)

EFFECT OFDEDUCTIONTO DATE ($)

TOTALSURRENDER

VALUE ($)

VALUE OF BASICPREMIUM PAID

TO-DATE ($)

EFFECT OFDEDUCTIONTO DATE ($)

TOTALSURRENDER

VALUE ($)

PROJECTED AT 5.25% INVESTMENT RETURNPROJECTED AT 3.75% INVESTMENT RETURN

D

E

By investing in an endowment, you are

buying into the insurer’s asset

allocation.

Compiled by BT

‘’

THE BUSINESS TIMES WEEKEND SATURDAY/SUNDAY, MAY 25-26, 2013 smart money 27

By Genevieve Cuagen@sph.com.sgAN insurance endowment plan is likely to be one of thefirst things that comes to mind when one wishes to em-bark on a medium- or long-term savings plan.

Endowments are widely seen as an efficient form ofsavings. You may put it on an auto-payment plan so thatyou don’t run the risk of any lapse in payment. You neednot fret about what assets to invest in, and it appears tohave little volatility.

Yet for some policyholders, endowment plans havedisappointed in terms of their maturity values, causing ashortfall in their savings objectives. What can typically gowrong, and what should you watch out for?

There are two broad types of endowments: “participat-ing” and “non-participating”. A participating or par planis a “with-profits” type of insurance plan where premi-ums are pooled together by the insurer and collectivelyinvested to achieve a rate of return.

A non-par plan is designed to pay fixed or guaranteedbenefits. The insurer typically will invest the premiumsin bonds whose maturity profile matches that requiredby the policy. The funds are managed on a segregated ba-sis – that is, the funds are not co-mingled with the partici-pating life fund. Non-par endowment returns are typical-ly lower than those of par endowments.

What you should know:

Understanding bonusesWith par endowment plans, there are two componentsto the return: guaranteed and non-guaranteed. Thenon-guaranteed portion of returns is expressed in termsof bonuses. Sometimes a plan can also feature cash divi-dends, although a bonus structure is the most common.

A plan may have an annual or “reversionary” bonus,as well as a terminal (TB) or maturity bonus. As the namesuggests, an annual bonus is accrued annually. The matu-rity bonus is typically a one-off bonus in the final year ofthe policy. It is typically expressed as a percentage of theaccumulated annual bonus to date.

Some insurers may also give a one-off “performance”bonus which is paid when the policy matures or is surren-dered, or when a claim is made.

Once a bonus is paid, the amount becomes part of theguaranteed value. You will find details on the annual andother types of bonuses in the product summary thatshould accompany the BI.

In par policies, returns are “smoothed”. This meansthat in a good year, the insurer may choose to pay out itsnormal bonus rate and retain more surpluses. In a pooryear, it may distribute more of the retained surplus as bo-nuses to maintain the bonus rate. The effect is a fairlysmooth rate of return, which masks any volatility that thelife fund may experience.

Under the Insurance Act, shareholders receive up to atenth of the bonus allocation, and policyholders get upto 90 per cent.

What you should always keep in mind is the non-guaranteed nature of the bonuses. In fact, over the lasttwo decades, policies’ bonus rates have steadily de-clined. While a number of factors may affect bonusessuch as unexpectedly large claims including deathclaims, the largest factor is the fund’s investment experi-ence.

The bulk of insurance monies is invested in fixed in-come assets where yields have steadily fallen. Yet anoth-er challenge is that the bond market may not offer matu-rities that match insurance policies’ maturities. Thismeans that insurance funds often incur re-investmentrisk and have to re-invest their funds at steadily loweryields.

Even equity returns expectations have become moremuted compared to 10 to 20 years ago. Life funds’ equityallocation tends to vary between 10 and 30 per cent. Equi-ties are typically expected to provide the kicker tolong-term portfolio returns, hence enabling insurers toquote fairly generous maturity bonuses. But in recentyears, for older generations of policies, TBs have beensubstantially cut.

In short, insurers may cut bonus rates and this typical-ly happens for the cohort of policies whose previouslyquoted rates of return at inception have become unsus-tainable because of increasingly depressed yields. Insur-ers do try, however, to avoid cutting rates as this causesdisappointment among policyholders. Instead, newerpolicies are quoted with lower rates of return.

Projected investment rate of returnAll with-profits BIs carry two projected investment ratesof return: 5.25 and 3.75 per cent. The Life Insurance Asso-ciation (LIA) sets an upper limit to projections at 5.25 percent, and insurers have to present a second scenario1.5 percentage points below the maximum projection.The cap is currently under review and may be adjusted.

The rates represent what insurers’ life funds are ex-pected to achieve, net of the life funds’ investment ex-penses. The BIs carry two rates to show policyholdersthat volatility can occur and there can be a range of out-comes. As LIA says in its guidelines, the rates are only forillustration and do not represent the upper or lower lim-its achievable by the life fund.

But what you should note – and this is very important– is that you should not think that your own policy actual-ly earns 3.75 or 5.25 per cent.

To get a sense of your policy’s net rate of return, youhave to net out policy expenses such as mortality costs,management expenses, and distribution costs which in-clude commissions and other costs.

