Internal Rate of Return: Case Study: Saving Plan - Think IRR first Before Invest

Today, I am going to share some insight about the so-called saving plan and to point out some important aspects we should concern about. Besides, I will also demostrate the computation of the effective interest rate of the return from the saving plan. The two cases of saving plan are what I heard before. So, lets justify the so-called return based on IRR – Internal Rate of Return calculation:

For this ‘Plan’, all you need to do is to save 28,000 annually for 10 years. In between these years, you will ‘receive’ some cash return as shown in the cash flow below (case 1): 3,600 for first three years, then 8,400 for the consecutive years until the mature date.

Case 1:

1: 28000 – 3600 = 24400

2: 28000 – 3600 = 24400

3: 28000 – 3600 = 24400

4: 28000 – 3600 = 24400

5: 28000 – 8400 = 19600 

6: 28000 – 8400 = 19600

.

.

.

9: 28000 – 8400 = 19600

10: 28000 – 8400 = 19600

11: -8400

12: -8400

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.

.

30: -8400

In order to increase the return, you can ‘re-save’ the cash return, and just get a 900,000 at the end of mature date. Does it sound pretty nice? Simple calculation will tell us then we only save 280,000 with 10 years, then after another 20 years, we will got a total saving of 900,000, or around 321% (900/280) return for the 20 years, or 16% return annually (321%/20). Does it sound very nice now? Please think ‘IRR’ first before making a decision! Again, the cash flow of this plan can be summarized as below (Case 2).

Case 2:

1: 28000

2: 28000

3: 28000

4: 28000

5: 28000

6: 28000

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.

.

9: 28000

10: 28000

11: 0

12: 0

.

.

.
28: 0
29: 0

30: -900,000

In order to save my time, I just calculate the Case 2, for Case 1 computation approach can be refer to my previous IRR tutorial.

Equation for case 2:

900,000 = 28000 (F|A,IRR,10)(F|P,IRR,20);

(F|A,IRR,10)(F|P,IRR,20) = 32.1429

From time value of money table:

IRR = 3%

(F|A, 3%,10)(F|P, 3%,20) = (11.464)(1.806) = 20.703984

IRR = 4%

(F|A, 4%,10)(F|P, 4%,20) = (12.006)(2.191) = 26.305146

IRR = 5%

(F|A, 5%,10)(F|P, 5%,20) = (12.578)(2.653) = 33.369434

So, based on IRR calculation, the effective interest rate of return is only approximate to 5%. Besides, we should also consider other risks of this kind of plan, namely:

1. Liquidity risk:

I believe, normally, at least one significant financial crisis will occur within 10 years. If it is, then do you capable to pay the annual fee to avoid lose of termination.

2. Hidden Cost:

One of the most powerful thing is this world is ‘hidden cost’. It may look small, but it ultimately will kill a ‘big tree’. So, always identify all potential hidden cost of the plan. Example of hidden cost is APL – Automatic Premium Loan. APL is powerful enough to kill an ‘elephant’ when you realize that its interest normally is higher than 6% annually. So, please make you after 10 years, there is not such APL in the plan because it will ultimately make the so-called guaranteed return become guaranteed lose.

This is no free lunch in this world. As a value investor, I can tell you that a effective 6~8% annually from a portfolio requires sufficient homeworks; effective 8~10% annually from a portfolio requires business mindset plus sufficient homeworks; effective 10~12%  annually from a portfolio requires good business mindset plus sufficient homeworks and so on. Of course, sometimes, we can get more 100% profits in one year when 'opportunity' is available, but maintaining 100% return annually is quite impossible. If you still believe that simply find a good plan will lead you to financial freedom, then you must make sure that the fund manager is capable enough to do what Warren Buffett did and does for his shareholders.

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Written by: Xaivier Chia

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