Recently NTUC Income published their actual yield of their endowment and whole life policies. Although I tend to believe Income’s returns are not the best in the industry (considering it has cut bonuses before but another has never cut bonuses), having a yield of about 6%pa for endowment and 4.7% to 5.4%pa for whole life is not bad considering there is no perceived volatility of the “investment”.  So what on earth does insurance company invests in?

The insurance companies’ monies are invested into life fund which its portfolio simply consists of traditional assets classes such as bonds, equities and sometime physical properties. Nothing fantastic right? Yeah, the good old fashion traditional asset classes. The composition of the portfolio is normally a balance composition. But what is amazing about this life fund is that the insurance company introduces a “smoothing” technique so that the policyholder perceived year to year return has almost no volatility. In both good and bad years, policyholders never receive a statement declaring negative bonuses. In fact, it is always a positive bonus (I have never heard of zero bonus – not yet?). But what people always complain is that the bonuses were below projections. Well, cutting bonuses were historically painful and I’ll write about this in the future. For now, it is sufficient to know that these bonuses once declared becomes “lock-in”. Thus, previously declared bonus becomes guaranteed cash value. The fact that these bonuses are always positive (worst case zero) and never negative means that the cash value always seem to be increasing and never decreasing. Yet we know that market goes up and down every year. The apparent differences in perceived return and actual return of the life fund is what we call the “smoothing effect”.

Here is how “smoothing” works. During good years, the profit of the life fund is not entirely distributed to all policyholders. Rather a portion of the profit of the life fund is channeled into a “reserve” fund. Thus policyholders’s declared bonuses for that year are less then the actual profit. However, in the bad years when the life fund earns zero or negative return, the money in the “reserve” fund is used to declare to the policyholders. In this way, policyholders receive bonuses in both good and bad years. What is amazing in such smoothing technique is that it is a matter of innovative accounting acrobat. No risky derivatives are necessary in the portfolio to produce this kind of “absolute” return.  Hedge funds try to give absolute return by using all sort of risky derivatives to achieve this yet unable to guarantee any returns. However, the insurers’ life fund achieve this “absolute” return by using accounting techniques.

Here is a simple example of no smoothing: Let’s say the STI return for Year 1 and Year 2 was 20% and -10% respectively. A person who invests lump sum at the beginning of the year will end up (1+0.20)*(1-0.10) = 108% of capital or 8% in absolute return at the end of 2nd year. But remember that he has to endure the negative Year 2 which is usually extremely painful and emotional.

a)     Same market condition Year 1 and Year 2 is 20% and -10% returns respectively as above. Say he invests lump sum of $100 beginning of Year 1. By end of Year 1 his capital becomes $120.

b)     Let say he takes $15 out & put into a reserve fund (call R) which continue to invests in the same thing. So R = $15. His capital C = $120 – R = $105. Therefore, his perceived return for Year 1 C/$100 – 1 = 5% return. .

C = $105 ……….(1)

R = $15  ………..(2)

c)     In Year 2, his C from $105 will become

C = 105 x ( 1 – 10%) = $94.5 …………. (3)

d)     But R which also invests the same market will become

R = $15 x (1-10%) = $13.5. ……. (4)

e)     Now, he decides to withdraw the entire $13.5 from the reserve fund. Thus

C = (3) + (4) = $94.5 + $13.5 = $108………… (5)

f)      The perceived return for Year 2 is (5)/(1) – 1 = $108/$105  - 1 = 2.86%.

The above smoothing effect give him the perception that Year 1 and Year 2 returns were 5% and 2.86% although the final value turn out to be the same. Truely amazing? Haha.. it is a mental accounting game so to speak.

There are some considerations in such smoothing effect. The most problematic is anti-selection. Since a reserve fund is withdrawn upon to help give some positive return during the bad years, a clever investor will invest into such a life fund during bad times – after all he knows he is going to get some money from this reserve fund. During the good years, he could liquidate his position in the life fund to invest directly into the market – thus the life fund losses the opportunity to channel part of the profit for that year back into the reserve fund.

Another problem can occur if there are many sick people who buy into such a fund. If everybody has a short life, then it means that there will be massive premature withdrawal. This will impact the smoothing effect because there is not enough opportunity for the fund to channel the profits into the reserve fund.  Perhaps it is with this reason that it seems only life insurance companies are able to do this smoothing effect on their life fund since underwriting every case before accepting customers into the pool is their bread and butter.

So why bother to smooth and what is the advantage? Technically in terms of return I don’t see any advantage because at the end of the day it is what the underlying investments that really matters. Moreover, there is a cost of doing this “accounting” game. For life insurance company, only 90% of the profits are distributed to the policyholders (98% for cooperative insurer). Thus there is a 10% “performance” fee so to speak. If let’s say the return of the life fund is 7% before “performance fee”, then 7%*10% =  0.7% of percentage points becomes a cost. This effectively increases the expense ratio of the fund by 0.7 percentage points.

On the other hand, it is well known that people give up investing because of volatility. So if their investment can be “smooth” and give a perception of low volatility then it might be worth while spending this extra “cost” so that they can stay invested on a longer term. It is always better to stay long term and have reasonable return (although nothing fantastic) then to give up and put all money under the pillow.

Actually I would hope that CPF Board can consider setting up this kind of “smoothing” fund especially for CPF Special Account. Afterall Special Account cannot be used for almost anything except retirement purpose. Can someone propose to CPF?

In the meantime, we might have to resort to DIY approach to smoothing technique. A savvy investor will immediate recognize it is just a metal game but then don’t underestimate the power of the dark side of one’s emotions when come to high volatility. So I am in for the idea of smoothing but the only problem is how to DIY? I got some idea of how to do it for my clients so that they can stay invested ESPECIALLY bear periods by employing smooth techniques. But then the details I have to think through. I am beginning to think that I might be just a crazy adviser coming up with this kind of idea! Haha…