27 July, 2010

Why SIPs make sense...

You might have heard of the rabbit and the tortoise story. Some people are like rabbits – they save massive sums, when they decide to invest and they do get disillusioned at other times and withdraw the lot, in search of the next rainbow they see on the horizon.

As opposed to that the tortoise sedately keeps a low pace and keeps walking… and lo & behold, the tortoise wins in the tale! Just like it happened in Aesop’s fable, there are rabbits & tortoises in real life too. There are those who believe in big bang investments who also make quick silver exits, like the rabbit. And there are others who believe in the boring way to investments – investing small sums regularly.

Such regular investments in Mutual Fund schemes have been called Systematic Investment Plan or SIP by the MF industry. Here small sums of money are regularly invested, typically on a monthly or quarterly basis, over a long period. There are several advantages of making such regular investments. Here are some –
Tighten your belt – Monthly investment of a fixed amount brings in discipline into your fiscal behavior. Since the amount gets deducted from your bank account automatically, you do not even realize it. This inculcates a savings habit, forces you to save and brings in a regularity in your investment pattern .

Timing risk is eliminated – By investing a fixed sum every month, you can make the timing risk irrelevant… for, when the market is high, you invest the same amount and get allotted a lower number of units and when the market is at a low ebb, you get allotted a higher number of units for the same quantum of investments. This is also called Rupee Cost Averaging. It is so named as your average cost of acquisition tends to be lower than the average sale price, over time. The only thing is that the broad longterm trendline of the markets should be upward. In our economy, it is very much so. The other risk is volatility. This works very well when there is volatility in the markets

Buying when it is low, we all understand, is the correct way to invest. But when the market is low, we seldom invest – for fear grips us and prevents us from doing the sane thing. SIP ensures that we get this right.

Convenience - The monthly investments can go directly from your bank account, taking the pain out of investing. By putting it on auto-pilot, you do not have to remember to issue cheques, nor miss out a cycle because you have just forgotten to invest, in a given month. Best for those with time constraints – which is all of us today!

Works well over long periods – Over long time frames, SIPs ensure that the average cost of investments come out lower as compared to market prices prevailing at a future point. Hence, inspite of short-term fluctuations and turmoil, you would be able to still get good returns, if you stay invested for long periods. For instance, Rs.1000/- invested in HDFC Top 200 Fund, gave a compounded return of 28.28%pa since inception ( 1996 ), 33.11%pa over a 10 year period and 24.52%pa over a 5 year period… not bad at all, considering there were couple of huge upheavals in 2000 and again in 2008. These are excellent long-term returns, any which way you look at it.

Power of Compounding – Getting to stupendously large sums over time seems incredible. It is simply the power of compounding. Albert Einstein called it the eighth wonder of the world. A small sum of money grows ino a huge sum over a long period, as the interest earns interest, over time. For instance, a Rs.50,000/- one-time investment grows into Rs.8.72 Lakhs, over a period of 30 years at a 10% pa returns. From your perspective, it is a sure-fire way to get to seemingly impossible sums of money, while investing driblets.

No need to wait to accumulate big sums – Since SIPs can be done for as low as Rs.500/-, you now have little justification to postpone investing, till you accumulate a big sum to invest. In fact, by waiting to accumulate a big sum before investing, you run the risk of spending the money being accumulated. SIP will address this problem squarely.

Reaching Financial Goals in a painless manner – If you have set sights on a car or simply want to plan a comfortable retirement, you could choose to invest small sums regularly and reach your goals effortlessly. For instance, to accumulate a retirement corpus of Rs.1.5 Crores after 28 years, assuming a return of 1% pm, you would need to contribute an amount of Rs.5,438/-pm, over this period. Now, that is not such a big deal, is it?

You might have thought that the suave, clued-in guy in your office, who is regarded as an investment guru, is a privileged one with investment acumen and timing genius. Well, he might be. Good for him. But, with SIPs, your returns are going to be the envy of the rabbits. Be the tortoise – it may be unglamourous. But, it wins races. You can too!

Published in DNA Money on 27/7/2010

12 July, 2010

Why not back load the Commissions?

