Saturday, 23 November 2013

Preference for Regular Payout Insurance

I have a couple of insurance policies; these can roughly be grouped into 2 categories -- those that I didn't opt out and those that I voluntarily bought. Insurance policies that fall in the former group are CPF's Dependents' Protection Scheme and Home Protection Scheme (HPS) while insurance policies that fall in the latter group are the "as-charged" Medishield plan and disability income insurance. The key difference between the 2 groups is the former has lump-sum, one-time payouts while the latter have variable or regular payouts over a period of time. As shown in the title of this blog post, my preference is always for regular payouts over lump-sum payouts.

For insurance to be effective, the asset (from insurance payout) must match the liability. Not only must the value of the asset and liability match, the timing of these cashflows must match as well. An asset that is realised one year after the liability falls due is no help at all. The reverse is also true, as will be shown later, but it is always better to have the asset earlier than the liability. Thus, when buying insurance, one must estimate the nature of the liability and find the appropriate insurance to match both the value and timing of the liability. 

When an unfortunate incident happens, it is likely to have 2 components, an initial period when there is high cash outlay such as due to surgery, and an recuperation period when the cash outlay is lower than that during the initial period but is regular, such as due to follow-up consultations, medication or loss of employment. Depending on the nature of the incident, the initial period will dominate for some incidents (e.g. accidents) while the recuperation period will dominate for other incidents (e.g. disability). Insurance with lump-sum, one-time payouts will be useful for the first type while insurance with regular payouts will be useful for the second type.

It is not wise to use a lump-sum insurance to cover a liability with regular expenses, as there is no certainty that the one-time payout is sufficient to cover the regular expenses even if the value of the payout and expenses roughly match. Take for example, a one-time $100K insurance payout and a liability that requires $3K in expenses a month over 3 years. The payout only needs to be invested at a rate of 3.1% to support the required cash outflow. It looks simple enough and does not require a bull market to achieve this rate of return. However, how can one be certain that there will not be a bear market that ruins the investment? Hence, there are challenges in trying to convert a lump-sum payout to a regular payout. Moreover, considering that the person is no longer as healthy as before, would he still be able to invest as well as he is when he is healthy? Thus, it is best to leave the risk of investing to the insurer and look for a regular-payout insurance to cover such a liability.

Notwithstanding the above, it may be possible to modify the cashflow of the original liability such that the asset and liability now match. For example, a loan obligation may require regular monthly repayments. It is possible to make a lump-sum repayment to either extinguish or reduce the amount of monthly repayment required in the future. A lump-sum insurance will work well in such cases. CPF's HPS plan falls into this category by extinguishing the loan when an unfortunate incident happens. 

In conclusion, it is important to match the asset to the liability. Buying the right insurance matters.

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Saturday, 16 November 2013

Unforeseen Risk in My Medical Insurance

Insurance should always be the first "investment" in any investment plan, because any major medical expenses could easily wipe out years of hard-earned savings and investment gains. However, insurance is usually not discussed as much as investments because it is a boring and taboo subject. A common thinking among investors is to try to grow one's wealth through investment quickly enough so that one does not need insurance. However, how many of us could ensure that we could grow wealthy before we grow old? A well thought through insurance plan would go towards ensuring that we are well covered during the period when we're still growing our wealth and are most vulnerable to any major expenses. However, sometimes, even the best laid plans can go awry when one is not in the best of health.

I have a private "as-charged" Medishield plan (Plan B) that covers me for hospitalisation in a Class B ward. When I was healthier and bought the insurance, I thought I would stay in a Class B2 ward if I were to be hospitalised. I did not buy any rider to cover the deductible and co-insurance portions of the medical bill, as I believe that medical insurance should be to cover large medical expenses. Hence, the coverage of a Medishield Plan B was adequate -- stay in B2 ward, covered up till B1 ward. I could not imagine myself staying in a Class A or even a private hospital ward. The money saved from not staying in these more expensive wards could be spent on a nice little holiday later. In fact, I have occasionally thought about staying in a Class C ward to save more on the deductible and co-insurance portions.

Unfortunately, Man proposes, Heaven disposes. I have not been in the best of health in the last few years. This has exposed gaps in my thinking and a major risk in my medical insurance coverage. I have seen specialists as a subsidised patient in a public hospital, private patient in a public hospital and private patient in a private hospital. Needlessly to say, seeing the specialist as a subsidised patient is the cheapest, but it can take 1-2 months to make an appointment. Seeing as a private patient costs more than as a subsidised patient, but the cost differential between a public and private hospital is not major. The lead time for an appointment as a private patient in a public hospital can range from 1/2 week to 3 weeks, while a private patient in a private hospital can see the specialist on the same day. Hence, in my haste to seek medical attention, I have seen a private specialist in a private hospital on a few occasions. This then exposes me to the risk of being hospitalised in a private hospital ward. The Medishield Plan B that I have only covers 50% of the insurable expenses in a private hospital ward, which is as good as not having any insurance.

Is it a case of being penny-wise and pound-foolish in not buying the most expensive Medishield plan? I don't think so, because if that is the case, I would not have upgraded to an "as-charged" Medishield plan. It is a case of not being able to foresee how I would act when I am not well. 

