Find out whether “Premium Financing” (financing an annuity plan using a bank loan to increase your cashflow and return on investment) is the right retirement income strategy for you 

Scenario: Tom is currently 40 years old, single, has no liabilities, and has no dependents to take care of. To prepare for his golden years, he wishes to grow his excess cash but is unable to find a suitable tool to redirect the monies. The thought of purchasing an investment property did cross his mind so that he can start creating a source of passive income and hopefully, enjoy capital appreciation when the property price increases in the future.

However, during his research, Tom read that owning an investment property is not as lucrative as it used to be with all the costs involved and cooling measures in place. Tom then recalled that Joel, a childhood friend, had introduced him to the concept of “Premium Financing”, which is where one finances an annuity plan using a bank loan to increase your cashflow and return on investment.  In this article, we will highlight the pros, cons, and factors Tom should take note of before deciding if premium financing is suitable for him in the long run.

How does premium financing work?

For this strategy to work, Tom will first need some capital. Suppose he wants to receive a perpetual stream of income of about $2,300/month as part of his retirement plan, he will need to purchase an annuity plan with a sizeable premium of S$1,000,000. However, given his good credit record, Tom can loan up to $700,000 from the bank to pay the bulk of the premium, while he will only need to contribute the balance of S$300,000. Since interest rates are at an “all-time low”, this is the best opportunity to execute this strategy.

After putting this in place, Tom will only need to pay off the monthly interest of the loan till he passes on or when he decides to surrender the plan, whichever happens first. During this period, he will concurrently receive a monthly income from the annuity plan that is supposedly higher than the monthly loan repayment amount. Tom will also have to do a collateral assignment whereby he appoints the bank as the primary beneficiary of the annuity plan. In the event of premature death, the death benefit payout will first be used to pay off the outstanding loan before distributing the balance to Tom’s beneficiaries.

This conditional assignment of the policy, also means that if Tom is somehow not able to pay the monthly interest obligation, the bank reserves the right to cash in the annuity plan and recover what was owed. Given that the projected monthly income from the plan is higher than the monthly loan repayment amount, Tom is confident that he can fulfill the obligation.

The math seems to check out for Tom, but he is still conflicted between going for the conventional path of getting an investment property for rental income or to take up the strategy as suggested by Joel. Joel then gave him the push he needed and illustrated to him how much he could receive should he decide to execute this lucrative strategy today:

• The premium of the annuity plan is $1,000,000, whereby $300,000 is paid using his own cash, and the remaining $700,000 is funded using a bank loan. The day-one surrender value of the plan is 80% or $800,000.
• With a good credit rating and no history of bad debts, Bank ABC is able to offer Tom an interest rate of 1.267%* (1% spread and 0.267% based on 1-month SGD SIBOR) based on the loan quantum size as of July 2021.
• With such an arrangement, Tom’s monthly interest payment works out to be $739.08/month and will remain so throughout his entire loan tenure as long as he only pays the interest each month.
• The annuity plan will then start paying a monthly income to Tom at the end of the second policy year at a projected rate of 3.648% of the net single premium of $1,000,000. This works out to be $3,040/month (comprising $1,040/month guaranteed and $2,000/month non-guaranteed illustrated at an investment return of 4.25%) from the start of year three.
• After deducting the interest payment, Tom can expect to receive $2,300/month perpetually as long as he holds onto the plan and loan.

In addition, the longer Tom holds on to this plan, the higher his projected Internal Rate of Return (IRR) would be. The table below shows what Tom could receive if he held the plan for 10, 15, 20, and 25 years.

 10 years into the plan, Tom would be 50 years old

15 years into the plan, Tom would be 55 years old

20 years into the plan, Tom would be 60 years old

25 years into the plan, Tom would be 65 years old

*For illustration purposes of this article, we will assume that the bank interest rate is fixed at 1.267% p.a.

#For illustration purposes of this article, the monthly income receivable is based on a projected rate of 3.648% of the net single premium (of which 1.248% is guaranteed and 2.40% is non-guaranteed). The non-guaranteed monthly income is illustrated based on a 4.25% p.a. investment rate of return.

From the above, it is evident that premium financing works very well if Tom has a long runway to hold the plan as the rate of return would only increase with each year passing.

What are the potential pitfalls with this strategy?

