Insurance is protection, not for your life and your limbs, but for your assets. When you start building wealth early in life, you can only rely on human capital. You hope to be employed, earn income and build wealth. If you have a family that depends on your income, their life also depends on human capital.
Insurance is your tool to ensure that the wealth you plan to create is there for you and your family should anything happen to the human asset that could affect its ability to earn an income. Your insurance product will kick in and compensate for you if there is a loss of life or limb. That’s why the calculation of the amount of insurance you need takes into account income, expenses and savings. You choose the goal you want to set for your wealth.
This is why insurance is needed earlier in life. Act as a shield that protects your assets. It is not an investment, even if sold as such. It gradually becomes expensive to buy insurance if you want it to work as an investment as well. Term insurance is the cheapest because it serves the primary purpose of providing lump sum funding to your dependents should you pass away. If you think you will need to provide for your child’s higher education, you have the option of comparing a term insurance and an investment product separately before combining them. We digress.
My friend won’t need insurance when he turns 65 because he’s almost reached the end of his earning phase. Ideally, he would have enough saved assets for his retirement and old age. It would be both expensive and superfluous to try to buy another cover of the same value. My friend should know that he doesn’t need insurance if he has enough accumulated wealth. That he gets older and poses a higher risk to the insurance company, that’s the insurer’s side of the story.
That he finds it expensive to buy health insurance is an extension of this story. We are experiencing this transition in India when healthcare is overtaken by corporate interests and insurance companies. Treatment options are unnecessarily elaborate and expensive to fuel the revenue goals of service providers. Finding an inexpensive health insurance option for a senior who also has pre-existing medical conditions is difficult. My friend raises a fair point, but the answers have to wait for another column for the space this question needs.
Now let’s move on to the home loan. A loan is just a facility to use tomorrow’s income today. It is always an expensive choice to exercise. The interest on the loan is the price to pay for this facility. A loan is useful when there is enough income to pay an installment but not enough wealth to buy the asset today. Most would not have been able to own a home without this facility, although it does come at a cost. The lender will primarily care about the value of the financed asset and the repayment capacity of the borrower.
My friend at 65 doesn’t need this expensive option. He has enough money in his retirement corpus to be able to buy everything he needs. If he were to use his assets as collateral, he can still get a loan. But he would have to repay it out of his investment income, now that he is retired. The calculation will not work. Its assets may generate a return lower than the interest rate of the loan. It will make no sense to take out a loan; it should focus on optimizing the return on its investments and assets and adopt an income and expense orientation, rather than trying to create new assets.
This brings us to his investments. There’s nothing wrong with keeping your money with the government. Lending to the government is the technically correct thing to say. Sure, as my friend knows. But that’s why the government gets away with paying the lowest interest rate. In the loan market, the rate at which the government borrows is the base rate. No one can borrow cheaper than that. There is no doubt that the government is in a position to honor its obligation to pay the interest and repay the capital. It can unilaterally raise taxes; borrow abroad and in the worst case print money. But that’s the borrower’s side of the story.
As a lender, my friend should ask himself if he is being too conservative in settling for a low rate of return. The answer is not to swing wildly to lend to the neighborhood finance company that offers a mind-blowing rate. Many smart choices exist in the middle. Managing the pension corpus requires a strategic approach to allocating how much will be invested and where. Some amounts for growth in equity assets, some in quality income assets that offer good interest, some for safety and security, and some for easy withdrawal and use. A combination that keeps risks low and delivers optimal returns. Blindly choosing one form of investment is clearly sub-optimal for risk and return.
Now for the latest reverse mortgage bombshell. The product is simple. Instead of taking out a loan and building an asset, you sell the asset up front to enjoy a stream of income. The lender buys your house for a price today, but agrees to pay you a monthly payment for many years, at the end of which it repossesses the house. You continue to live in the house, while earning an income. The reverse mortgage is a distressed option; not a normal. You give up the appreciation in your home’s value, in exchange for some desperately needed income. If you only have a home as an asset and no other wealth or income, a reverse mortgage is your last choice. Don’t treat it like a regular income option.
These are very simple and oft-repeated fundamentals. But it is frightening how many hold these notions with great conviction.
(The author is president of the Center for Investment Education and Learning.)