Mutual Fund VS Unit Linked Insurance plan

 

Few days ago, two of my friends, one in corporate aged 50 and the other in Defence Services aged 35, came to me and said that of late an insurance agent has been pressing them to buy Unit Linked Insurance Plans (ULIP). He is giving the logic that Budget 2018 proposal to re-levy the long term capital gains (LTCG) tax on MF has made them less attractive vis-à-vis ULIP. I told them to let me carry out an objective assessment and then put across both these products. The assessment transpired as follows:

MF – A mutual fund is an investment vehicle made up of a pool of moneys collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

ULIP – It is a combination of insurance and investment. As a single integrated plan, the investment part and the protection part can be managed according to specific needs and choices. As a structured life insurance product, this provides risk cover for the policy holder along with investment options to invest in any number of qualified investments such as stocks, bonds or mutual funds. Here policyholder can pay a monthly or annual premium. A small amount of the premium goes to secure life insurance and rest of the money is invested just like a mutual fund does. Policyholder goes on investing through the term of the policy – 5, 10 or 15 years and accumulates the units. ULIP offers investors options that invest in equity and debt. An aggressive investor can pick equity oriented fund option whereas a conservative one can go with debt option.

Comparison

Ø  Costs – Until 2010 the cost structure unequivocally favoured the MF that only levied Total Expense Ratio, and entry/exit loads whereas ULIP levied multiple charges like premium allocation, policy administration, fund management, surrender and mortality. While the MF charges aggregated to about 1.5 to 2.25%, the ULIP went as high as 25 to 30% in the first year and reduced thereafter. Consequent to directions of the insurance regulator (IRDA), the maximum reduction in yield, excluding mortality charges, due to ULIP costs are now capped in the first 5 years at 4%, from 5 to 10 years at 3% and from 10 year onwards at 2.5%. Moreover, the costs of ULIP are front-loaded (mostly levied in the first five years of the investment) whereas those of MF are even-loaded (levied regularly and evenly through the entire duration).

Ø  Returns – MF have consistently delivered better returns than ULIP in all time horizons. It is only after 12 to 15 years that ULIP come at par with MF for returns. A comparative chart by Advisorkhoj proves this point:

Category Top Performing MF Top Performing ULIP
Large Cap equity 13 – 14 % 11 – 14%
Flexi cap Equity 14 – 16% 8 – 9%
Small/Mid Cap Equity 14 – 18% 13 – 15%
Balanced 13 – 14% 10 – 13%
Debt oriented Hybrid 10 – 12% 10 – 11%
Income 8.5 – 9.5% 8.5 – 9.5%

Ø  Cost-Return Relationship – The ULIP have equitable cost for investment in debt and equity oriented schemes. However, the TER charged by MF is more in case of equity oriented funds and less in case of debt funds. This implies that in accordance with the lower returns of a debt MF, an investor pays lesser investment cost and pays more for investing in equity MF that give higher returns. However, in ULIP he pays uniform cost for investing in debt and equity schemes, which is not beneficial for the investor.

Ø  Taxation – This is where the ULIP scores heavily against the MF after the recent budget proposal. Earlier, the taxation policy was slightly biased in favour of ULIP since they provided the Sec 80C relief to the investor, which MF, except ELSS, did not provide. Moreover, ULIP offered tax free returns after staying invested for 5 years whereas only equity MF gave tax free returns after one year lock in. The tax free advantage of ULIP extends beyond the equity funds to the fixed income space, which is not the case in MF.

Ø  Liquidity – The ULIP are less liquid than MF since they have a five year lock in period and permit only partial withdrawal after that period. In the case of MF only the ELSS have a three year lock in period. In other MF the investor can redeem fully or partially after paying an exit load of about 1 to 1.5%, if redeemed within one year from the date of investment.

Ø  Flexibility – This has two aspects. The first is flexibility to redeem when required that is more in case of MF as discussed under liquidity. The second aspect is switching funds or stopping investment, which is afforded more by MF than ULIP. In MF, one can switch investment at will between different schemes of the same Asset Management Company (AMC) or even switch to other schemes of different AMC. However, this is not possible in the case of ULIP where one is allowed to switch only between offered schemes of the same AMC.

Ø  Transparency – MF are relatively more transparent since they are more widely tracked by numerous agencies vis-à-vis ULIP. Moreover, charge structure of ULIP is fairly complicated and some of the charges levied by ULIP are not built into the NAV, unlike the MF, but are deducted directly from the units held.

