Why protection?

Investment and protection are two distinct strategies that address two very different needs. Both, however, are necessary in order to meet an individual’s financial goals

Manpreet Gill, Senior Investment Strategist, Standard Chartered Bank
04 Jan 2012

MOST of us tend to relate our financial goals with our investments. Within this framework, success in our investments correlates with meeting our investment goals, while protection is usually incorporated to the extent that it addresses the downside risks of the investment portfolio.

We think protection and its role in meeting one’s overall financial goals, however, have a much wider meaning. Downside risk extends beyond the risk of losses on one’s investment portfolio. For example, if an individual were unfortunate enough to be rendered disabled such that returning to a regular job was impossible, his or her income would be reduced or stop completely. But financial commitments and goals will not change. Without a similar level of income, it would be increasingly difficult or impossible to meet their financial goals.

In our view, investment and protection are two separate, but highly complementary activities that work together to help you meet your financial goals. Investments focus primarily on growing your capital (or just staying ahead of inflation). Protection, on the other hand, focuses on ensuring continuity of cash flows so that you are able to meet your commitments even if your primary source of income reduces, or stops.

There are, in our view, two significant risks that should be addressed through a protection plan, over and above any existing investment strategy that one may have in place.

The first is the risk of early mortality or disability. This is the obvious one – however unfortunate and unlikely, if mortality or disability were to occur then your income would cease. Your family’s financial commitments, however, would not. An investment portfolio cannot fully address this risk because a financial market instrument that allows you to directly hedge against this risk does not exist.

The risk of early mortality or disability is also highly uncertain in terms of timing and likelihood. Protection – in this case executed via insurance – is necessary over and above one’s investment portfolio in order to mitigate this risk and ensure one’s family is able to meet financial commitments such as education costs and ordinary living expenses.

The second is the risk of longevity. This is less obvious. According to World Bank data on life expectancy, the average Singaporean national born in 1965 could expect to live till the age of 67. The average national born in 2009, however, could expect to live till the age of 81. There is a greater risk, thus, that an individual born in 2009 outlives his or her savings or investments.

Investments can help somewhat in the second case, but they cannot provide a solution alone. Assuming a retirement age of 60, the individual born in 1965 would have to fund only seven years of retirement without a regular income. The person born in 2009, however, will have to fund 21 years of retirement without an income. This additional money has to come from somewhere.

In our view, there are a few ways in which individuals can mitigate this risk.

• Setting aside additional funds is the intuitive solution, but this is easier said than done. All factors held constant, this would require a higher savings rate over one’s lifetime on average.

• Working longer would be one solution. This would both raise total lifetime earnings (and therefore savings) and reduce the length of retirement without income.

• Starting to save and invest earlier would also help. This, together with a strong asset allocation approach, would help increase the chances that investment returns meet target levels.

To mitigate longevity risk, it makes sense to start the savings and investment process early, and to use a long-term asset allocation process. This is important simply because it increases the chances of meeting one’s financial goals while potentially lowering the volatility of returns.

Following a good asset allocation strategy can be central to capturing solid investment returns over time by (a) reducing the chances of not being invested in a winning asset class, and (b) helping avoid selling at the worst possible time.

To use an illustrative example, a portfolio consisting of 100 per cent global equities would have generated a cumulative return of 181 per cent over the past 20 years. However, a diversified portfolio consisting of 60 per cent global equities and 40 per cent global bonds would have returned 233 per cent over the past two decades.

While intuitively one can put together a good argument that equities should outperform bonds over the long run, clearly this was not the case over the past two decades. An asset allocation-based approach helps to ensure you remain invested.

The aspect of timing brings us to our second point – end-points do matter. In the above example, year-by-year comparisons would show that the somewhat counter-intuitive returns can be attributed to poor returns in equities in the last few years alone. However, for someone retiring around this time and selling their investments, this particular choice of end-point would have a real impact.

This risk can be reduced by

• Starting to invest early so that over the course of many business cycles one can reduce the risk of missing out on the best parts of a business cycle.

• Modifying the asset allocation breakdown as one approaches retirement

Investment and protection are two distinct strategies that aim to address two very different needs. Both, however, are necessary in order to meet an individual’s financial goals.

The risk of early mortality or disability and rising average longevity are two risks that are an important component of an individual’s financial plan, but they both cannot be addressed by investments alone. It is, in our view, important to have protection in place together with an investment plan in order to mitigate the risk of not meeting one’s financial goals.

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