Q. Hi Goalwise, Wanted to get your advice on term plan. I have zeroed in on HDFC term life insurance and have 2 options -
1. Full Lumpsum option: which gives my family a lumpsum of Rs 3.5 Cr on my death, or
2. Partial Lumpsum + Income option: which gives my family a lumpsum of Rs 2 cr + 1 lakh/month income for 20 yrs on my death.
I am inclined towards the second option, as it seems more logical to have some monthly inflow than just a one time lumpsum payment.
Can you please suggest which one is better and why?
A. First let us compare which options is better in a strictly monetary sense.
The difference between the two option is essentially choosing between the extra Rs 1.5 Cr lumpsum (option 1) vs choosing the monthly payout of Rs 1 lakh/month for 20 years (option 2).
A naive way of comparing would be to say that in the second option one gets Rs 1 lakh/month for 20 years which is about Rs 1 lakh * 12 months * 20 years = Rs 240 lakhs = Rs 2.4 Cr
which is higher than Rs 1.5 Cr so that's a better option.
But Rs 1.5 Cr today vs Rs 2.4 Cr spread over 20 years can not be compared just on the basis of amount.
Because of something called inflation.
Let's first try and understand it intuitively before diving into the exact calculations.
Would you pay Rs 2.4 Cr today and opt to get the same amount back but over 20 years as Rs 1 lakh/month? Obviously no!
Because that would mean you are giving an interest-free 20 year loan. Why would you do that if you can easily get 6-7% interest just by putting your money in a bank deposit?!
So that means that the lumpsum equivalent of Rs 1 lakh/month for 20 years is definitely less than 2.4 Cr.
But how much is it then? Is it 2 Cr? Is it 1 Cr?
That depends on what kind of interest rate you can get for your lumpsum.
Someone who can reinvest that lumpsum at say 10% interest can generate the Rs 1 lakh/month income stream with a lower lumpsum than someone who can only get 4% interest on his money.
This assumption is a very critical and even a 1% change can affect the calculations in a big way.
For eg, let's assume we can get 8% returns per annum on our lumpsum (eg by investing some part of it in Mutual Funds).
That means if I have 1.5 Cr, I can get 8% of 1.5 Cr = 12 lakhs every year (and not just 20 years) and still have my principal intact!
So obviously 1 lakh/month income for 20 years is much less valuable than having Rs 1.5 Cr today (assuming we can invest the Rs 1.5 Cr at 8%).
Hence, option 1 wins by far monetarily.
What if we could only get 6% returns (eg by investing everything in FDs) for our Rs 1.5 Cr?
Then for the first year, we would get 6% of Rs 1.5 Cr = 9 lakhs as interest but since we want 12 lakhs we would have to dip into our principal (for the remaining 3 lakhs).
Which is okay since we have to make it last only for 20 years and not forever.
The computation gets slightly involved now, but essentially our principal gets reduced every year and eventually will become zero at some point since we will be withdrawing 12 lakhs every year.
The question then is how many years?
Well, at the end of first year we will have Rs 1.5 Cr starting amount + 9 lakhs interest - 12 lakhs withdrawal = Rs 1.47 Cr or Rs 147 lakhs.
In the second year, the interest will be 6% of Rs 147 lakhs = 8.82 lakhs.
At the end of second year we will have, Rs 147 lakhs + Rs 8.8 lakhs - 12 lakhs = Rs 143.8 lakhs
And so on.
You can do this calculation for 20 years and you will find that you still have about 40 lakhs left at the end!
So option 1 is still somewhat better monetarily even at 6% rate of interest.
Side Note: The technical way to analyse the two options would be to calculate the interest rate at which the two options are equivalent i.e. the interest rate at which at the end of 20 years nothing would be left and then see if that interest rate is high or low.
If it is low, say 5%, that means you can do better on your own and hence you should prefer the lumpsum payment.
If it is high, say 10%, then you should prefer the monthly payment as you may not be able to generate 10% returns in a guaranteed way without taking risk.
In this case, the equalizing interest rate is actually 5%.
Another way to think about it is that the insurance company is offering you 5% interest on your lumpsum of Rs 1.5 Crores by converting it into a monthly income of Rs 1 lakh/month over 20 years.
Would you take it?
So, if we look at it monetarily then the full lumpsum option (i.e. option 1) is better.
There are other reasons also to prefer the full lumpsum option:
a) The lumpsum received can be used to clear off any major outstanding liabilities (eg a house loan or business loan etc) immediately.
b) It's not clear what happens to the monthly income stream in case the nominee (eg your spouse) also passes away before 20 years - unfortunate case but possible hence needs to be considered. If in such a case, the heirs (eg your children) don't get that income then basically you just lost all that money to the insurance company!
I believe in having your money completely accessible to you (and your family) at all times and not giving up control of it.
So based on these reasons, we would recommend going with the first option of full lumpsum instead of partial lumpsum + monthly income.
Finally, just in case you are wondering why such partial lumpsum + monthly income plans are being marketed (apart from the reason that they are better for the insurance company), the purported reason given by the insurance companies is this -
"The monthly payout option is best for families that are not very savvy with investments and can’t manage the lump sum on the unfortunate demise of the policyholder."
Source: HDFC Life
Well, if you ask us, you don't need to be a financial genius to just keep the money in FDs which would still give a better outcome than the monthly income option.
And even in case you are worried about the financial savviness of your family in your absence, it is better to educate them rather than opt for a worse option.
As always, personal finance is personal so your final decision should ultimately be based on your level of comfort with each option. :)