Pre-Need Part 1

Unless you’ve been living under a rock, you’ve probably heard about the senate and congressional hearings about the state of the pre-need industry.  The crux of the matter being that a group of pre-need companies have signified the very real danger of them being unable to pay the benefits theypromised unless the government gives them help either in the form of relaxed regulations or an outright bailout.  For the most part, they have pointed to the ongoing global financial crisis as the culprit behind the erosion of their companies’ trust funds.  Now, on the surface, that seems like a reasonable argument as everyone is suffering from it but if you just dig a little deeper, I believe that you will agree with me in saying that most of the problems currently facing the pre-need industry were of their own creation.  Why?  Consider the following…

First, lets look at how a pre-need plan is supposed to work.  At its most simple level, a pre-need plan consists of an individual handing over cash to a company in exchange for the promise that the company will return a much greater amount at a future date.  The simplest example would be a person paying 10,000 pesos now with the promise of getting 20,000 pesos in 10 years.  Sounds simple right?  So lets go deeper…

Now, in order to establish a baseline, let’s ask ourselves what annual rate of return would the 10,000 have to accomplish in order to double in 10 years?  The answer is approximately 7.2% compounded annually.  Keep that figure in mind for now.

From the questioning of Senator Roxas, it was revealed that the average pre-need company does not actually invest the entire 10,000 pesos that an individual gives them.  Instead, they only invest part of that amount — the rest of the money is used to pay for the company’s operating expenses.  This then is the crux of the entire matter.  Since only a part of the 10,000 is actually invested, this means that the amount that is actually invested now has to earn a higher rate in order to deliver the promised return of 20,000 pesos.  To illustrate this, I have constructed the following table.  The first column represents the amount that is invested while the second column shows the annual rate of return the first figure would have to achieve in order to deliver 20,000 pesos in 10 years.

Amount Invested	Required Rate of Return
9,000	8.312%
8,000	9.596%
7,000	11.069%
6,000	12.79%
5,000	14.87%
4,000	17.46%

Now, from press releases coming from the pre-need companies themselves, they say that they usually target an annual return of about 12%.  If true, this would mean that they regularly invest about 65% or 6,500 pesos for every 10,000 pesos that they receive.  Furthermore, an annual return of 12% is very doable.  Hell, I’ve done more than that by myself working from home so it is a very realistic figure.  Unfortunately, this nice little picture has some rather big, glaring problems.

First, it is unclear just how much of the premiums they receive pre-need companies actually invest.  From the hearings I saw on TV, (and somebody please correct me as I hope I heard wrong) it sounded to me that they sometimes actually invest less than half of the money they get.  If that is true, (and I truly hope it isn’t), that would mean that they will have to achieve an annual growth rate of about 15% just to hit the 20,000 peso target.  And that brings me to the second issue…

Remember when I said that a 12% return was doable?  Well, it really is, but here’s the catch — It is EXTREMELY difficult, if not verging on impossible, to do that for 10 consecutive years.  In recent times, Madoff was pretty much the only one who claimed never to have posted an annual loss and we all know how that turned out.  It is almost a statistical certainty that at least one year in 10 will result in negative growth.  In my case, while I have definitely made more than 12% in some years, I have also lost more than 30% in other years.  Now, for an individual, that usually just means some belt tightening or the pushing back of some planned purchases but a pre-need company doesn’t really have that luxury.  What do I mean by this?  Consider this example :  Assume that on January 1, 2000, somebody placed 10,000 in a pre-need plan with the understanding that on January 1, 2010, they would receive 20,000 pesos.  Next assume that from that date until December 31,2007 everything went according to plan.  Assume that while there were some bad years, there were also some really good years so that by December 31,2007, the fund is on schedule to meet its payments and is valued at 15,943 pesos.  Then 2008 happens but assume that the fund manager was so good that the fund did not lose any money (super best case scenario).  So, at the end of 2008, the fund’s value is still 15,943.  What does this then mean?  It means that in order to meet it’s commitment on January 1, 2010, the fund will have to earn 4,057 pesos or an annual return of 25.44% — a very tall order.  Of course, since the company definitely sold other plans after January 1, 2000, its very easy to say that they can just use those funds to cover the Janury 1, 2010 obligation.  The trust fund money is fungible after all.  Unfortunately, that leads to the next problem.

If the company does use “other” funds to pay its maturing obligation, it is in effect digging a hole as the remaining funds will now have to work harder in order to recover the amount that was, in effect borrowed from it.  Remember, before the company “borrowed” that money, it only had to earn 12%; but since the money has been reduced, then whatever is left has to achieve higher returns — thereby increasing the risk that the company will be unable to meet it and be forced to “borrow” again.  Keep in mind that even a 15% annual return, which would normally be considered good, becomes meaningless if the required rate is 16%.  After all, that 1% difference becomes very significant once we’re talking about millions if not billions of pesos.  It therefore becomes a very vicious cycle and it only becomes worse if the period of low returns extends past one year.  (I actually ran some figures on Excel but its too depressing and scary to put here.)

Whew, long piece but there’s more to go.  Let’s take a short break but before you go, take a look at this page as we’ll need to chew on it next….

Back for more?  Well, hold on as things are going to start getting bumpy…

Did you check out that link above?  It pretty much lists the performances of most of the mutual funds over the past five years.  Why is that important?  Well, it’s important because a significant number of pre-need companies either invest directly in those mutual funds or in the very same securities (such as stocks, bonds and t-bills) that those mutual funds invest in.  Consequently, the returns achieved by those mutual funds can serve as a pretty fair indicator as to how the funds invested by pre-need companies would have performed over the past several years.  If you think that’s not reasonable, then please let me know of another publicly available resource that we can use.  I just used those figures because they encompass the great majority of investment options currently available here as mutual funds invest in a whole plethora of tools.

Next, go back to that page and take a look at the column titled “5-yr Return”.  Look at all the figures in it.  Notice anything?  If you look at all the funds listed, you will see that only one fund achieved double-digit returns consistently over the past 5 years.  Think about that and remember that pre-need companies are supposed to be earning at least 12% annually for 10 years.  And that 12% is based on the assumption that they invest 65% of the money they get.  If they invest less, then the rate becomes higher.  Now, here’s the kicker…(As if we haven’t been kicked enough.)

Based on this report, which is admittedly 3 years old, the Pre-Need code pending in congress all this time can potentially allow pre-need companies to invest only 48% of the amounts they receive.  What that means is that they can potentially keep more than half of what you pay for themselves and just use the remainder to grow into the amount that they promised you.  Of course, if they fail, and given the high rates of return they set for themselves, (remember, they are the ones who make the promises, not the consumer), there is actually a very good chance that they will be unable to meet those promises, they can just declare insolvency / bankruptcy or whatever and leave you, the consumer, to deal with the consequences of their failures.

Ok, now that we’re all gloom-and-doom, the question now becomes what can we, as consumers and regular pinoys, do to protect ourselves and our hard earned money?  Well, we’ll tackle that in part II as it is now nearing lunch and I am kinda hungry already…Stay tuned for Part II

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