As an investor, a difficult decision is choosing which investment vehicle to use in achieving one’s financial goals. For a beginner, this can be overwhelming due to the sheer number of options available. Shares, Mutual Funds, Dear Safe PPF, and what about ULIPs? The list is endless. In this article, we will attempt to shed some light on two major options: Mutual Funds and ULIPs.
The debate whether ULIP or MFs are better has been ongoing for years. Post the budget 2018 announcement on taxing long-term capital gains (LTCG) from equity and equity mutual funds, the tax advantage has shifted towards the unit-linked insurance plans (Ulips) of life insurance companies. This tax disparity between the two has led to a renewed effort by insurance companies to hard sell Ulips.
Are ULIPs a better choice than equity mutual funds?
Let us explore points both in favour of and against ULIPs.
The Benefits of ULIPs
1, The maturity amount in ULIPs is tax exempt whereas Long Term Capital Gains at taxed at 10% on the sale of Equity Mutual Funds. If your entire corpus is in a debt ULIP fund, the maturity proceeds are still tax free.
With a debt mutual fund, one has to pay long term capital gains tax at 20% after accounting for indexation. But remember the LTCG tax will only be applicable only when you redeem money, which may happen many years later. Until then, you are deferring the tax payment, which has a compounding effect on your investment.
2, If you switch to another fund within the same ULIP, it does not give rise to any tax liability.
For example, you can shift from Aggressive Growth (equity) fund to a conservative fund (debt) or vice-versa within the ULIP without incurring any tax liability. With mutual funds, switching from one fund to another is equivalent to redeeming from one fund and purchasing in the other. This gives rise to both exit load and capital gains tax implications.
So the cost of rebalancing your portfolio is lower in ULIPs.
3, Ulip supporters argue that the lock-in period of 5 years results in discipline and investors investing for the long term.
Before exploring the drawbacks of ULIPs, let us understand how they are structured.
How ULIPs work?
ULIPs are a combo of Insurance and Investment. So a portion of your premium or accumulated wealth is spent on providing life cover and the rest is invested. ULIP charges fall into 4 broad categories.
Premium Allocation Charges (as a percentage of annual premium. Higher in the initial years. Typically, not applied after a few years)
Policy Administrative Charges (Typically, an absolute amount. Recovered through the redemption or cancellation of fund units)
Mortality Charges (Provides life cover. Charged by cancelling or redeeming fund units)
Fund Management Charges (Charges towards the management of your funds. As percentage of your wealth. Inbuilt into the fund NAV)
When you pay your premium, premium allocation charges are deducted upfront from the premium. The remaining portion of the premium gets invested. Your fund value (corpus) increases through accrued returns and premium paid over the years.
Policy administration and mortality charges are recovered through cancellation/redemption of units.
The Benefits of Mutual Funds
The performance of ULIP funds may be misleading.
In Ulips, the mortality and admin charges are deducted by the cancellation of units. Hence the NAV of your fund does not get impacted, however the number of units you hold reduces.
With mutual funds, the performance that you see is net of all the charges (expenses).
Costs are easier to understand and explain in a mutual fund because it’s one number and the NAV reflects this cost. But in the case of a ULIP, it’s difficult to explain or compare costs in the absence of a single expense ratio. What you see is what you get.
You pay a whole lot more for life insurance
One might reason that a portion of the investment goes towards life insurance so the two products shouldn’t be compared as mutual funds are pure investment products. Whilst ULIPs provide both investment and life insurance benefit.
However the insurance that ULIP provides cost lot more than a regular term insurance. The mortality charges in a ULIP are almost three times higher than what than what you would pay for the same life cover, taken through a term insurance.
Also the premium for a term life insurance plan remains constant during the policy term while the mortality charges increase every year in a ULIP.
This is why your age affects your returns in a ULIP. Remember, what may be shown in the brochure may be the return experienced by a 25-year-old. However, if you are 50 years old, the return that you experience in the same plan may be much less.
In fact, three Asset Management Companies (AMCs) – ICICI PruLife, Aditya Birla Sun Life (ABSL) and Nippon India – at present offer free optional in-built insurance cover to the people investing in mutual funds (MFs) through a Systematic Investment Plan (SIP) based on their SIP contributions and tenure. The insurance cover is valid till 55 years of age.
In exceptional cases, mortality charges may even eat away a significant portion of the amount invested as mortality chargers are very high due to old ago.
You can’t exit an underperformer in ULIP
If one of your MF investments were underperforming; you would probably exit the investment and invest the proceeds elsewhere. What about with a ULIP? You have a choice of 4-5 ULIP funds from the same insurance company. But these are different types of funds. So if, you invested in a ULIP in the large cap and if the fund underperforms, you can perhaps switch to a balanced fund from the same list of 5-8 funds. However, you cannot switch to a fund from say ICICI Prudential. This takes away your flexibility.
Mutual Funds are more transparent than ULIPs
Mutual funds provide detailed information on the portfolio holding, asset allocation, fund managers, etc. The portfolio disclosures of ULIPs are not as transparent and comprehensive as in the case of mutual funds.
You can’t top up the premium without purchasing additional cover
If you want to increase your mutual fund investment, you may do so at your convenience: by lump sum, or increasing your SIP. With ULIPs, it is not that easy. Though you can top-up your premium, you can’t do so without purchasing additional life cover.
Therefore, if you want to invest more than the usual amount in a ULIP, you have to bear mortality charges for additional life cover as well. Regardless of whether you need the additional life cover or not.
ULIPs are illiquid for 5 years
Investments in Equity Funds are liquid from Day 1. You can redeem the fund any time, except for ELSS funds which are locked in for 3 years but ULIPs are locked in for 5 years. Even if one surrenders the policy, the money will be transferred into a discontinuance fund thereby unavailable to the unit holder. Once the money is in the discontinuance fund, the amount would earn about 4 per cent for the rest of the tenure.
