[Internal rate of return] What does IRR mean for savings insurance and annuities? How is it calculated?

Internal Rate of Return (IRR) can be understood as the “annualised rate of return” and is commonly used to compare the returns of savings insurance and annuity products. However, some consumers are still unfamiliar with the concept of IRR, so today 10Life will explain IRR in detail.

As the saying goes, “time is money.” Today’s HK$100 and HK$100 a year from now are not the same. Take a look at the following two short-term savings insurance products. Although their premium payment methods differ, they ultimately deliver the same return. Which one do you think offers the higher return?

Product A: A one-off premium payment of HK$10,000, with HK$13,000 received after 5 years.

Product B: The policyholder contributes HK$2,500 at the beginning of each of the first 4 years, with HK$13,000 received after 5 years.

Although you may not know how to calculate the annualised rate of return for these products, your instinct may suggest that Product B offers the better return. This is because Product A is paid in a single lump sum, meaning the funds are locked up for longer, so it should deliver a higher return. In fact, using IRR, Product A has an IRR of 5.39%, while Product B has an IRR of 7.68%.

The mathematical formula for IRR is relatively complex. For ordinary consumers, the simplest way to calculate IRR is to use Excel’s IRR function. When using Excel, you need to create a cash flow table to record cash inflows (positive values) and outflows (negative values), as well as the relevant timing, as shown in Table 1 below.

Table 1: Cash flows and IRR of Products A and B (HKD)

Savings insurance and annuities are common financial planning tools, but they often involve multiple cash flows in and out at different times. Take the tax-deductible annuity QDAP as an example: during the premium payment period, premiums need to be paid annually, and there may also be a savings period before annuity payments are received within a specified age and timeframe. Using IRR, users can easily compare the returns of products. The higher the IRR figure, the higher the annualised rate of return:

• 短期儲蓄保險比較
• 長期儲蓄保險比較
• QDAP（儲蓄年金）比較
• 即期年金比較   
   

Of course, return is only one of the factors to consider when choosing a product. Before taking out insurance, consumers should first understand the product’s design and features. For more details, please refer to our earlier article: 【QDAP Tax-deductible Annuity Guide】5 Steps to Plan for Retirement, Compare AIA, Manulife and Prudential Products — Which Offers Greater Flexibility?

Return on Investment (ROI) is another commonly used metric. Its calculation is relatively simple, namely (return/principal) x 100%. Taking the above Products A and B as examples, since their return (HK$3,000) and principal (HK$10,000) are both the same, their ROI is also 30%. This shows that ROI does not take into account the time value of money, and is therefore more suitable for products involving a one-off cash outlay and payout.

Table 2: Return on Investment (ROI) vs Internal Rate of Return (IRR)

Note: This article was last updated on 22 November 2022.

This English version of this article has been generated by machine translation powered by AI. It is provided solely for reference purposes. In the event of any discrepancy or inconsistency between this translation and the original Chinese version, the Chinese version shall prevail.