Product Allocation – The Key to Personal Financial Planning
Previously in Retirement Goals and How to Get There, we introduced the concept of Product Allocation (hat tip Moshe Milevsky). This is distinct from the more common concept of Asset Allocation. For example, in personal financial planning, we are often have to make choices of Whole Life and Term Life Insurance policies to take up, and investments in bonds and stocks. We also make decisions about buying and investing in property, as well as the mortgages and other loans which we take to finance these properties, investments and even insurance policies. We usually do not think of insurance policies as assets, but rather, as products, just as we think of liabilities such as mortgage loans and overdrafts as products which fit into our overall personal financial planning portfolio.
Thinking about our portfolio of products is a key difference in personal finance. But this is not what we find in most finance textbooks. Most of finance theory and practice is for institutions and companies, which do not grow old and pass away. They also only focus on monetary profits for shareholders. We, on the other hand, do grow old, may meet with our demise accidentally or through illness, may lose our ability to earn a living, and ultimately invest and make financial decisions in order to be able to buy the things we need in life.
What is different in Personal Finance?
Applying financial theories and practices meant for institutions and companies to our everyday lives lead us to many practices which simply do not gel with the way the vast majority of people live, such as:
- Buy term insurance only, and invest the rest
- Rent, do not buy a house, as home ownership is a burden and liability
- Put all your assets in to stocks and bonds or other financial assets
Clearly, this is not how we live our lives, and not how our financial advisors advise us to do. We:
- Buy a mix of whole life and term insurance, as well as insurance for critical illness and healthcare expenses
- Buy our homes and take out mortgages to pay for them, as property ownership ensures we have a roof over our heads and can be used to leave a bequest for our offspring
So, either finance theory is wrong when we try to apply it to personal finance, or most people have been living their lives wrong! It is unlikely that the wisdom of crowds is wrong, so we need to understand why personal financial management is different.
Firstly, we grow old, fall sick, have injuries, and die, so our ability to work and earn is limited and uncertain. To this end, insurance products play and important role in our financial decisions.
Secondly, we cannot eat an unit trust, or live in a REIT. Our objectives in personal financial management must be for actual consumption. We buy a house to protect ourselves from rental inflation and from having to move. We invest, not to beat the returns of the market index, but to stay ahead of inflation.
What is Product Allocation?
So, Personal Financial Planning is really about making choices about the products which serve our needs best, or allocating our funds between different products. In short, Product Allocation. These products could be:
- Cash, which has liquidity and no risk, but zero returns
- Financial assets, which have risk, in exchange for monetary returns
- Insurance products, some of which have no returns (e.g. term insurance, health insurance) but protect us in unforeseen circumstances. Other insurance products may have a mixture of protection, risk and return
- Real assets, like housing, which provide non-cash benefits and incur cash liabilities
It is like picking out a mix of flowers at a florist, which look pretty, has a pleasant aroma, keeps insects away, and give our homes a splash of colour.
What is Asset Allocation?
If Product Allocation is choosing a bouquet with a mix of different flowers, Asset Allocation is choosing a bouquet of the same type of flowers but in different colours.
Asset Allocation is really about choosing a mix of investments, trading off risk taking for the chance of higher profits. The risk we take in making asset allocation is that the price or value of these investment can fall. But we cannot eat these assets, nor live in them, nor do they protect us from life’s mishaps. So for all the agonizing over whether we should have more in bonds, or stocks, or REITs, or gold, or Bitcoin, the reality is that asset allocation only forms a part of our financial life and financial planning. Yet because of the focus on “academic” finance, which is only entirely applicable to institutions and companies, we spend most of our time on this!
Hopefully, after reading this, you will have a better idea of how to manage your financial life. At the same time, we can have a more complete approach to personal finance, as something related to, but distinct from corporate finance. To start us off on this journey thinking about product allocation in personal financial planning, let;s look at some examples we may come across in our lives:
Product Allocation Example 1: Annuities and the 4 Percent Rule for Retirement Income
The first example of Product Allocation is something we wrote about previously in 4 ways the 4 percent rule can work in Singapore, and in The Yield Shield, 4 Percent Rule and CPF Life – A Perfect Retirement Combo? These two posts deal with combining an investment portfolio with an annuity for better retirement outcomes. The starting point of this is The 4 percent rule for Financial Independence, which we showed does not work very well in Singapore here, given our low interest rates and high volatility of the stock market. The table below shows the success rates for a 30 year retirement when we invest and use various withdrawal rules (including the 4 percent rule) in Singapore:
Success rates of different withdrawal rates from a retirement investment portfolio
|Withdrawal Rate||20 years||25 years||30 years||35 years||40 years|
Not very promising, right? To have our investment funds lasting 30 years in retirement, we can only withdraw 2% a year. But when we combine this in a 50:50 mix with an annuity like CPF Life, the results look much better:
Success rates for a 50:50 CPF Life:Investments Allocation (Male)
|Withdrawal Rate||20 years||25 years||30 years||35 years||40 years|
This looks much better, right? A male retiree now can survive a 30 year retirement withdrawing 4% from his combined CPF Life and investment portfolio. Elsewhere, we have also shown how a Yield Shield portfolio can help protect against Sequence of Returns Risk in retirement. Again combining the Yield Shield portfolio with an annuity gives us a much better outcome than using either one alone.