Ø  Choice – The choices available in MF are far more than those available in ULIP. There are 42 AMCs with over 2400 schemes available in MF, whereas ULIP count runs only into a hundred plus. Besides choice, it is easier to invest online in MF than ULIP, once KYC is done, as ULIP requires more documentation and insurance being an insurance product.

ULIP COMPARISON POINT MF
Higher COST Lower
Less RETURNS More
Lower TAXATION Higher
Less LIQUIDITY More
Lesser FLEXIBILITY Greater
Less TRANSPARENCY More
Less CHOICE More

Luring Investors

Ø  Insurance Cover –The investor must understand that the insurance cover provided by ULIP is inadequate. Ideally, an earning member must insure himself for ten times his annual income. However, ULIP provides life cover that is only 10 times the annual premium, which is far lesser than annual income. Moreover, ULIP certainly does not cover deaths due to war and most of them also exclude death due to terror or terror related activities. Therefore, read the fine print (especially defence and paramilitary personnel) for exclusions before signing on the dotted line.

Ø  Wealth Creation – ULIP is normally sold as a wealth creation instrument. One must remember that investment prudence suggests mixing up investment and insurance in one product is less productive from wealth creation point of view than separate investment (MF) and insurance product (term plan). The wealth creation normally takes place after 12 to 15 years of investment when the ULIP starts generating higher returns with lower costs.

Ø  Age of Investor – Lot of agents incorrectly sell ULIP to retired or retiring people by saying that they must take an insurance product since their corporate or group insurance policies will cease after their retirement. Normally agents selling ULIP as an insurance product entice investors of all age groups by quoting tax free returns, 10 fold insurance cover of the premium and its wealth creation ability. ULIP is a reasonably good product for young and high tax bracket investor. Entering ULIP after 50 or 55 years of age has some distinct disadvantages. First, you require regular cash flow to pay regular premiums or lump sum investment for one time premium. Second, the lock-in period of 5 years restricts your flexibility and usability of the funds. Third, wealth creation takes a long time (12 to 15 years) and thus may not be feasible for aged investors.

Exiting ULIP

Ø  Free Look Period – By and large if you are not satisfied with the terms and conditions of the policy, you can return the policy document to the Company for cancellation within 15 days from the date of receipt of the policy document or 30 days from the date of receipt of the policy document, if the policy is purchased through distance marketing.

Ø  Policy Surrender – Normally during the first five policy years, if you surrender the policy, the Fund Value including top-up fund value, if any, after deduction of applicable discontinuance charge, shall be transferred to the Discontinued Policy Fund (DP Fund). You or your nominee will be entitled to receive the DPF Value, on the earlier of death or the expiry of the lock-in period. Currently the lock-in period is five years from policy inception. However, on surrender after completion of the fifth policy year, you will be entitled to the fund value including top-up fund value, if any.

Ø  Partial Withdrawal – In general partial withdrawals are allowed after the completion of five policy years and on payment of all premiums for the first five policy years. You can make unlimited number of partial withdrawals as long as the total amount of partial withdrawals in a year does not exceed 20% of the Fund Value in a policy year. The partial withdrawals are free of cost. Partial withdrawals and switches are not allowed during the settlement period.

Exiting MF

Ø  Exit Load – In case you decide to exit fully or partially, before one year then you are liable to pay exit load that is charged at the time of redeeming (or transferring an investment between schemes). The exit load percentage is deducted from the NAV at the time of redemption (or transfer between schemes) and this amount goes to the scheme.

Ask these Questions Before Investing?

Ø  What is your risk appetite?

Ø  What are your financial goals?

Ø  Do you need insurance cover?

Ø  What is your investment horizon?

Ø  Do you clearly understand the complicated structure of ULIP?

Ø  Can you organize regular and sustained cash flow to pay your premiums?

Ø  Are you an active investor to switch within the structured ULIP products?

Ø  Are you willing and equipped to continue the ULIP until its maturity or you will be forced to exit early?

PENTAGON OF PERSONAL FINANCIAL PLANNING

Lot of us leave our financial planning to our parents during the early years of our career or to our financial advisers during the latter half of our lives. It is your money and leaving it to others to plan your finances is escapism due to lack of knowledge. It is not difficult to crack the numbers and plan your finances wisely. After all, you are the best person to know your needs and goals. In this article we give you an insight into five important aspects of financial planning that you must know and understand.

