How suitable are investment-linked policies for your portfolio strategy?

OVER the past two decades, we have not used investment-linked policies (ILPs) when building investment portfolios for our clients because we do not think they are suitable. But ILPs have since evolved, and we have been asked whether we would change our stand on them.

Protection-based ILPs were first developed in the early 1990s. Similar to whole life plans, for every dollar in premiums you pay, a portion goes into covering the cost of insurance, after deducting distribution cost (commissions) and other fees; the remaining balance is invested.

But unlike whole life plans, where the cost of insurance is fixed throughout the lifetime of the policy, ILPs’ cost of insurance is charged based on your age at policy inception. This cost rises as you become older. In whole life plans, the investment portion of the premium is invested in the insurers’ life fund. In ILPs, it is invested into unit trusts.

The value proposition of ILPs is that there is cost transparency; you know the cost of insurance, and how much is invested. Policyholders can choose from a menu of funds. But because the cost of insurance rises with age, there is a risk that the policy may lapse if the cost of insurance exceeds the premium you pay, especially if the underlying fund is not performing. In addition, fund choices are limited and the burden of obtaining an investment return shifts to the policyholder.

Wealth-accumulation ILPs

In recent years, insurers have launched ILPs designed for wealth accumulation. These ILPs are also known as 101 ILPs because the insurance coverage is 101 per cent of the value of your investment or total premiums paid, whichever is higher; they are designed to attract buyers.

The regular premium version is typically a limited-pay product, although some allow policyholders to pay throughout the life of the policy. Here are some details on 101 ILPs with a 10-year premium payment term. At the start, 100 per cent of your premium is invested and depending on the product, you may receive a welcome bonus of 5 per cent to 200 per cent of the first-year investment amount.

After the 10-year premium payment period, you may receive a yearly loyalty bonus of anything between 0.1 per cent and 2 per cent of your accumulated investment value for the lifetime of the policy, subject to terms and conditions. In terms of the underlying investments, most underlying funds for these ILPs are actively managed, and try to beat the markets through forecasting. Forecasting is a process where securities are picked based on a view of their future prices.

Some ILPs even offer funds that are typically available only to accredited investors, but are now accessible to retail investors as an underlying fund choice for an ILP. But there is no free lunch. If you surrender your policy before the minimum premium payment term (or lock-in period), or make partial withdrawals beyond the allowable amount, you will be dealt a heavy penalty. This is because insurers have incurred costs – they pay commissions upfront to their distributors and distribute bonuses to policyholders.

So, with all these new features, are ILPs now suitable vehicles to execute your investment strategy? Let us first look at the cost of 101 ILPs relative to other options.

Earlier this year, our solutions team was commissioned to do deep research on 101 ILPs. To arrive at the cost, the team used insurers’ benefit illustrations to calculate the projected net annualised return, which are returns net of underlying funds’ total expense ratio and other ILP fees. Taking the difference between this set of numbers and their projected gross return, the team was able to work out the ILPs’ total annualised cost at the end of a specified holding period.

We then compared these costs with the costs charged by financial advisory (FA) firms that use higher-cost actively managed funds, and those using low-cost non-forecasting funds. It is possible that ILP costs are lower than the charges of FA firms using higher-cost actively managed funds. But ILPs’ costs are still much higher than those who use low-cost non-forecasting funds.

But beyond cost, whether ILPs are suitable will also depend on your investment convictions. At our firm, we assess product suitability based on the four pillars of our investment philosophy.

Pillar 1: We invest in assets that have an economic contribution. For an asset class to generate long-term returns, there must be an economic basis or theory behind it. If an investment does not create any economic value, then we should not expect long-term investment returns. This is important to generate the more-reliable returns that our clients need. Equities and bonds meet this requirement.

In this respect, ILPs are suitable since they invest in these asset classes.

Pillar 2: To ensure reliability of returns, we validate eligible asset classes with empirical observations, observed across multiple markets and economic cycles. To further ensure reliability of returns, we do not invest based on forecasting or timing the market. Evidence shows us that actively managed funds that invest based on forecasting do not beat the markets most of the time. For those that do, they cannot do it consistently over the long term.

ILPs are less suitable as most of their underlying funds are forecasting-based.

Pillar 3: In terms of implementation, portfolios should be well-diversified and not overly concentrated in any particular investment, and costs should be kept low. Diversification has been proven to be the only effective way to enhance a portfolio’s risk-return trade-offs, and lower cost translates to higher return.

ILPs are less suitable, as their total cost is still relatively higher than exchange-traded funds and non-forecasting funds. Higher costs eat into returns.

Pillar 4: In implementing portfolios for clients, practical considerations include investors’ liquidity needs, investment efficiency and how best to help clients stay invested to capture returns.

ILPs are less suitable as their early-exit penalties make them less liquid, and fund choices are limited. There is also operational inefficiency, as ILPs have to be transacted on a different platform from other investment instruments. Using ETFs and funds that can be transacted on the same brokerage platform creates cost-effectiveness and operational efficiency.

Proponents of the 101 ILPs may argue that the lack of liquidity may “force” investors to stay invested for the long term and capture returns.

But this comes at a huge expense. What if the underlying fund managers underperform? What if there are no suitable funds within the insurers’ range to switch to? It may be difficult to redeem ILPs without incurring huge losses. There are better ways to help investors stay invested through robust cash flow planning, risk coaching and a turbulence management programme.

The writer is chief executive of Providend, South-east Asia’s first fee-only comprehensive wealth advisory firm