Episode 348 - On this week's show Harvey explains why the new breed of life insurance products that refund your premiums after 10 years, if you don't make a claim, are poor value for money. I also explain how to judge when a stock market is overbought or oversold and set for a possible reversal. Finally, I explain when it might be a good idea to switch from drawdown to an annuity in retirement.
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Abridged transcript - Episode 348
Damien Fahy 3:53
We have three pieces on the show this week. We're going to start with Harvey with a link back to last week's show where we discussed how you assess financial products and services. There's a nice link to a new style of life insurance product whereby they're promising to give you back the premiums after a 10 year period. Harvey's going to go into detail on that and explain why they're not good value for money even though they might seem it on the surface because of marketing. I'm going to do a piece on investing and it's about markets being overbought and oversold and a useful indicator to use. It's off the back of a nice piece of research I did for 80-20 Investor members. And finally I'm going to do a piece on when is the best time to buy an annuity.
Why life insurance offering premiums back if you don't claim is often a bad deal
Damien Fahy 5:16
Harvey's back on the show this week. Last week we spoke about how products are made and what to look for, and how you should be a bit cynical about new products that you find. As an example, I talked about packaged accounts and how the banks that provide them are banking on you not going in to assess whether you can get all the different benefits more cheaply yourself separately, and they're banking on the idea that you probably won't use any of the products anyway to boost their profit margin. Harvey writes our protection content and is going to talk about some new products in the marketplace that promise to give you your premiums back on life insurance. It's a case of dig beneath the surface, you'll find out whether it's good value or not.
Harvey Kambo 6:20
So we came across some products that promise a fairly nominal sum of life insurance, around £25,000 and they promise you all of your premiums back if in 10 years time you haven't died. This plays into a lot of people's desires to get something back for insurance, because none of us like to pay for products that don't really give us anything in return for the money that we've spent.
Damien Fahy 6:55
So that's different to normal life insurance because if you have a term insurance policy, you take it out, you pay your premiums and you're not going to get anything back at the end of the term; you only get paid money back from a life insurance policy if you actually die within the agreed term, say 10 years for example. But that's what the product is there for, it's not meant to be an investment. People seem to know the value of travel and home insurance as a means of protecting their lifestyle and their family. They know people who've claimed on it. Life insurance is different. I don't think people really talk about it, if they have claimed on it. I think we need to reposition that with people who think that life insurance is poor value. It's not, you're protecting your lifestyle.
Harvey Kambo 7:54
The attraction that these new policies have for people is that sense that they’re getting something back for the money they're spending. There are products out there that promise lots of different kinds of cashback, but the particular kind of policy that we were looking at promised you all of your premiums back at the end of 10 years, and that's slightly different to most incentive deals out there with life insurance. So what would happen here is you would get about £25,000 worth of life insurance, you'd be covered for 10 years and if you didn't die within the 10 years, you'd get all your premiums back. So that's roughly £3,000. What people don't factor in is that your money is losing value. And so inflation erodes some of the value of your money that you're paying in. We looked at the equivalent cost of £25,000 worth of life insurance over 10 years for somebody if they didn't want their money back and the astounding thing is that for an average 30 year old person, it's not more than £2-£3 a month. So you could have that level of life insurance for £2-£3 a month. Let's say we rounded that up to £5 a month you'll still have paid £20 a month more for this product, just in the hopes of getting the premiums back at the end of 10 years.
Damien Fahy 9:12
So with this new style of product that's out there, if you cancel the policy within the 10 year period then that's it, you don't get any money back once you've paid your premiums.. You mentioned that £3,000 premiums will be given back at the end of the 10 years and it was roughly £25 a month, which is obviously hugely different from the life insurance policy premiums you mentioned, but is that £25 a month age related, because obviously with normal life insurance the amount you pay depends on your age, so if you're younger the life insurance premiums are cheaper? With this new style of product, is the premium age-specific or is it the same for everybody?
Harvey Kambo 9:51
Yes the rate is the same for everyone, so it's a flat £25 per month, which more than covers the cost of an increased age. Even if you were older, it's probably not going to cost you anything like £25 a month for £25,000 of normal life insurance cover over 10 years.
