Better investment alternatives to Endowment Policies for those with low risk tolerance

In our previous post Are the Returns on Endowment Policies worth our Time & Investment?, we looked at how the returns over 2 decades from endowment policies incepted all those years ago have fared. To our surprise, the results have been mixed. One policy eventually delivered investment returns better than what had been promised twenty years ago (returning 4.05% rather than the 3.77% promised). But the other fell short by a long way (returning 3.46% instead of the promised 5.49%). Can we expect endowment policies to help us grow our investments at a 4% pace in the future? Or are there better investment alternatives to endowment policies to achieve this?

Endowment Policies require patience and long term commitment but grow your money slowly

What do Endowment Policies offer us today?

Let’s start by taking a look at what sort of returns endowment policies can give us today. Our first stop is the CompareFirst website for indicative illustrations of 20 year, regular premium endowment policies available today. As luck would have it, there are 4 such policies, which we show in the table below:

Indicative Benefits Illustration for 20 year regular premium Endowment Policies

	Insurer 1	Insurer 2	Insurer 3	Insurer 4
Annual Premium	$4,998	$5,000	$5,000	$5,000
Maturity	20 years	20 years	20 years	20 years
Final Payout (4.75% par fund returns)	$144,961	$159,037	$140,962	$139,327
Internal Rate of Return	3.42%	4.24%	3.17%	3.06%

Obviously, with the lower interest rates of today, the rates of return which we got for one of our 20-year endowment policies of 4% are much more difficult to get now. Most of the insurers are projecting returns of 3% to 3.5%. And these are non-guaranteed returns as well, mind you, which means that the benefits can be cut in the future. So, there are two issues here. Firstly, can the insurers reach the 4.75% returns benchmark for policyholders to get the meagre 3% to 3.5% returns? Secondly, if the insurers are making 4.75% on their par funds, why are the policyholders only getting 3% to 3.5%? Isn’t the money in the par fund the policyholders’ money in the first place?

Is a 4.75% return on the par funds something we can expect?

Let’s look at the first issue – can the insurers get 4.75% returns on their par funds? As we show in this article, over the period 2005 to 2018, most of the insurers in Singapore (including the four above) did not achieve a compounded return of 4.75%. If history repeats itself, then it is possible that the 3% to 3.5% returns on endowments will be cut back!

Returns for insurer par funds 2005 to 2018

Now, there is one anomalous case in the indicative endowment policy returns above, where the insurer has projected a 4.24% return over twenty years! Can this be possible? Unfortunately, this insurer has not actually achieved at 4.75% return on its par fund in the past. Hence, there is a good chance that they will not really be paying out 4.24% to any endowment policyholder in the future. But also, why are endowment policy returns so much lower than the insurers’ par fund returns?

Why are endowment policy returns so much lower than par fund returns?

That juicy 4.24% return over seems somewhat unlikely for a number reasons. It means that the insurer will pay out the maximum they can should their participating fund returns hit 4.75%. In Singapore, for every $9 an insurer pays out to policyholders, they can recognize up to $1 as their profit. This is on top of the fund management fees already charged before the computation of the 4.75% return. In short, if the insurer earns 4.75% on its par fund, the maximum payout to policyholders will be 4.27%.

And being profit-oriented companies, there is no doubt that the insurers will take their full share of profit, as we can see from the financial returns they file with the Monetary Authority of Singapore (MAS) every year:

Allocation of par fund returns declared by insurers in 2019

	Insurer 1	Insurer 2	Insurer 3	Insurer 4
Policyholder bonus	$146.1 million	$683.7 million	$430.9 million	$504.3 million
Insurer’s surplus	$17.9 million	$76.7 million	$47.9million	$45.4 million

Apart from the 90:10 rule, most endowment policyholders will be aware that a significant proportion of the premiums they pay in the first few years of the policy end up covering management, operational and distribution expenses, instead of going into the par fund. Another portion may end up going to pay for the pure term life insurance premiums for the policy, which goes into the non-par fund of the insurer.

Suppose 10% of all premiums paid over the lifetime of the endowment policy (the first 2 years’ premiums) end up covering these expenses. Since the amount “belonging” to the policyholder in the par fund is now 10% lower than the full amount of premiums paid, it means that the returns they get on the policy will also be another 10% lower than the par fund returns when assessed against the total premiums paid over twenty years.

Hence, what we can conclude is that endowment policy returns will at best be 20% lower than an insurer’s par fund returns, due to the 90:10 profit sharing rule, and the deduction for expenses at the start of the policy. What this means is that if the insurer manages to achieve a 4.75% return on the par fund, at the very best, the policyholder can look forward to 3.8% returns on the premiums paid.

Alternatives to Endowment Policies: Traded Endowments

Having seen how taking out an endowment policy today will likely lead to pretty poor returns over the next two decades, what other better investment alternatives to endowment policies are there for those of us with low risk tolerance? And hopefully which can give us a 4% return on our investments? Now, the person who invests in endowment policies, besides having a relatively low risk appetite or tolerance, is probably also someone with a long term commitment to paying the premiums or investing, and is also able to bear the illiquidity of stashing away money in an endowment policy which will almost certainly leave him or her worse off if it is surrendered early.

Given these characteristics, one investment which has been touted for these people, and with better returns are traded or resale endowment policies. These are endowment policies, like those we have discussed above, but which have been sold before their maturity, not via surrendering them to the insurer for a paltry sum, but to a third party broker for somewhat better returns for the original policyholder. In turn, the third party broker now resells them for a profit, but at a slightly higher projected internal rate of return to a new policyholder. The new policyholder has to come up with a lump sum investment at the point of purchase, and furthermore commit to paying the remaining premiums (if any) for the policy, but will now be entitled to the payouts made by the insurer upon the maturity of the policy.