Older BIs used to have a section to spell out the “re-duction in yield” (RIY). This explicitly shows the net re-turn to the policyholder assuming that the life fundachieves 3.75 or 5.25 per cent. You’ll find that the actualnet rate of return is significantly lower. For a 3.75 percent assumed return on a 20-year policy, the net returnmay be less than 1.5 per cent. For 5.25 per cent, the netannualised return for the policyholder could be less than3 per cent.

For some shorter endowments, net returns may beeven lower. On a 10-year plan seen by this writer, using afinancial calculator, the net return to the policyholderwas just 0.2 per cent for the 3.75 per cent assumed re-turn. For the 5.25 per cent column, the net annualised re-turn was 1.8 per cent. The policy was incepted in 2011.

Of four BIs perused by this writer from different insur-ers, only one firm spells out the RIY – and it does sobased on the two headline rates of return of 3.75 and5.25 per cent. The RIY ceased to be part of most BIs since2008. Prior to 2008, it was quoted based on a single as-sumed rate of return.

The RIY is arguably one of the most important piecesof information as it illustrates the total expense ratio ofthe policy. It also helps to you to compare projected re-turns among insurers as expense ratios can vary signifi-cantly. And, particularly if the death benefit is minimal,you are able to compare the policy net returns againstother investment options such as a balanced fund or aportfolio of bonds. If your BI does not spell out the RIYs,do ask your agent to calculate it for you.

Flexible withdrawalsMost plans are designed to give policyholders the flexibili-ty of making some withdrawals, which may be called acoupon or cashback. This type of policy is traditionallycalled the anticipated endowment. Today, the withdraw-al feature is built into the endowment plan. In the past,withdrawals could only be made at three-year intervals;

today, you can make withdrawals as frequently as annual-ly.

Typically, you can withdraw 5 per cent of the deathbenefit annually. The total withdrawal over the life of theplan may be up to 120 per cent. If you choose not to with-draw, the coupons or cashback is then deposited withthe insurer at a certain interest rate. The rate is not guar-anteed and may be cut.

Do take note of these two points: One, there is a poten-tial here for misunderstanding and mis-selling. This is be-cause the cashback is sometimes mis-represented as a re-turn on your capital. This is wrong. As mentioned earlier,the coupon or cashback is actually a portion of the deathbenefit.

Two, when you make withdrawals, you affect the poli-cy’s rate of return and defeat the purpose of savings inthe first place. If you withdraw every year, the final matu-rity value will of course drop and the net rate of returnbased on the lower maturity value will be negative.

DeductionsAll BIs will reflect a table of deductions. Under the respec-tive projected rates of return, you’ll see a column, “Valueof premiums paid to date”. This reflects the assumptionthat you are able to invest the premiums without incur-ring any expenses and earn the headline rate of return.

Another column shows “Effect of deductions to date”.This shows the accumulated value of expenses such asthe cost of insurance, distribution costs, surrendercharge, and expected transfers to shareholders. The dif-ference between the two columns is reflected in the “sur-render value” column, which represents what you will re-ceive should you choose to terminate your policy beforematurity.

You will find that on most policies, there is no surren-der value in the first year. The breakeven point of the poli-cy – the point at which you recover your premiumsshould you surrender – is also typically very long. On a25-year policy, the breakeven point assuming a 3.75 percent return may be some time after the 20th year. Assum-ing a 5.25 per cent return, you may break even some timeafter the 15th year.

The BI will also show you “total distribution costs” ,which includes commissions and overrides paid to theadviser. On a long-term policy of 20 or 25 years, all distri-bution costs may be paid out by the sixth year.

Asset allocation and insurer’s track recordLife funds are invested in market assets. It is a mistake toassume that because your returns are smoothed, thefund does not experience volatility. Life funds are typical-ly invested in a very diversified manner. The bulk is in-vested in fixed income assets to provide a stable profileof returns. A relatively modest portion is invested in equi-ties, usually less than 30 per cent. Other assets may in-clude real estate and loans.

Every year, you will receive an annual bonus updatewhich will show you the bonus that your policy has ac-crued. You will also receive a par fund update whichgives a snapshot of the insurer’s life fund performance.The update will tell you the asset allocation and returnsover one year and the past three years. There may also becommentary on the experience of the past year and thenear term outlook. Some insurers also include top five or10 holdings.

What all this shows is that by investing in an endow-ment, you are buying into the insurer’s asset allocation.If you have a horizon of 20 or 25 years for your savingsplan, you may want to consider investing in funds whereyou can control the asset allocation. While endowmentsare seen as instruments that allow you to sleep at nightbecause of their apparently low volatility, they are notwithout risk to your savings goals especially if the insurercuts bonuses substantially. Net returns may also notkeep pace with inflation.

Some policyholders have been disappointed by their maturity values. Here are some things you should watch out for.

The ins and outs of endowment plans

26 smart money THE BUSINESS TIMES WEEKEND SATURDAY/SUNDAY, MAY 25-26, 2013

Once a bonus is paid, the amount becomes part of the guaranteed value. You will find details on the annual other types of bonuses in the product summary that should accompany the benefit illustration (BI).

Endowments are a type of bundled insurance product offering savings plus protection. They are a staple in Singapore’s insurance market. They are typically marketed to parents with young children as a form of savings for future university fees.