Risks, Costs and Returns for Whole Life Insurance Funds

In our previous posts on risks, costs and investment returns, we first look at how ramping up the risk on your investment portfolio does not necessarily lead to much higher returns. This is because higher risk and higher volatility creates a drag on the returns, and over a long period of time, this diminishes the compounded returns to a level below the short term annual returns of the investments. As many of us make investments using our CPF Ordinary Account savings as well, we look at how this drag on returns due to higher risk and volatility has reduced the the returns on CPF Investment Scheme approved funds. In this third post, we look at risks, costs and returns for Whole Life Insurance Participating Funds, where many of us also have investments.

Whole Life Insurance Participating Funds

In general, insurance companies in Singapore offer three main types of products:

Whole Life (WL) insurance (of which endowment insurance is a close variant)
Term life insurance
Investment Linked Policies (ILPs)

Insurers segregate the investment funds into at least three separate funds, for each class of insurance product.

Whole Life insurance are also called as participating policies (or “par” policies for short). Part of the premium policyholders pay is invested by the insurer, and policyholders participate in the returns of these funds. In contrast, term life insurance policies are commonly known as non-participating (or non-par) policies. The entire premium which the policyholder pays is for the payment of future death benefits only, with no participation in the future investment gains the insurer makes.

To a layman, these terms sound quite strange, as it almost appears that the policyholders are privileged to participate in the investment upside of the insurer, which is essentially the policyholders’ own money! But insurance is an old industry, and so still uses some fairly archaic lingo.

Why Do Returns on Whole Life Insurance Participating Funds Matter?

When a Whole Life insurance policy is purchased, the death benefits and future cash values of the policy are illustrated for the policyholder using two scenarios. The first is a lower return scenario of 3.25% per year. The second is a higher return scenario of 4.75% a year. If the insurer does well investing the policyholders’ funds, a higher payout can be expected in the future.

The cash values in the lower return scenario are considered close to being guaranteed. The cash values in the higher return scenario are usually touted as the potential upside of investing in insurance. In reality, there is no guarantee for either. So Whole Life insurance policyholders should be concerned about the investment returns they are getting over time.

Insurers publish their annual investment returns (net of expenses) every year. In practice, those policyholders who surrender their policies upon maturity often find that the actual rate of investment returns are lower than the average of what the insurers get in returns. What is happening here?

Historical Risks, Costs and Returns on Whole Life Insurance Participating Funds

Let’s take a look at how the par funds of major life insurers in Singapore have fared in the past. The table below shows the annual returns of the various insurer’s par funds. Now, there are sub-funds for each insurer, so the returns shown may not be specific to the par fund for your policy. But they should not differ too much. After all, it is the same fund managers who are managing all the par funds of the insurer.

Annuals Returns Of Insurance Par Funds in Singapore

We see that the annual returns of insurance par funds in Singapore share similar highs and lows. This is because they have very similar asset allocations. Usually, insurers allocate two thirds of assets in bonds, and another one third in equities. The next table shows the Average Annual Return. the Annual Volatility, and the Compounded Returns. The Compounded Annual Returns is the metric of interest, as insurance policies are very long term contracts and it is the compounded return over time which determines how well they have fared as an investment.

Risk and Returns Of Insurance Par Funds in Singapore

The next 2 columns shows the volatility of the fund returns. We use this to predict the long term compound return on the fund. Recall that an annual return of x% and a volatility of y% gives an annual compound return of:

Risk, Costs and Returns in CPF Investment Scheme Funds

In the column “Difference”, we see the actual drag on returns in reality are almost exactly as predicted. Incredible! Perhaps, unlike the CPFIS approved funds, the fund managers of the par funds add little value in terms of mitigating the effects of the risk drag on returns. Given that the expense ratios of these par funds can range from 0.8% to as much as 3.0% per annum, it seems that insurers incur a lot of costs in managing the funds for very little benefit to policy holders.

Across all the insurers here, the average annual return is 4.77%. The average annual compound return is 4.49%.

Hence, when we look at the figures which the insurers report every year, we must remember to subtract off 0.28% for the effects of volatility over the long haul. So far, it still looks quite good, considering the insurers’ returns span the Global Financial Crisis. However, it seems unlikely for us to get the payouts to our WL policies under the 4.75% return illustration.

What about insurers’ expenses?

But the story doesn’t end there! To work out the return we get from the par funds, we need to account for the expenses as well. Usually, the returns reported by the insurers are all net of expenses. But there is a second layer of expenses. Under the law, the insurer can take a profit of 10% of the bonuses declared each year. Since all positive returns must eventually be declared as a bonus (no insurer wants to leave anything on the table at the end of the day), the returns for the policyholder are less by this amount as well.

Note that while the insurer takes 10% of the bonuses declared as profit, they do not take anything if zero bonuses are declared, in the event of a loss. So the 10% profit is actually an option on the return of the par fund. Given the volatility of the par fund, and assuming a risk-free rate of 2.5%, we can use the Black-Scholes option pricing formula on this 10% profit option. The results are in the last 2 columns in the table above.

As expected, the value of the 10% profit option is higher for the higher volatility par funds. Across all the insurers, the average cost of this 10% profit option is 0.42%, which comes form the policyholders’ returns. And not just profits, there are other expenses charged to policyholders which further lower their returns!

So once we account for the insurer’s profit, the average compounded return across all insurers accruing to policyholders is roughly 4.07%.

So is it a good idea to buy Whole Life insurance? Or buy Term insurance and invest the rest?

Whole Life insurance gets a lot of flak. Many financial planners advocate the mantra “buy term and invest the rest” while many insurance professionals encourage us to purchase whole life insurance to avoid the outcome of “buy term and spend the rest”! From the historical performance of the insurers’ par funds in Singapore, the outlook for buying whole life insurance is not promising. The returns are not high enough to justify the lifelong commitment. Compared to an alternative of putting the premiums (after buying term insurance) into a mandatory savings scheme like the CPF Special Account which pays at least 4% annually with no risk, the outcomes are almost indistinguishable.

Comparing between putting $7,000 into whole life insurance and into CPF Special Account over 30 years

And that is not all, because the annual amount of $7,000 when put into the CPF Special Account is tax-free. The equivalent put into insurance premiums is likely to be post-tax. If you are in the 11.5% tax bracket, that means that you will get 11.5% more if the monies were put into the CPF Special Account instead. In other words, you have another 11.5% (or S$805) to purchase all the term insurance you need.

Concluding thoughts on Risks, Costs and Returns for Whole Life Insurance

It looks unlikely that whole life insurance par fund returns will be 4.75% per year compounded, based on past risks, costs and returns. But the returns will be better than 3.25%. So, a more relevant mantra when thinking of life insurance is “Buy term and invest the rest”. Or rather:

Buy term & top up your CPF Special Account!

*Here’s an update on the gap between the returns insurers make on their par funds and what customers actually get.

*Life insurers’ projected investment returns on their participating funds 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.