While concerns have been raised from time to time as these traded or resale endowment policies are not regulated, and there is unlikely to be any way of making a claim in the unfortunate event that the life insured passes on, in general, we can think of these traded endowment policies as bond-like products. But what sort of returns can we expect from these investment alternatives to new endowment policies?

Projected Investment Returns on Traded Endowment Policies

A glance through the lists of endowment policies for sale at the websites of several third party brokers shows that the projected returns for an endowment policy with roughly 10 years to maturity tend to hover around 4%. Take note, though, that this is based on the insurer’s projected returns, which may or may not be met. In all likelihood, in the current low interest rate environment, these may be cut in the future, leading to lower returns on these traded endowment policies. But, as endowment policies are also subject to sequence of returns risk, poor returns in the last half of the policy’s life tend not to affect the final payout as much as poor returns in the early half. Hence any poor returns to the traded endowment policy should already be reflected in the updated benefits illustration.

This doesn’t mean that investing in trade endowment is risk free, or even entirely straightforward. For a start, the buyer needs a lump sum for the initial purchased of the traded endowment policy. Thereafter, he or she needs to maintain payment of the premiums due. Finally, the investment itself is illiquid, and having to sell it or surrender it before maturity will definitely eat into the projected returns. After all, in order to provide a return of 4% on a traded endowment policy which yields around 3% to 3.5% on average, the third party broker can only offer the seller an investment return of 2.5% to 3%, or less, for the policy in the first place.

So what other better investment alternatives are there besides endowment policies, whether new, or resale, for trying to get 4% returns in a relatively safe and low risk manner?

Alternatives to Endowment Policies: Bond Funds

A further better investment alternative to endowment policies is a bond fund. A cursory search turns up several which look pretty interesting and which fit out investment criteria of being low risk and able to provide an investment return of around 4% a year in payouts. Payouts which can either be retained, or re-invested.

Illustrative Sample of Bond Funds, Dividend Payouts and Capital Gain Returns

In some ways. bond funds have the advantages of traded endowment policies, as well as some of the downsides. The advantages include:

• Dividends paid are guaranteed returns, just like declared reversionary bonuses on endowment policies
• While the final payout amount upon selling the fund can vary, in general the price return has been between 1% to 2% per year. And this is on top of the dividends, for a total return of around 5% to 6%

In some ways, they have the same disadvantages:

• A lump sum investment is required at the start. But thereafter, unlike traded endowment policies, you can choose to either continue to invest periodically, re-invest the dividends, or simply just collect the dividends and do nothing else

And there are also advantages which make them better investment alternatives over both endowment policies and traded endowments:

• The bond fund investment is liquid as you can sell it off anytime without incurring a loss
• If you have overdraft funding (against collateral), low risk bond funds can leverage up to 80% LTV! Assume an overdraft interest rate of 2%, and bond fund dividend-only returns of 4%. Conservatively purchasing a bond fund valued at $100 with $50 of investment plus $50 of overdraft can give a return of 6% on the invested $50!

Why don’t I invest in the bonds directly instead of through a bond fund?

If bond funds are such simple investments relative to endowment policies, and can match or better the returns, why not invest in the bonds directly, and cut out the fund expenses of 1.5% per year? Unfortunately, unlike investments in stocks, this is not so easy to do. Except for some very low risk retail bonds with low yields meant for retail investors, most bonds require an investment of $250,000 for SGD bonds, and US$100,000 for USD bonds, which put them out of reach for most investors. Moreover, there is the use of derivatives for hedging the currency risk as well. So, accessibility to the bonds themselves is not straightforward for a typical investor.

Furthermore, have you ever wondered how bond funds can return 4% to 6% per year? Especially when bond yields have been hovering around all time lows of 1% to 2%? A significant portion of the gains in bond funds comes from riding the yield curve. That is, buying a 10 year bond at the current 10-year bond yield of 2%, and selling it 4 or 5 years later at the 5-year bond yield of 1%. Doing this, and replenishing the portfolio with a new purchase of 10-year bonds takes considerable management effort! See here for more on this.

Finally, it is much harder to diversify low risk bond investments compared with a portfolio of stocks. After all, virtually all the bonds in the portfolio have exactly the same type of interest rate risk! A bond fund manager may diversify across different credit qualities, different maturities etc. But because the main risk is interest rate risk, it takes a much larger portfolio of different bonds to achieve the same sort of diversification as, say, a stock portfolio with 25 different stocks.

At the end of the day, investing in a low risk bond portfolio involves a lot more operational work than a stock portfolio. Accessibility to the bonds themselves is also much more difficult. Leave this work to the professionals!

Concluding thoughts: Bond Funds as better investment alternatives

Most of us are not full time or professional investors. Which is why it is easy for us to end up with a collection (not a portfolio!) of endowment policies. It is so much easier to wait for an eager financial advisory representative, or an insurance agent, or the neighbourhood bank officer to sell you something than to do the legwork yourself!

But good investments need not be complicated (like regular and traded endowments), or require a lot of work. Bond funds might be the better investment alternatives to endowment policies for those with low risk tolerance, but want better returns.

Finally, one of the great things about bond fund investing is that it allows you to invest safely with leverage. More on this here!

PS: Despite the low returns returns on endowment policies relative to the investment returns of the life insurers’ participating funds, projected investment returns will be cut from 1 Jul 2021. The upper illustrative return of 4.75% is now lower at 4.25%, and the lower illustrative return goes from 3.25% to just 3.00%. You can read about the implications of this here.

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