The Significance of IRR in Investment

Shri Sharad Ranjan and Shri Hariti Tyagi

The Backstory

The relationship manager of a well-established bank reached out to my daughter, who is in the beginning of her twenties, and proposed an investment plan. The investment plan, according to him, is the best investment option available at present in the market. Further, he added an insurance cover that makes this investment secure and lucrative. Describing the plan, he highlighted the investment plan’s key attributes such as guaranteed maturity benefit at the end of the term, yearly guaranteed addition coupled with a guaranteed loyalty addition, and a high premium benefit resulting in a higher basic sum assured. It is important to mention that investment plans of this type are becoming the norm and open to everyone. Emphasizing the word guaranteed repeatedly is especially effective in attracting younger individuals. However, it limits their access to better investment opportunities that could be a more financially sound decision for them to consider.
To support his argument, the relationship manager used an illustration to show that such type of investing is a wise decision. In addition, he orally stated that the proposed investment would yield returns of 8%, which is better than many existing corporate FDs.

They provided the following table and figure to consider this investment.

Table 1: Premium and Benefit Details

 

End of Policy Year

 

Premium

(₹)

Accrued Guaranteed yearly Additions

(₹)

Guaranteed Loyalty

Additions

Guaranteed Maturity

Benefit

 

Death Benefit (₹)

1 50000 5000 0 0 605665
2 50000 15000 0 0 615665
3 50000 30000 0 0 630665
4 50000 50000 0 0 650665
5 50000 75000 0 0 675000
6 50000 105000 0 0 705665
7 50000 140000 0 0 740665
8 50000 180000 0 0 780665
9 50000 225000 0 0 825665
10 50000 275000 0 0 875665
11 0 275000 0 0 875665
12 0 275000 0 0 875665
13 0 275000 0 0 875665
14 0 275000 0 0 875665
15 0 275000 100111 875665 875665

Nevertheless, the proposal included an additional table that showed the actual premium to be paid, which included GST and Cess. The proposal has a single, convenient location where one can find the total premium amount, GST, and cess. The reason could be that they want to avoid prospective investors from factoring in the effect of GST and cess on the eventual returns. The final premium will align with the table below.

Table 2: Final Premium Payable Amount Adjusting GST

 

Premium

 

First year

 

Second year onwards

 

Base Premium (Yearly)

 

₹ 50,000

 

₹ 50,000

 

GST and Cess

 

₹ 2,250

 

₹ 1,125

Total Yearly Premium

(incl. GST and Cess)

 

₹ 52,250

 

₹ 51,125

Understanding Investment Gains

The typical focus on Table 1 figures may lead novice investors to be swayed by its substantial absolute figures and associated death benefits, Isn’t?  Over time, ULIP and money back insurance policies have established this experience. We endeavor to offer recommendations to investors before they commit to this type of investment.

First, one should avoid focusing solely on absolute figures when evaluating returns. Initially, an absolute number may appear attractive, but eventually it may be inconsequential in terms of its value. The real value of ₹ 8.75 lakh after fifteen years will not hold much significance in this situation. The Rule of 72 may determine the extent to which inflation influences the worth of money over a period. For example, divide 72 by the annual inflation rate. By dividing 72 by the inflation rate of 8 percent, it can be determined that it takes 9 years  for the purchasing power of money to decrease by 50 percent.

Second, the Death benefit clause has the potential to be alluring to many. It is unusual    that a person in their twenties has financially dependent parents. Even if that is the case, the death benefit amount of this plan is meager to serve any significant purpose. If the purpose is to get compensated in the event of the individual’s demise, it would then be prudent to evaluate a basic term plan instead of the current one. Thus, if something unfortunate were to happen, the financial benefit to the supposed dependents would hold little value. That being said, it is also commonly accepted that the probability of experiencing misfortune in early life is insignificant. We believe that investors who have crossed a certain age threshold will not be eligible for such a scheme.

Third, one should not trust verbal investment returns without verification, and this is the last but not the least important thing to remember. One cannot rule out the possibility of mis-selling of such products. Consequently, it is advantageous to compute the Internal Rate of Return (IRR), an easily calculable metric using a financial calculator. Online calculation is an option if one cannot do it. Conceptually, IRR is that discount rate which equates the present value (PV) of the cash inflows with the PV of the cash outflow. We input the data into Excel and determined that investing in it would only yield a return of 5.66%. With such a low return, the investment will lose even its face value eventually because the retail inflation rate is higher than that. One may alternatively choose to invest in equities, mutual funds, or debt instruments such as PPF and EPF, given the investor is too conservative. The usual investing

rule is to invest in bonds that match one’s age. Young investors, therefore, should seriously consider equity investment over debt investments.

Table 3: Calculating IRR of Proposed Investment

 

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 IRR
-52250 -51125 -51125 -51125 -51125 -51125 -51125 -51125 -51125 -51125 0 0 0 0 875665 5.66

Conclusion

About the foregoing discussion, it is advisable to avoid investment recommendations   that involve complex products that combine investment and insurance. The investment plan must align with investment options, and a simple term insurance policy should provide insurance coverage. Last but not the least, it is a prerequisite to determine IRR when there are cash inflows and outflows happening over a period, regardless of the size or nature of those flows. We should compare the obtained IRR against our expected returns.

About the Authors

Sharad Ranjan-Professor of Economics, Zakir Husain Delhi College Evening (University of Delhi) 

Hariti Tyagi – Analyst, KPMG Global Services

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