Damien Fahy 10:12
Harvey effectively deconstructed the concept. She looked at what would happen if you simply paid for a normal 10 year level term life insurance policy with a sum assured of £25,000, which means that you're going to get £25,000 back if you die within 10 years. If the cost of that life insurance is only £5 a month, it leaves a £20 difference, when compared to the cashback policy Harvey has been describing, to save or invest. Harvey then ran the numbers and compared that to the £3,000 you'd get back in terms of premiums. And what was the result of that?
Harvey Kambo 10:42
I thought about what I could do with that extra £20 a month. So instead of handing my £20 a month over to an insurance company so that they can invest it, grow it, make money from it, what would I do with that extra £20 a month. So if I just bought myself a normal level term life insurance policy that doesn't offer me any money back, but costs me £5 a month, and took that extra £20, we looked at examples of where we could put it into a savings account or even invest that £20 a month. The reality is that you may get a little bit less back than you would do from £25 a month paid to this policy that if it does pay you in 10 years time would give you £3,000, but you maintain access to your money, you also maintain control over your money, and you're not having to worry about whether this company will still be around in 10 years time to pay your premiums back.
Damien Fahy 11:42
With the investing route, based on a 5% interest rate which is an assumption, you would be marginally better off and have just over £3,000 at the end of that 10 year period. This is a brilliant example of a product that's marketed in a way that they're banking on you holding their product for 10 years, so they've got access to your money, they can do what they want with it. You are thinking you're getting a good deal because you get your premiums back if you don't claim. But when you deconstruct it like Harvey did, you could actually be better off at the start of a policy because there are deals out there that can give you cashback, for example, which these sorts of policies don't tend to do, if you cancelled midway through these new styles of policies then you don't get anything back in that 10 year term.
But like Harvey said, if you've been setting aside the balance of the premiums, that £20 a month into a savings account or investing it yourself you’ve got access to that. And even in the end, if you'd been investing the difference in premiums, you would be probably better off or as well off as having the premiums back from the insurer on this new style of product. This is a brilliant example of where you need to dig a little bit deeper on these products and shop around and take a bit of time. It didn't take you long to do a bit of research about the premiums on a standard £25,000 life insurance policy for 10 years did it?
Harvey Kambo 13:10
It didn't. Also, most of us that need life insurance during our working lives need in excess of £25,000, because we've got mortgages, children, all kinds of things that would need funding. If we were to die, £25,000 may appeal to an older person who thinks that will cover the cost of a funeral or may cover the cost of a few things that they need tidying up when they pass away but the reality is that a 10 year policy isn't the right kind of policy for that kind of need. You probably need an over 50’s or whole of life type of policy so it's not the right advice. But that then is because these kinds of products aren't regulated, it means that people that buy them aren't covered by the Financial Services compensation scheme. So if these companies fold, you don't get any money back, you're not protected. So that's another thing I would say to our listeners to look out for is that they should always check that the product is regulated and that they are covered by the Financial Services compensation scheme.
The key thing is to compare the cost of what you're looking at. We all feel slightly begrudged to pay for insurances because if we don't claim that's money that we've spent, we've not seen any value for and actually a lot of these deals are playing on that sentiment. So they're playing on the fact that you want something in return for your money and that can look attractive e.g. there are policies that market 10% back on your first year's premiums - compare the cost of that policy with the cheapest policy you can get and more often than not that 10% cashback in the first year is rolled into the cost of the policy and you may actually end up paying a lot more for your policy over the period of your policy term. There are other deals where you can get gifts, cash backs, but again, always just compare with the cheapest product like-for-like without the deal, and see how much money you're really saving. Insurance companies have usually rolled the cost of that incentive into what they're charging you.
Damien Fahy 15:35
Harvey's just produced a really good article on life insurance with cashback (see resources section below). It gives you the links to where you should go and get advice to get the best products and someone will do the work for you and recommend suitable products.
Relative Strength Index: The stock market momentum indicator
Damien Fahy 15:56
For the investment piece, I want to cover a topic that I wrote for 80-20 Investor members - "Fear & Greed: Investing like Buffett".
I won't cover everything, as that's exclusive to 80-20 Investor members but if listeners want to read that research piece, they can of course take out a free trial (by clicking the link above). I’m going to talk about something called the relative strength index, the RSI - it is a very useful indicator in determining if the market is likely to rally or collapse, so highlighting a potential turning points (i.e a market top or a market bottom).
