Sunday, January 18, 2009

Buying an endowment plan

As much as possible I don’t usually recommend people taking up an endowment plan. In my opinion, you can achieve the same objectives if you do the saving yourself. To have an idea of the message that I am trying to relay across, I suggest you read my article on the Best endowment plan first.

Now if you are aware of the pitfalls of an endowment plan but still decided that such a forced saving plan is suitable for you, nobody can really stop you. Ultimately a lousy saving plan is still better than having no plan at all. In this article, I am going to share some of the factors that you need to look out for before deciding on a plan.

Endowment is supposed to be a saving plan. Therefore one should not rely on to it as a mean for protection. As such, I will ignore the protection portion in the rest of this article. Take the protection coverage as an added bonus but not as a requirement.

Before deciding on a regular premium endowment plan, you need to ask yourself how much you are willing to save each month. Of course it does not make sense to sign up for an expensive plan if you cannot afford it. With the amount that you are comfortable with, request an advisor to introduce you a plan and to generate you a Benefit Illustration (BI) of the plan. A typical BI will look something like the picture below.

BI of Plan A

There are two sections of a BI which are the death benefit and cash value. As I have said, I will skip the death benefit section which is too immaterial to consider. At the cash value section, there are three important columns that you should focus on. They are the age of policy, premiums paid and guaranteed amount. I think the first two columns are self explanatory. The guaranteed cash section is the most important part of a BI. It shows the minimum amount that you will receive upon termination or on maturity of your policy. Also from these three columns, you can know at what age your endowment plan can breakeven. For the above plan, the breakeven age is only after 20 years. The other sections are the non-guaranteed sections which are based on certain projections. One should ignore these sections as they are just estimates and are not guaranteed.

Finally when comparing endowment plans, one should compute the guaranteed Yield To Maturity (YTM) of the plan. YTM is the so called return on your premiums paid. Obviously the higher the guaranteed YTM for the same period, the better is the plan. Let me show two plans available in the market. Can you guess which plan is better in terms of guaranteed YTM?

Plan A
Period of premium payment: 15 years

Maturity year: 20 year
Annual premium: $2,801
Total premiums paid at end of 15 years: $42,015
Maturity value: $66,009
Components of maturity value: $65,000 (guaranteed) and $1,009 (non-guaranteed)

Plan B

Period of premium payment: 12 years
Maturity year: 21 year
Annual premium: $2,847
Total premiums paid at end of 12 years: $34,166
Maturity value: $64,558
Components of maturity value: $40,000 (guaranteed) and $24,558 (non-guaranteed)

At first glance Plan B looks better because you are paying lesser premiums and for a shorter period. But if you calculate their guaranteed YTM, Plan A has a much higher guaranteed yield than Plan B. If you can afford to pay $2800 per annum, why settle for a plan which gives you a lesser return? You can compute the YTM of both plans with MS Excel XIRR function. Take a look at my example on how to use the function.

Attached below is an illustration of calculating the YTM of those plans in MS Excel.

YTM calculations of endowment plans

In conclusion, it is important that you look at the guaranteed portion of an endowment plan if you decide to take up one. Compare the YTM of other plans with similar maturing period and pick the one which gives a higher guaranteed rate. Of course you may want to compare with the yield of a risk free rate of similar maturity to see if it is worthwhile to sign up for such a plan.

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