First and foremost is financial discipline. One must understand that a monk seeking self-realization (his goal) leads a rigorously self disciplined life. In the same way, you must also lead a financially self disciplined life to realize your financial goals. A sure way to achieve this is to inculcate the habit to ‘first invest and then spend’. Lot of us tend to first meet our expenses and then invest what we manage to save. Warren Buffet had once famously remarked, “If you buy things you don’t need, you will soon sell things you need.” The habit to invest before spending helps one to differentiate between his needs and wants. Therefore, it mitigates the habit to overspend on wants, a widespread financial indiscretion. Once you have decided to invest first and spend later, then you must invest regularly to achieve rupee cost averaging to beat the market volatility. For the market related instruments, this is best done through a systematic investment plan (SIP) or systematic transfer plan (STP) for mutual funds or systematic equity plan (SEP) for securities. In case of fixed income products, you have the option to invest through monthly installments in recurring deposit (RD) or public provident fund (PPF).

Second important aspect is goal formulation. Half the battle is won if one correctly formulates his financial goals. Your financial goals may include purchase of house, children education and their marriages, your own retirement, purchase of consumer products, vacations, and creation of emergency funds etc. Simply put, it entails that you first list out all your financial needs or requirements along with their tentative year of realization. Then calculate the number of years to their realization from the current year. This way you can classify these into short, medium and long-term goals. Goals falling between 0 to 3 years will be classified short-term, 3 to 7 years will be medium term and above 7 years is long term. This will then help you to correctly invest in the appropriate financial product. Ensuring capital protection is the singularly important consideration to meet the short-term goals. Therefore, one must invest in fixed income products like fixed deposit (FD) or RD, or ultra short or short-term debt mutual funds. In the case of medium-term goals, one must look to achieve growth of the investment while ensuring capital protection. Therefore, investment in balanced schemes or accrual debt schemes of mutual funds, or tax saving FD or bonds (5 to 7 years tenure) or PPF is a good option. For long-term goals wealth creation is the main consideration. Therefore, an investment in direct equity, equity oriented mutual funds or unit linked insurance plan (ULIP) is a good option. For the conservative investor, long-term debt (hold till maturity) mutual funds are a suitable option.

Third is the aspect of taxation. If you only concentrate on investments based on returns and not keep taxation in mind, then you may come to grief at the end of the financial year when your tax return will show large amount that you owe the taxman. In so far as taxation is concerned, you must first understand the different income tax sections under which one can save tax. You should judiciously invest to save maximum of Rs. 1.5 Lakh under Sec 80C under various available financial instruments. Take a medical insurance policy for yourself and your dependents that will provide you a relief of up to Rs. 60,000/-, if senior citizens are involved. One must also try and capitalize on home and education loan interest repayment deduction under Sec 24 and 80E respectively. Similarly, use Sec 80GG for saving from HRA. Next, is the implication of short and long term capital gains (STCG and LTCG) on various mutual fund schemes or securities, tax on dividend distributed income and income tax on fixed income products. After the 2018 budget, all equity mutual fund schemes and securities are taxable at @15.6% for STCG and other than equity are taxable as per applicable income tax slab rate of the individual. Further, all equity schemes have now been included under the ambit of long-term capital gains (LTCG) @10.4% without indexation and other than equity schemes @20.8% with indexation. Although all dividends are tax free in the hands of the investors, however, companies have to pay dividend distribution tax (DDT) @11.65% for equity oriented schemes and @20.8% for other than equity oriented schemes, which implies lesser dividend payout to the investor. All these tax rates include the surcharge and cess. When it comes to returns from interest income, they are mostly taxable as per the investor’s applicable income tax rate, except investments in PPF/EPF, Sukanya Samriddhi Yojana (SSY) and ULIP that enjoy the EEE status (exempt during investment, accumulation and redemption phases).

Fourth is to understand asset diversification. Proverbially, asset diversification implies that you don’t put all your eggs in one basket. The primary asset classes are real estate, equity, fixed income and gold. You can invest in each of these either directly or through a broker. Digitization of markets has brought in tremendous transparency for the learned investor to take well researched and considered decision to avoid falling into a trap. One must carry out diversification to beat the market volatility after his financial goal planning and assessment of risk profile, which is function of his age and liabilities. Overexposure in any these asset classes run the risk of either capital erosion or low returns that cannot beat the inflation. Moreover, before investment you must also understand their liquidity value so as to maintain balance between cash and asset holding. During your investment and accumulation phases of life, plan and invest with the aim to achieve ‘cash abundance and minimal assets’ for a comfortable and hassle free post retirement years.