The RSI measures the price changes of an index or asset to evaluate whether a market or asset is overbought or oversold. Yahoo Finance is one of the best free charting websites out there. If you google the terms S&P 500 and Yahoo, you will be taken to a page that has a chart of the index. If you look at that page, there is an icon that allows you to go into more detail on that chart, so you could go and look at a very detailed chart of the S&P 500 over any given time frame that you choose.
You can draw on the charts, you can do trendlines, you can add in moving averages, all sorts of things that form part of technical analysis and might help people make a decision about whether they want to invest or not. Below that chart will be another smaller chart, that is a wave that's going up and down. That is usually the RSI which is a statistical measure that is calculated in a slightly convoluted way. It looks at a market or an index or an asset over a given period of time, typically 14 days, which is the one that I would look at. It will look at the average gain on ‘up’ days in that period for that particular index and the average loss on ‘down’ days over that period. It then calculates a mathematical formula, which spits out a number between 0 and 100. That's then displayed as an oscillator on these charts.
So if you look at the chart that I mentioned on the S&P 500, the small chart you'll normally see below it will see a wave going up and down. Most of the time, that wave ticks up and down, particularly between the numbers 30 and 70 which are the key points on the RSI to a watch. The S&P 500 has been rallying quite strongly this year and if it gets to a point where people are piling in and the price rises are significant. The RSI will flag up if the market is starting to go into overbought territory which is typically when that number is above 70, so as soon as the RSI gets above 70, then that is one indicator that potentially the market could be due a reversal and pull back.
In the beginning half of November 2021 we hit that on the S&P 500 and now if you look at markets we've had a decent pullback in the last couple of weeks for a number of reasons but partly because of the discovery of Omicron. So from a technical point of view, it was always likely that we might get a pullback. On the bottom end of that, on the flip side, if you see the market is falling, so go back to March 2020 when the world was imploding when COVID was first around and the stock markets plummeted to new lows, we saw the S&P 500 crash and most stock markets fell somewhere between 20% and 30% in a matter of weeks. At that point the 14 day RSI broke below 30. And for a contrarian investor, that would be a sign that it could be a good entry point to buy. And as it turned out, it was a very good entry point to buy. Central banks stepped in and basically underpinned the market with all their easy monetary policy, the markets rallied to where they ended up in November and the recent highs that we've seen.
So the RSI is a very useful momentum indicator that can be used in conjunction with other indicators to try and judge where markets are going to potentially reverse and change. So it's really a contrarian indicator. Now another reason why it's relevant this week, is that we saw that indicator hit 30 this week, and again, that was because of Omicron and also because Jerome Powell, the chair of the Federal Reserve in America stated that the central bank would likely have to taper more quickly, basically remove easy monetary policy.
Of course, that was negative for stock markets. So we saw the RSI on the S&P 500 hit 30, which from a contrarian investor's point of view was a potential buy sign. So we almost hit max fear. I've talked about the CNN fear and greed index on midweek markets so go and listen to the midweek market show this week. I talk about what's been going on and the fear and greed index is another indicator that's out there that really just gives you what motion is driving markets. It goes from extreme fear to extreme greed and it's somewhere in between usually. At the moment it’s extreme fear and it goes back to that famous Warren Buffett investment adage, “Be fearful when others are greedy and greedy when others are fearful”. And people at the moment are fearful. So it'll be interesting in the next couple of weeks to see whether the RSI is proved right in this instance and it's a good entry point for the US stock market.
So some people, particularly traders, might use RSI to find an entry and exit point on stock markets. As long term investors, we wouldn't place too much emphasis on it but it is interesting for people to explore and potentially use if they want to for information purposes. Something else to think about with the RSI 14 are divergences. People can look it up but the RSI isn't foolproof. There are times when you get overbought or oversold signals flashing, and the market doesn't reverse. But it seems to be more likely that a reversal is going to happen when you get a divergence between the index itself (i.e. the S&P 500) and the RSI oscillator. Imagine that the market was falling, so the S&P 500 in our example was tumbling and the RSI had fallen and it had hit 30, but then had started to move higher into a new higher low. Then that divergence in the RSI (starting to form a new uptrend) at the same time that the S&P 500 is still tumbling can be a good sign that a reversal is about to happen. And conversely, you can get the other way around where maybe the S&P 500, or whatever index asset you want to use, is rallying strongly, but you see the RSI is starting to fall over. That could be a sign of a potential downturn ahead. You don't have to do the calculations yourself. As I mentioned, you can use Yahoo Finance if you want to draw charts and see them, but also if you go to investing.com and put in an index such as S&P 500 or the FTSE 100 and a table containing a lot of the technical indicators including the RSI 14. So you can see if it is below 30 or above 70 and then that can inform you of potentially what might happen to markets in the future. But of course, there's no certainty in being able to predict where markets are going to go in the future.
