We discuss the main risk associated with guaranteed return products that buyers must factor in before deciding to buy. This may seem obvious to regular readers, but even in 2021, there are scores of people who cannot appreciate these products’ main pitfall.
It is quite common for insurance agents to present product illustrations to potential customers. These pamphlets are heavily peppered with phrases meant to ‘hook’ on to a readers attention: “guaranteed returns”, “assured pension”, “double the premiums paid back”, etc. However, things are not as rosy as they seem.
Such illustrations are regularly posted in a personal finance forum like the Facebook group Asan Ideas for Wealth. With a “is this a good plan for retirement or my child’s future?” question.
Many members take the trouble of reading the painfully small illustration, take out a spreadsheet, compute the annualised return and explain why it is “only somewhere between 4.5% to 6%” and “is not enough” for the need mention. These are two examples: Truth about these ads: 8% Guaranteed Returns, LIC Scheme closing soon! And Why Time is Money and How Life Insurance Plans Exploit it!
So, where is the problem? Where is the risk? To appreciate this, we must understand why these good samaritans who compute returns said “only” 4.5% to 6% return and “is not enough”. Why did they say “only”,? and why is that return not enough? If we answer this, we understand the main risk associated with such products.
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Imagine yourself as the hero of your own life (you are not, but it will not hurt to imagine). You have a villain in your life (no need to imagine that!), and he has taken something away from you. So you chase after him.
The villain is speeding away at 200 miles per hour. If you need to catch up with him, you need a car that will go just as fast or faster. This is the simple logic associated with a chase. We need to appreciate that investing is also a chase and the villain is the rate at which the price of what we want increases, aka inflation.
College fees notoriously increase every year – if there is a demand for a course, the fee increases; if there is no demand for a course, the fee increases. The rate of this increases is a guaranteed double-digit number: Min 10% but 12%, 14%, 15% are more commonly observed.
When presented with an insurance product illustration, you can safely assume without calculation that the return is about 5%. Now let us say you will invest 60% in PPF/SSY and 40% in this product.
Assume you will get about 7.5% returns from PPF over the next 15 years (this is an overestimate!). This means you can assume your portfolio grows each year at the rate of (60% x 7.5%) + (40% x 5%) = 6.5%.
Your money is growing at 6.5% each year, and your target corpus is growing at 10% each year. How will you ever reach your target? By investing more. This is why those good people said “only” and “is not enough”.
They actually mean that guaranteed returns will always be lower than inflation (else the company will collapse), which means you have to compensate by investing more. If you do not benchmark your returns with inflation before you start investing, you are guaranteed to fail because of your hatred for market risk for daily fluctuations in price.
Suppose the college fee for a UG course is Rs. 25 lakhs today. At 10% yearly inflation, this will be about one crore in 15 years. This means at 6.5% yearly return, the monthly investment should be Rs. 35000 or Rs. 4.2 lakh a year.
This means investing in two PPF accounts or one PPF and one SSY account and one insurance product: 60-70% (PPF/SSY) and the rest in the guaranteed product. There are risks in assuming a fixed return from PPF/SSY over the next 15 years, but if we ignore that for the moment, notice how we fixed the amount to be invested.
The monthly or yearly invested was fixed using the 10% inflation rate (which may be an underestimate!). Not doing is the biggest risk referred to in this article. If you can now afford to spare Rs. 4.5 lakh a year in “safe” products without any daily fluctuations. If the inflation estimate is wrong and turns out to be actually higher, we will fall short of the corpus, but it will not be a disaster.
What if we cannot spare this money? Then the only reasonable choice is to take on some market risk. If we increase the overall portfolio return (after tax) from 6.5% to 7.5%, we can reduce the investment amount per year by about Rs. 60,000.
There are several choices available to increase the return. However, it will depend on our willingness to learn and get used to daily risks. For example, people complain that gilt funds (MFS that invest in govt bonds) are risky.
Yes, this is true. They certainly are risky compared to PPF, but the reward for putting up with that risk the chance of a higher return: PPF vs Gilt mutual funds: Which has done better over 15 years? Also, comparisons can be (should be) done both ways: Gilts funds are riskier than PPF or SSY, but their daily fluctuations are still about 3-5 times lower than equity funds.
The point is, we can invest anywhere we are comfortable. However, we need to understand how those products will fare against inflation and if we can invest enough if we choose to avoid market risks.
There is always a price to pay in investing. Market volatility is the obvious price. In guaranteed return products, the price to pay is not obvious. We need to slow down a moment and understand the risk. Sadly many of us are in a hurry to make mistakes.
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