Last but not the least is the Portfolio Review and Re-balancing. The first phase of reviewing the portfolio entails going through your entire portfolio in detail to see if it is on track to meet your designated financial goals. It must also find out the out performer and under performer schemes in your portfolio. In the second phase of re-balancing, one must exit from the under-performing schemes after due consideration for the exit load and tax implications while holding on to the outperforming schemes. In case your portfolio is not in sync with your financial goals then one must carry out asset diversification to re-balance after considering his risk profile. Re-balancing is best achieved through a judicious mix of switching from one scheme to another of the same fund house, redeeming to invest in an outperforming scheme of another fund house through SIP or STP, or merely starting a fresh SIP to bolster the portfolio.

DO NOT PUT ALL YOUR EGGS IN ONE BASKET: DIVERSIFY

Introduction

➢ Diversification is a fundamental of investing. Oxford dictionary defines diversification (especially in business) as the act of developing a wider range of products, interests, skills, etc. in order to be more successful or reduce risk. Online portal Investopedia elaborates diversification as a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

➢ Why Diversify? Diversification will safeguard your portfolio against total loss, hedge your investments to cater for market volatility and accommodate your financial goals at varying timelines. Ipso facto, diversification of the portfolio must take place in the under mentioned varied asset classes.

Asset Classes
➢ Large numbers of asset classes, as follows, are available in the Indian market and it is important to understand their peculiarities before investing in them:-
Real Estate. Investment in real estate can be done by purchasing residential or commercial property (land, bungalows or flats), REIT (Real Estate Investment Trust) or REMF (Real Estate Mutual Fund). Investment in real estate is capital intensive and thus should be done early in life by availing home loan option to avail its tax saving advantage. Even so, one must avoid using entire savings towards payment of home loan EMI and concomitantly invest a portion of it, preferably through SIP, to ensure wealth creation. To avail maximum advantage, investment in this asset is for long duration of at least a decade plus. Property market, which is fuelled by black money is on the decline due to Government instituted measures to restrict its use in the economy. Thereby, this asset may yield lesser returns in India in the coming decade. Retail investors should be wary of frauds and cheats galore in this sector and should carefully check the documents before striking a deal.
Equity (Stocks). Investing in equity or stock market is a good option in the long run (minimum 7 to 10 years to ensure good returns). Investment in equity can be done directly by the investor through demat (dematerialization) account or through mutual funds (MFs) with high equity exposure. While the MFs are managed by professional fund managers, investments in demat account will require the investor to manage them himself. For this, the investor should be abreast with the market trends and carefully select the stocks (large, mid or small cap) based on his risk profile. Since 1990 till date, Indian stock market has returned about 17 percent to investors on an average in terms of increase in share prices or capital appreciation annually. Besides that on average, stocks have paid 1.5% dividend annually. A safe expectation would be 15 to 18 percent average return provided the investor stays invested for more than 5 to 7 years. It is felt that 100 minus your age is the percentage of your total net worth that should be invested in this asset class. E.g., if your age is 40 years then 100-40=60% of your portfolio must comprise of equity. Nevertheless, this is just a yardstick and one must seek his financial advisor’s advice before investing. The relationship between risk and returns in this asset class is directly proportional.
Fixed Income Instruments. Indians by nature, especially the burgeoning middle and salaried class, are moderate or conservative investors. Probably, this was one of the reasons that helped us tide over economic meltdown of 2008 with relative ease. A wide array of fixed income instruments is available in India for a retail investor. To name a few – bank/post office fixed and recurring deposits/provident funds, Government/Corporate Bonds and plethora of Debt MFs. These instruments give an effective post tax yield of 6 to 8 percent per annum that barely beats the inflation. Moreover, the interest earned is also taxable in most cases that further compounds to the investor woes. However, these instruments are a good means of investment to give stability to your portfolio since erosion of principal investment due to market volatility is nil to bare minimum. As the investor’s age advances, these instruments become prudent investments for the elderly.
Cash/Liquid. This investment is suitable for investors to cater for short to ultra short term financial goals. Investing in Liquid or money market/cash instruments is a good option since they have high credit quality and are highly liquid. Considering the low risk, the returns in these instruments vary from 6 to 8 percent per annum.
Bullion. Traditionally, Indian investors are crazy about investment in gold. The market now offers gold Exchange Traded Funds (ETFs) that rule out physical holding of gold with freedom from ensuring its security. The latest Government launched Sovereign Gold Bonds is another good option since they carry sovereign guarantee, on the interest, and an individual is exempted from Capital gain tax arising on their redemption. They are available demat and paper form with a minimum tenor of 8 years with option to exit in 5th, 6th and 7th years. Another metal, silver is also a good option to invest. Bullion is good to hedge your portfolio against market volatility and about 5 to 10 of your net worth must comprise of this asset. Investing in jewelry is not a wise decision because you lose 15 to 20 percent of the asset value on each transaction due to non refundable labor charges. The best way for physical holding is buying coins & bars from reliable sources.
Arts and Antiques. This form of investment is gaining ground for high net worth individuals or genuine art and antique lovers. This form of investment is fraught with danger of fakes and swindling. However, a genuine masterpiece can fetch you your asking rate if the buyer needs it.