When is the best time to buy an annuity?
Damien Fahy 24:06
The final piece is about annuities and when would be a good time to buy them. Because of pension freedoms back in 2015, annuities fell out of favour, but they were already in decline, largely because of tumbling annuity rates. The annuity rate is the percentage figure that is used to calculate what your annual income would be, if you gave an insurance company your pension pot, then it would work out how much income they would give you every year. Those rates were falling. They're linked to gilt yields and gilt yields have been falling, which you can trace back to the financial crisis and beyond. So they were already in decline, then pension freedoms came along and opened up the possibility of more people using drawdown for accessing their pension or indeed cashing in their pensions entirely, so annuities fell out of favour. But there's been an interesting piece of research done by LCP. We will link to in the resources section below.
The research looked into the idea of there being a right time to buy an annuity, and the conclusions are quite interesting. They explored the idea of somebody aged 60 and the attractiveness of them taking out an annuity at that age versus somebody who was in their 70’s and 80’s doing it. To assess that attractiveness, they came up with a happiness matrix. There were three factors that they said would impact whether people will be willing and happy to have an annuity. One of them was called ‘upside’, where they assumed that people would be happy if their income in retirement goes up, rather than goes down, ‘avoiding downside’ which was looking at whether people would be unhappy if their annual income falls in retirement, and finally, their desire to bequest money, so to leave an inheritance to their heirs.
How those three things interact changes over time. It also depends on lots of factors such as your age, investment returns, and they did lots of scenarios where they looked at how those different factors interact, and whether people might be happier taking an annuity at a different date in retirement. The conclusions are quite interesting. One of the things that they suggest is that there's a longevity risk that occurs in retirement. So let's say you are aged 60, then on average, you will live another 26 years to age 86. The chances of you living twice as long as the average person, so therefore living to 112, are quite low. But conversely, if you think about somebody who Is aged 80, on average they are expected to live another nine years, so to age 89. The chance of them living twice what the average expectation is, so living to 98, is unlikely but it's much more likely than the person aged 60 living to 112. If you think of it in another way, the longer you've lived, the more likely that you're going to live longer than the average person, pretty much you've already been doing it anyway. So thinking of it like that, somebody who might be using drawdown to fund their retirement income, is therefore going to have to keep making judgment calls about how long they're going to live, especially as they get towards 80. That starts causing problems that you may therefore start being more frugal than you need to be, taking less of a retirement income, and therefore having a bit more of a difficult retirement than you needed to have. The difficulty in judging how much to take from your retirement pot becomes more and more difficult because in an ideal world, the day you died would be the day you spent your last pound, assuming that you didn't want to leave anything to your children or relatives. So that in itself starts to become a problem and that adds to people's unhappiness. So what they did by looking at all these different scenarios, ages, investment returns, they were able to come up with this idea of what would make people happier, what would become an optimum decision.
You can look at the methodology, it’s a little heavy, but the conclusions are interesting nonetheless. They found that as people got older, there was much more attractiveness of switching to an annuity or at least part of their income to an annuity rather than being in drawdown. The magic age, which depends on the appetite for risk, is on average 67. So that would be a good time to switch to an annuity because it would be much more attractive. Lots of retired people would have previously looked at annuities at age 55 and age 60 and thought they weren't a good deal but the message of this piece of research is that they become a much better deal as you get older. Don't forget annuity rates also increase the older you get, so you get more income for your £100,000 pot at age 70 than you would at age 60 because the insurance company is betting that you won't live as long, so you get a higher income. The research advises people who are more risk-averse to move out of drawdown sooner, and that is at age 64 as they're unlikely to have a large enough pot to justify staying invested in the stock market. Whereas somebody who has a much higher appetite to risk should hold on to age 70 before buying an annuity because they can grow their pension more quickly in the early years.
The research highlights that the decision process when you reach retirement isn't a "one and done." It can be that you decide to go into drawdown, it can be that you delay retirement, it can be that you do a combination of both of those, and at some point start to move towards annuities because they become more attractive from an administration perspective, from a stress perspective of managing your money, but also financially as well.