How insurers make money by selling you dreams
Investments should be weighed by considering risk and returns. But the insurance sector would rather divert your attention to major life goals so that you skip the downsides of their products.
India fairs poorly at financial literacy. And we aren’t getting better fast enough. This allows insurers, along with a vast network of agents (including your own bank), to continue playing investors for fools. Their trick for the past two decades has been similar; rather than innovate, they frame an emotionally-charged story about how a particular product will fund your child’s education or marriage, your own retirement or secure your family’s security in case of your early death. This works because it gives you the impression that it is helping you achieve your goals without much thinking on your part. This is exactly the kind of lazy participation it wants from investors, who would easily find out what’s wrong with their products if they looked closely. Let’s figure out how this whole thing works.
It begins with advertising…
Financial advertising is very, very coercive and the emotional messaging often leaves the average investor with the feeling that once you do invest in one of their elaborate schemes, you have performed your duty toward yourself and/or your family. In fact, these schemes aren’t much different from plain-vanilla products, except for the fancy story and, of course, the high charges. Wherever you invest your money, you still need to examine how it is performing compared with similar options, and how it fits in with the rest of your investments.
…and continues with banks, agents
We usually need to be pushed into investing our money. So insurers and fund houses have those we trust approach us. Remember that neither of them gets paid by you – they’re paid a commission in exchange for your investment. So their incentive is to sell you what will net them the most commission, which, in most cases, is the story that you should invest in an insurance policy that provides for your child even after your death or in a mutual fund with a five-year lock-in.
Examples of poor choices
Buying online is a good option, but most of us don’t want to go through the trouble. So if you are exposing yourself to the advice of bank representatives or agents, watch out for these recommendations:
Child insurance plans instead of long-term mutual fund investment
Child insurance plans are investment-oriented insurance plans. They promise strong long-term returns by the time your child turns 18 or 21, depending on his or her age at the time investment. In case of your death during the term, an insurance policy continues to pay the premiums on your behalf so that your child could go through college.
Everything about these schemes is wrong. The insurance premium is to be paid once a year, so that’s a lump-sum investment in a highly volatile equity market. You could instead put a SIP into a good mutual fund, which lowers your risk. Secondly, the insurance component is negligible; a better option would be to take a large term-insurance plan. And lastly, there’s nothing specifically related to your child’s education that this plan is doing, so there’s no need to pay its high charges, relative to a mutual fund.
Endowment plans over Public Provident Fund (PPF)
The two are not exactly interchangeable, but because they both provide a deduction under Section 80C, agents often try to substitute endowment plans for a Public Provident Fund (PPF) investment. The reason, of course, is that PPF would give them just 0.5% commission. Moreover, they would need to coax you into making the investment every year to earn the measly sum. With the endowment, they know you will incur a loss if you stop paying your premium; so they happily earn their 7% in commission in for the first year and up to half of that for a few years to come.
And how do they sell it to you? By claiming that it goes a long way toward fulfilling your responsibility as the breadwinner of the family, when it tends to give returns of just 5-6%. In fact, the PPF not only earns a higher return, but combined with a term insurance plan your family also enjoys the security the endowment plan can only promise.
Picking a pension plan over equity mutual funds (combined with a systematic withdrawal plan)
Pension plans are another category that find takers only because of good marketing. Overall though, they give returns of no more than 7%. And while the premium you pay gives you a tax exemption, the pension you earn once you retire is fully taxable. This is not the solution you want, as those returns will easily be eaten up by inflation and your tax liability would be substantial.
Instead, if you’ve begun planning your retirement fund early enough – as you should – consider investing in a mix of equity mutual funds through the SIP route. The volatility of the stock market would be significantly reduced over the long-term, while giving you a serious chance of achieving double-digit growth without the high tax bill. Combined with a systematic withdrawal plan, which would provide you with regular income in your retirement years, it would be a far superior pension plan.