Last Updated on
Benjamin Franklin wrote in 1748 that Time is Money in a note titled “Advice to a Young Tradesman”. This can be used in multiple ways and in this post, I use it to explain an important idea known as the Time Value of Money. Shall try to follow it up with other examples in future posts.
Journalist Yogita Khatri did an article for ET Wealth as to why traditional life insurance plans should be avoided (link below) that includes my inputs. I expand on some of the numbers provided to her.
Scenario 1: Guaranteed, but gradual payouts
Consider a typical “guaranteed income plan” offered by many insurers. This promises to pay a “regular income” for Y no of years after the premium is paid for X no of years. This sounds so great on paper. Let us investigate more with an example.
Say you need to pay a premium of Rs. 100 for 10 years. Then over the next 10 years, the insurer will pay you, double the total amount of total premiums paid. That is, you paid Rs. 100 x 10 = 1000 over ten years. It will pay you 2 x 1000 = 2000 over the next ten. Does it sound like a good deal?
We ned to find out the internal rate of return (IRR or XIRR) to find out how good this is. IRR represents the annualised rate of return. Read more: CAGR vs. IRR: Understanding investment growth measures.
The premium paid is written as a -100 to represent cash leaving your hand. The payout is +100 to represent a receipt. So you can see the cash flow for 20 years below.
Notice that the payout is only Rs. 100 for nine years (from years 11 to 19). In year 20, the payout is Rs. 100 + Rs. 1000 = Rs. 1100. Making the total payout received twice the total premiums paid. Notice the IRR. It is a pathetic 5.84%. Many people fall into the lure of guaranteed income without understanding the idea of IRR and how to calculate it.
The formula one can use in Excel or Google Spreadsheet is indicated at the bottom.
Scenario 2: Guaranteed, but immediate payout
What if the insurer paid you twice the amount of premiums paid in the 11th year itself?
Well, if they did that, they will have to close down! Notice the huge difference in IRR. More than twice. This is the time value of money at work. When the payments are not immediate, you lose immensely and they gain immensely. And we are not even considering the fact that the insurer can invest the premiums collected and earn a return on it over the many years they hold on to it. Where do you think the bonuses come from?!!
If you receive the payout immediately, not only is the return high, you can use it any way you want. If they delay payouts, they can use it any way they want. Time is money!! This idea is also known as opportunity cost.
In context, it also means that liquidity matters! If the money is locked-in, we lose more than we know. In a sense, this proverb sums it up:
Link to Yogita Khatri’s ET Wealth Article: https://goo.gl/q7cF7p
Link to Benjamin Franklin’s essay: Advice to a Young Tradesman
About the Author
M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy
Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google NewsFreefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication.Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via: Feedburner
Our Publications
You Can Be Rich Too with Goal-Based Investing
This book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earnerYour Ultimate Guide to Travel
Free Apps for your Android Phone
- All calculators from our book, “You can be Rich Too” are now available on Google Play!
- Install Financial Freedom App! (Google Play Store)
- Install Freefincal Retirement Planner App! (Google Play Store)
- Find out if you have enough to say "FU" to your employer (Google Play Store)
Great post, Pattu. Loved the post headline.Might borrow it for my blog 🙂
Of course! Glad you liked it.
The link to Yogita Khatri’s article is invalid. Kindly fix it Sir.
Thank you, done.
I always felt these plans are beneficial to the buyer (rather his family) only if he dies after paying one or two premiums. If he survives, he will die immediately in shock when he receives his payout and calculates the returns.
ha ha, Even if he dies early, the sum insured is too small.
Thanks for taking care of it.
Most of us fear losses more than the joy we get from Profits, hence the risk taking capabilities are at stake, If an investor lacks the proper knowledge and risk taking capabilities then the nominal return form the Insurance products serves the purpose, It helps the individual in simplifying his financial information. Insurance is subject matter of solicitation, Please read the offer document carefully.