Dear Mr Hari Narayanan,

Thank you for the slew of changes your organisation has brought about in the recent past, mostly pertaining to Ulips. These changes have made the products customer-friendly and significantly reduced the charges they had to bear earlier. There is lesser incentive for an agent to ‘churn’ given that the charges are more uniformly recovered and his/ her commission also will not be a bumper figure in the first year and taper off in the remaining years. I’m sure there is more to come from your side on Ulips, and we eagerly wait to know what that is.
There are a few things I want to draw your attention to — I’m sure you are working on this too, but we are not aware of it as yet.
l . What about traditional products? Ulips are transparent — charges are visible — and there has been a clamour for reduction of charges in the interest of the customer. This has been addressed to a great extent by the changes you have proposed. But, what about traditional products? Their charges are not disclosed at all. However, they are there, like salt in sea water. And they are high — how can they offer a first year commission of up to 40% in endowment and moneyback products?
Won’t tightening of Ulip norms incentivise insurance companies to look at traditional products and push those instead?
Customers are still sold policies. Most of them don’t know the details of their insurance policies. Addressing one portion of the insurance product space and leaving the other open is going to create an imbalance in future, with companies and agents interested only in selling traditional products. The charges structure in traditional products needs a relook
A reverse incentive structure — why not invert the incentive structure and pay the agents highest in the last year of the policy and the least in the first year? This is a win-win situation for every one. Insurance companies will have more money in the kitty to work with as the outflow to start with will be minimal. The customers will not start their policy with a disadvantage and are paying the agent over a period for servicing them over the term of the policy. The agent may sulk, but this is good for them too as the agency will prove to be a wealth creator, giving ever-increasing amounts as trail commission over time. This will improve persistency and curb churning like none other.
Misselling / misleading clients — getting a signature on the benefit illustration and returns on Ulip products to be shown at 6% and 10%, freelook period etc are efforts in that direction... this alone does not sort out misselling. The process has to be internalised by the insurance companies and their channels.
Banks and national distributors are the worst offenders here. The employees of banks especially have a captive audience — ironically, an audience that believes that these banks are trustworthy! My experience tells me that bank staff who double up as insurance salesmen have very poor knowledge and in view of their targets, are prone to misselling to their customers. They have nothing to lose as they do not have any real connect with the customer like an individual agent, who keeps going back to the client. They know that they will be elsewhere (in another branch, another bank!), probably with a promotion on achievement of targets — even if it is by dubious means.
A foreign bank affiliated with a prominent private insurer only used to sell Ulips that gave them 60%+ first year commission, when there was another version of the same product which gave them 20+% commissions. I have personally seen people on the verge of retirement being collared for Ulips, when what would have worked better is an investment product. I keep getting illustrations from banks that show product returns at 30%... Banks always pitch for high premiums and that compounds the problem of clients. There are three things you could consider doing — i) Ensure that these personnel have requisite knowledge — the workarounds to properly studying and giving an exam should be curbed ii) The examination should be comprehensive and stringent iii) Have a complaint mechanism in place and initiate stringent action (suspend their licence and take legal action) when malpractices are uncovered.
You have set the ball rolling. I hope my pointers and suggestions are of some use, going forward.
Suresh Sadagopan

03 July, 2010

The Ten Commandments from IRDA

After groping in the dark for a while, IRDA has found it’s feet. It is now alive and is competing with SEBI regarding changes it wants to introduce in it’s space; every second day there is some circular about some aspect or other of the insurance policies trickling in. Currently, it is focusing its energies primarily on the Life Insurance space. All these changes are good for the end user, who has been playing Santaclaus, all these days.

The latest circular of IRDA has a nice bouquet of changes on offer.

1. ULIPs to have a lockin period of 5 years: This is good for the client as it clearly orients them for longer term investments and only those kind of people will now come in.

2. Level premiums: There were policies where the first year premium was a much higher figure and the subsequent year’s premium was a minnow beside that. This meant that the first year charges, which is itself high, are recovered on a much higher premium amount. This was an unsavoury practice which has now got addressed with this.

3. Even distribution of charges: This is fair on clients as for a long-term product, the charges should be taken over time – not upfront.

4. Minimum Premium paying term of 5 years: The whole idea seems to be to project ULIPs as a long-term product, instead of investing now and cashing out after three years, like it has been happening until now. This ensures that only people who have a serious long-term investment intent, will come in.

5. Increase in Risk Component: Insurance companies forgot in-between that they were Insurance companies and were competing with investment products. Now, IRDA has mandated that there be at least a life cover of 10 times the annual premium or higher (as per a formula) for people below 45 years of age and 7 times or higher (as per a formula) for people of age 45 or above. The life insurance companies can instead give a health cover too – the higher of 5 times the annualized premium or Rs.1 Lakh for people below 45 and the higher of 5 times the annualized premium or Rs.75,000 for people who are 45 years of age or above. This is a novel introduction by IRDA and shows that it is applying thought (like Wipro calls it).

6. Top-up premiums: Top up premiums also need to have an insurance cover of 125% of the annualized premium for customers of less than 45 years and 110% of the annualized premium for customers of 45 years of age or more.

7. Minimum Guaranteed return for Pension products: A minimum Guaranteed return of 4.5% in Annuity products (including ULIP pension products) is now mandated. This is good for the clients, but can be a challenge for the insurance company, if the interest rate climbs down in the longterm.

8. Surrender of policies: This was addressed in an earlier communique, where it sought to bring down the surrender charges substantially - 15% in the first year coming down to 5% in the fifth year for policy term of more than 10 years and 12.5% in the first year and coming down to 2.5% in the fifth year for policy term of less than 10 years. This ensures that the effects of any misselling is minimized. It also ensures that the agents cannot foist a dud on their clients and scoot. This is a very customer friendly move.

9. Returns from ULIPs: IRDA had previously brought a guideline which stated that the difference in gross yield and net yield at maturity be only 3% or less for terms less than 10 years and 2.25% for terms of 10 years or more. But this was to be applicable on maturity, which effectively left out most, who tend to surrender polices prematurely. Now that anomaly has been corrected. The difference in the yield now applies from the 5th year onwards. It can be 4% in the fifth year reducing progressively to 2.25% from the 15th year onwards.

10. Loans: Maximum loan amount in a ULIP in a product with Equity component of 60% or more can be 40% of the Net Asset Value and 50% of NAV in a product with a 60% debt component.
Besides all these IRDA is working on a Key features document that will help demystify complex products, Needs Analysis is an initiative to curb wrong advice & mis-selling & has set up a Customer Affairs Department for grievance redressal & customer education. That’s quite a broad brush stroke from IRDA – one that is pleasantly surprising, after years of somnolence.

Published in Moneycontrol.com on 30th June 2010