What will I do now? One option is to upgrade to a Medishield Plan P that covers private hospital wards, provided I am still insurable. But frankly speaking, the annual premiums of Plan P are not cheap. If this option is chosen, at some point in time, I might downgrade to Plans A or B to manage the premiums. Anyway, there are going to be changes to the plans with the introduction of Medishield Life. I will wait and see the benefits and premiums of each Medishield plan before deciding.

If I am no longer insurable, I could only continue on Plan B, and if the specialist in the private hospital diagnoses that I need to be hospitalised, I would go to the Accident & Emergency Department of a public hospital to seek hospitalisation. That probably seems the best way to manage this risk. 

Sunday, 10 November 2013

Why Unit Trust Expense Ratio Matters

Many investors would have the familiar experience of finding it difficult to make money from unit trusts. My own experience with the few unit trusts that my family and myself bought is the same. In my last post, I charted the price performance of the 2 unit trusts in my Supplementary Retirement Scheme (SRS) account since my first investment 6 years ago. They have not recovered to the initial price which I made my entry even though the Dow Jones Industrial Average is reaching new highs. Why is it so difficult to make money from unit trusts?

There are several reasons for it. Firstly, studies have shown that it is very difficult for fund managers to beat the market indices. So, most actively managed funds actually fare poorer than the market indices. This poorer performance is even before deducting the sales charges and annual expenses of the funds. Secondly, the annual expenses of the funds is a huge drag on the fund performance. The typical equity fund charges approximately 2% of the fund's net asset value (NAV) annually. This goes towards paying the fund manager and trustee and for other expenses such as administration and audits.

At first glance, 2% of NAV might not seem a lot to pay for professional management of the funds. However, what is the annual returns that investors could realistically expect from equity investments? Approximately 10%. So, a 2% expense ratio out of 10% typical annual returns is equal to 20% of the annual profits that investors could expect. That is a lot of money! In poorer years, the equity returns would be lower than 10% or even become negative, but a 2% expense ratio is still charged. So, in poorer years, the fund managers get more than 20% of the profits that investors could earn in that year.

In comparison, hedge funds' fees comprises 2 components, namely, a management fee based on NAV of the fund (same as non hedge funds), at around 1-2% of NAV and a performance fee based on excess returns, at around 20% of returns above a pre-determined hurdle rate. Take for example, a hedge fund that has a fee structure of 1% of NAV and 20% of excess returns, hurdle rate of 2% and the underlying investments return 10% in a particular year. The total fee that the fund manager gets is 1% of NAV + 20% of (10% - 2%) or 2.6% of NAV in total. Although this is higher than the 2% expense ratio that non hedge fund managers charge, a majority of hedge funds have a high-water mark. If the returns of the hedge fund do not exceed the highest value achieved to-date, no performance fee is charged. So, for the same hedge fund, if the return of the underlying investments is 0% or negative in the subsequent year, the hedge fund manager will only receive the management fee of 1%. On the other hand, the non hedge fund manager will continue to receive the 2% expense ratio regardless of the performance of the underlying investments. From this perspective, the variable performance fee component of hedge funds is more palatable than the fixed management fee of both hedge and non hedge fund.

As a final note, the 2% expense ratio can make a huge difference in the total wealth after a long holding period due to the effects of compounding. Assuming the underlying investments earn 10% annually, a $1,000 investment in a typical fund with 2% expense ratio would become $10,063 while the same investment without the expense fee would become $17,449 in 30 years' time. The 2% difference in expense ratio causes a 73% difference in the total wealth.

Thus, do not underestimate the expense ratio of a fund. As far as possible, always select one with a low expense ratio. Index funds are a good choice, with low expense ratios and performance that are better than most actively managed funds.

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Sunday, 3 November 2013

Dollar Cost Averaging Works Best with Volatile Stocks/ Unit Trusts

I have 2 unit trusts in my Supplementary Retirement Scheme account. One is an equity unit trust (LionGlobal Infinity Global Stock Index Fund) while the other is a balanced unit trust (UOBAM Growth Path 2040). They are invested regularly on a monthly basis for the past 6 years. The relative performance of the 2 unit trusts since my first investment 6 years ago is shown in the chart below.

Relative Performance of Unit Trusts Since 1st Investment

From the chart, we can see that the performance of the balanced unit trust is more stable than that of the equity unit trust. During the Global Financial Crisis, it dropped to 60% of the initial investment price while the equity unit trust dropped even lower to around 45%. Subsequently, the balanced unit trust recovered to the 80% - 90% level and remained there for 3.5 years until February this year. In contrast, the equity unit trust recovered only to the 60% - 70% level during the same period and rising to the 80% - 90% level only recently. Throughout this period, the performance of the equity unit trust is worse that that of the balanced unit trust.

Yet, guess which of the unit trusts performed better in my portfolio? Surprising, it is the more volatile equity unit trust that performed better. It has returned 26% over the 6-year period compared to only 8% for the balanced unit trust.

The main reason for the better portfolio performance of the equity unit trust is because through regular monthly investment, the plan performs Dollar Cost Averaging (DCA). DCA buys more units when the price is lower and less when the price is higher. Since the equity unit trust has dropped more than the balanced unit trust, more units were accumulated. Hence, when the price recovers, the equity unit trust performs better, even though its price is consistently lower than that of the balanced unit trust throughout this period.

To conclude, Dollar Cost Averaging performs better with volatile stocks/ unit trusts than more stable ones.

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