Who needs pre-need?
The pre-need industry has taken a beating recently, with primarily giant education plan providers like CAP and Pacific Plans getting into trouble. With all that's happening, are pre-need products still a wise and safe investment?
My answer: a qualified yes [full disclosure: I am connected with two pre-need companies, both not on the SEC watchlist by the way].
Keep in mind that pre-need products are really just savings plans. Pre-need companies make different variations of basically the same thing: you invest a fixed amount of money for a number of years, usually five, and after a determined number of years, you will get an amount over and above your total investment.
What got some pre-need companies into trouble was the amount promised. I'm sure you all know what went wrong: traditional educational plans promised to pay whatever the tuition was when it was time your kid enters college. Before, tuition was regulated -- it cannot increase beyond 10%. Then, the industry became
deregulated, and it became a free for all. The obvious result: pre-need companies, particularly those selling traditional educational plans, could not keep up.
So, should you stay away from pre-need products? Not necessarily. Remember: other pre-need products such as pension and memorial are not affected, because they promise a fixed, pre-determined amount, not an open-ended one.
But what about those selling educational plans? Businessworld has this excellent
article that enumerates what you need to watch out for. You can also read the
Money Minute primer on pre-need products.
1. Make sure the company is really authorized to sell pre-need plans.
"...the initial step for a prospective client is to ask the Securities and Exchange Commission (SEC) whether or not the company has a dealer's license."
That's easy enough. You can go to the SEC website and check the
directory of pre-need companies.
2. Check if the company is financially healthy, if its directors and officers are well-qualified, and if it has a good track record.
"You have to look at the financial statement of the company."
Specifically, look at profitability, capitalization, and liquidity. The pre-need company should be able to provide you with its financial statements. And your trusty old accounting textbook will help you with the formulas for financial ratios.
3. Compute the ratio of its trust fund to actuarial reserve liability (ARL).
"Ideally, the ratio of trust fund to ARL should be 1:1. This indicates a pre-need's ability to pay the benefits expected by each and every plan holder."
The trust fund, which is actually managed by a third-party trust department of a commercial bank, is invested in various instruments that will allow it to increase in value in order to cover the pre-need company's future obligations to its planholders. The ARL represents the company's obligations.
The trust fund, then, should be more than 1, meaning it should be able to more that cover the ARL. But it's also important to check where the trust fund is invested. How much is invested in equities? In real estate? In fixed-income securities?
Now, back to my answer: a qualified yes. Why qualified? I have some reservations about educational plans.
- They are quite expensive for one thing, especially if it's for grade school and high school, because those plans need a shorter period of time for your investment to grow. I think the cost of open-ended college plans, on the other hand, are more reasonable. So you may want to go with a college pre-need plan but consider other ways to fund your kid's early education.
- On the other hand, you may also want to rethink paying for college through an educational plan. While the cost is significantly lower compared to plans for grade school and high school, I am a bit skeptical nevertheless. That's because you can set aside a much smaller amount to come up with the guaranteed annual payouts that these plans offer. What makes them more expensive (in this case relative to a do-it-yourself savings plan) is that they promise a hefty graduation gift at the end of the plan. You pay for that gift. It's not a freebie generously promised by the pre-need company. They're also expensive because they include commissions to the agent who sold the plan to you and a portion that will help pay for the company's overhead expenses, and then some. Sure, you pay commissions or fees for other investments, but commissions for pre-need plans are much more generous.
But they're not all that bad.
- What's good about these plans is that they force you to save. The disincentive to miss a payment is strong (you don't get anything). So if you have trouble setting aside savings diligently, this is one way to go.
- They may not be able to pay for all the future costs of a college education (the plan you chose may not be worth as much when you see the actual tuition bill, plus there are other expenses like dorm fees, textbooks, supplies, and junior's weekly allowance to pay for), but at least, a guaranteed payout assures you that you'll get something (I know, you might be too cynical to believe you will get anything at all, but that's where doing your homework instead of relying on an agent's rosy promises comes in).
So, you don't have to rule out educational plans altogether. It might be a good idea to augment one with a do-it-yourself savings plan. But if you're very disciplined with savings, and you invest them wisely, it's very possible you will end up earning more just by doing your own thing.
One of these days, I'll come up with actual numbers to demostrate this (and hopefully prove my point more convincingly). In the meantime, think about it. The days when securing your child's future meant paying off a traditional educational plan are over.