Despite its merits, there are a few factors that may cause this strategy to backfire, which Tom should take into consideration:

1. Change in interest rates

Interest rates are not fixed for the entire loan tenure unlike the scenario above whereby we assumed the interest rate is constant throughout at 1.267% p.a. The interest rate on his “perpetual” bank loan is subjected to change by the bank monthly, or every three months, depending on the loan agreement. This could mean that as markets recover, Tom’s interest rates would also increase, which in turn will also increase the interest payable and reduce the payout received from the annuity plan.

If we were to use the loan interest rate in 2019 of 2.91% p.a. (highest 1M-SIBOR peak since 2014), with all else being equal, the IRR would look very different, and we could even expect negative regions in the first 15 years and a measly 1.73% p.a. by the 20^th year.

1-month SIBOR rates from January 2014 to June 2021 (Source)

2. Total Debt Servicing Ratio

While holding on to the loan, Tom’s Total Debt Servicing Ratio (TDSR) would also be affected. Based on MAS regulation, a borrower’s TDSR should not be more than 60% of a person’s gross monthly income. TDSR is a mandatory requirement by a bank before it disburses a loan to purchase a home, second property, car, or any other personal loans. When Tom takes up a loan to do premium financing, his individual TDSR will be affected for life as he will not be intending to pay off the loan capital as long as he holds onto the plan. This could be problematic if Tom wants to purchase a second residential property in the future. If it matters, the premium loan will also appear in his balance sheet as a liability.

3. Deficit cashflow for the first few years

For a leveraged plan, there is usually no payout for the first few years depending on how the plan is structured, so Tom will need to service the loan interest without any payouts from the plan until the payout kicks in on the 25^th month. These periods of deficit cashflows will have to be taken into consideration as it is additional monthly expenses that would have to be incurred in the immediate short term.

4. Lack of liquidity

With a first day surrender value of 80% of the premium amount, Tom would be forced to hold onto the plan until the breakeven point of the plan if he does not wish to incur a loss. The breakeven point for this illustration will only happen on the 9.5^th year into the plan, and this is assuming the participating fund is able to achieve the 4.25% p.a. illustrated rate of return. At this point, we have not even factored in the effects of inflation and the opportunity costs involved should Tom choose to channel his funds elsewhere like a low-cost unit trust fund or use it to top up his CPF savings. Should Tom surrender the plan before the 9.5^th year, he will make an immediate loss, eating into his initial capital after paying off the $700,000 bank loan.

5. Costs involved in an insurance structured accumulation plan

There are several layers of costs incurred in an insurance-linked retirement/endowment plan. Costs such as distribution costs, mortality charges, and fund management fees incurred in such plans may eat into the true return of Tom’s accumulation strategy. Every $1 that goes into these miscellaneous costs would mean $1 less on his returns as compared to investing directly in a low-cost investment tool. Of course, each tool comes with their own set of fees and charges, but insurance-tied plans are known to be the least cost-efficient accumulation tool in the market. Nonetheless, the upside for such plans is that there is a guaranteed amount clearly stated within the policy contract, which investments cannot promise.

6. Payouts are not inflation-hedged

It is also worth mentioning that the non-guaranteed insurance returns do not hedge against inflation and would typically hover around the illustrated returns on investment regardless of market conditions. In contrast, property investment has seen property rentals go up in tandem with inflation, despite the various costs attached to it.

It is important to highlight that having a leveraged policy is a long-term commitment that not only locks Tom in a situation where the non-guaranteed returns (which could easily be replicated with other less restrictive investment tools) is dependent on a myriad of factors, but it also binds him to the risks involved should there be a change of life plans.

Considerations before taking up premium financing

Premium financing an insurance policy is objectively, a sound strategy if the below considerations have been checked off:

1. Tom has set aside a healthy amount of emergency funds should he require immediate liquidity for unforeseen circumstances.
2. Tom’s financial protection plans are in place in the event of a life/medical crisis.
3. Tom does not have plans to take up any more loans in the future, which may use his TDSR to determine eligibility.
4. Tom has sufficient cashflow in the first few years of non-income period to pay off the monthly interest rates generated from his loan.
5. Tom is aware that interest rates are subjected to change and the projected income receivable may be less, if not negative, should interest rates rise.

At MoneyOwl, we believe that accumulation strategy is not just about maximising returns or providing access to a bewildering slew of complex products. It is about getting a sufficient and reliable return that can give you the highest probability of meeting your financial goals.

If you are still unsure whether premium financing is suitable for you, feel free to reach out to us and our pool of qualified salaried-based client advisers will get in touch with you to have a discussion.