Success Rates for a 50:50 CPF Life:Yield Shield Allocation
|20 years||25 years||30 years||35 years||40 years|
But this is not something we find in traditional finance theory. As Yaari (1963) shows, an individual who wants a stable income and with no bequest motive should rationally put everything into an annuity. But the actual take up rate for annuities by retirees is only around 20%! This is because annuities cannot help us in an emergency. Nor can they be used for bequests for our children. Nor for lumpy healthcare expenses, especially towards the end of our time. In short, annuities cannot help us with most of our goals in retirement.
However, a combination of an annuity and an investment portfolio can provide a stable income, bequests, healthcare, emergency funds. By allocating between products, we can achieve a much better outcome than using either product by itself.
Product Allocation Example 2: Endowment Insurance and Investments for Education Funding
My second example of Product Allocation comes from a time when I was younger. Like many of us with newborns, I wanted to put some money aside for future education expenses. My insurance agent set me up with a series of Endowment Insurance products to help meet this goal. The sum of the premiums was $4,400 a year, a bit less than the $5,000 I wanted to put aside. On a whim, I decided to put the remaining $600 a year into REITs, which were relatively new back then. The dividends were reinvested annually as well.
Looking at the outcomes now, I am quite pleased at how they have turned out. The 88% of the savings put into the Endowment Insurance has a projected value of $100,000. Amazingly, the 12% put into the REIT investments is now worth a whooping $45,000!
Results of Product Allocation between Endowment and Investments
|Value now after 19 years||$100,000||$45,000|
It should be no surprise that over a long period of time, investments can vastly outperform an Endowment policy. Here, the 12% allocated to investments gave a return 3 times more than the 88% allocated to Endowment Insurance.
Looking back, would I have done anything differently? Hindsight is always 20-20. While I would have liked the younger me to have put a higher allocation in investments, there was much uncertainty back then following the Asian Crisis, the Nasdaq crash, the 9-11 attacks, and SARS. And all this even before the Global Financial Crisis of 2008! The assurance provided by the Endowment policy of a minimum, guaranteed return, plus the policy rider which paid off the premiums should anything happened to me was a valuable safeguard against adverse events.
So in this example, the Product Allocation between Endowment Insurance and Investments gave me not only a guaranteed return on the savings accumulated for the future, but also an option to accumulate an even larger sum. Using one or the other would not be as ideal as using both in combination.
Product Allocation Example 3: Whole Life Insurance and Buy Term and Invest the Rest
The third example of Product Allocation is the well known rule “Buy Term and Invest the Rest”. Put simply, it advises against the purchase of Whole Life Insurance in favour of Term Insurance, and using the savings from the premiums paid to invest.
But this is not a rule which works in every instance. For instance, it may be cheaper to use Whole Life Insurance to insure against the risk of death until an advanced age, such as 100. This is usually for a bequest, and the cash value built up in the Whole Life Insurance policy reduces the cost of pure mortality risk insurance, unlike in a Term Insurance policy.
Buying term insurance and investing the savings would most likely result in a larger sum at the end of a long period, and offers the flexibility of withdrawing partial sums from the invested amounts, which cannot be done with a Whole Life Insurance policy without surrendering it (or taking out an expensive loan against the insurance policy).
In this case, the effectiveness of Product Allocation between insurance and investments depends on one’s objectives, whether mortality coverage is more important, and until what age, versus the potential for higher returns.
As an example, a 25 year old male pays an annual premium of $256 to insure himself for $200,000 against death for 35 years (until the age of 60). For a decreasing term plan, the annual premium is $231. A similar Whole Life policy has an annual premium of $2,820 until a claim is made.
Assuming a compounded return on investments of 6% a year, the chart below shows the coverage in event of death over time for term life and whole life insurance. The death benefit is the sum of the insurance Sum Assured, and the value of the investments made. The dotted red lines show the coverage for the Whole Life policy. The blue lines shows the Term Life policies (depending on whether it is flat term (dark blue) or decreasing term (light blue)).
Death Benefits for Whole Life (Red) & Buy Term Invest the Rest (Blue)
We see that “Buy Term and Invest the Rest” results in death benefit coverage comparable with Whole Life. However, coverage dips once the flat Term Insurance policy runs out in the 35th year. But the value of the investments will continue to rise over the next few years to make up for the dip.
If we look at the cash value of the insurance policy and investments made, the chart below shows that “Buy Term and Invest the Rest” will outperform the Whole Life policy after about 20 years or so.
Invested Value for Whole Life (Red) & Buy Term Invest the Rest (Blue)
Of course, to achieve this, one must have the discipline to keep investing the savings from the insurance premiums. Also, a compounded return of 6% needs to be achieved (dark blue line). Note that the results still hold even if a compounded return of only 4% a year is achieved (light blue line). However, the out-performance will only show up after about 35 years instead.
Here, the benefits of Product Allocation are less clear cut, and depend on the objectives of the 25 year old! But there is flexibility to draw down part of the investments, something not possible with the Whole Life policy. But we also need to be careful as not all Term Life plans are the same!This is a plus for using Product Allocation.
In traditional corporate finance or finance theory, the choices made in investing are almost purely asset allocation decisions. An example of such decisions is whether to have more invested in stocks or bonds. The use of other products such as insurance, or housing, does not have any part in the investment decision. In personal finance, this is not the case. Our decisions on insurance and housing are closely intertwined with investment decisions.
Hence, to apply finance theory directly to personal finance issues is likely to lead us to inaccurate decision making. Product Allocation is a key aspect of personal financial management which makes it different and distinct from corporate finance.
The few examples provided here only scratch the surface of the possibilities in personal financial planning achievable through Product Allocation. As more products are introduced, many more solutions can be engineered to the specific needs and objectives of each individual.