Conclusion
➢ Is it prudent to invest in all the above asset classes? The answer to this question will depend on the investor’s risk taking ability based on his age, financial goals and cash flow. Ideally a twenty to thirty year old investor starting his career must invest 80 percent in equity, 10 to 15 percent in fixed income and bal in gold. During his middle age, he must invest in real estate to own a shelter by the time he retires and avail tax benefit. However, he must continue his equity exposure after moderation to take care of his home loan. During his sunset years, he must reduce his equity exposure and enhance his fixed income exposure to safeguard his principal investment and also get assured monthly income from investments.

OWNERSHIP Vs FIXED INCOME INVESTMENT

Initial Investment: Back in 2000, four friends made a New Year resolution to invest their savings of about Rs. 50,000/- each with the intention to ‘invest and forget’. Accordingly, on 01 Apr 2000, in the new financial year, friend A bought 7093 shares of AXIS Bank @ purchase value of Rs. 50,006/-, B bought 1015 shares of HDFC Bank @ purchase value of Rs. 50,029/- and C bought 2571 shares of SBI @ purchase value of Rs. 50,006/-. However, their fourth friend, being conservative, invested his savings in the cumulative FD of SBI @ 9.5% initial interest rate. Now in 2018, they decided to see their investment values and compare their returns. Thus, what they saw of their returns astonished them and we have summarized it below for your better understanding:

Investment Type Amount Invested on  01 Apr 2000 Value on 01 Feb 2018 Growth of Corpus XIRR Dividend
AXIS Bank (Friend A) Shares (Ownership) 50,006 38,14,261 7528% 27% 1880%
HDFC Bank (Friend B) Shares (Ownership) 50,029 19,07,946 3714% 23% 3008%
SBI (Friend C) Shares (Ownership) 50,006 6,98,669 1297% 16% 3750%
SBI (Friend D) FD (Investment) 50,000 1,96,315 293% 8% 0%
Notes:

ØThe holding period of the securities is 6515 days or 17 years and 10 months.

ØThe FD is quarterly compounding and a cumulative deposit.

ØDividend earned is on the face value of the shares .

Concept of Ownership: This concept entails that you buy shares of the bank or company that you want to take ownership. Buying some shares of the bank/company makes you a shareholder and provides your part ownership. However, prudence demands that before buying these shares you must check the fundamentals of the company to be sure that you put your money on a winner. The other point to be borne in mind is that you should undertake ownership for a long duration to cater for adverse market cycles and give time for the bank/company to grow adequately. Nevertheless, a word of caution that ownership is subject to market risks and subject

Concept of Fixed Investment: In this concept, you give your money to a bank/company for investment in a fixed deposit. By this, you ensure capital protection of your money but the returns are far lower than ownership. In fact, at times these returns cannot even beat the inflationary costs and gradually erodes the time value of you money. In the given example, the bank gives you a XIRR of 8% on your cumulative FD investment. In case, you require a business loan of larger amount then the same bank will provide a loan at 12%. Now, if you have to repay this loan, then your investments must fetch you a minimum of 18% return to repay and beat the inflation.

Taxation: As per the taxation policy in vogue, the capital gains (difference of sale value from cost value) from shares is taxable only in the short term (less than one year holding) @15%. No tax is applicable in the long term (more than one year holding). However, the income (interest) from FD is taxable at the applicable tax slab rate of the investor, irrespective of its holding period. The 2018 budgetary proposal has introduced long-term capital gains tax @10% (without indexation) on gains more than Rs 1 Lakh with effect from 01 Apr 18, but left short-term gains and interest income taxation unchanged.

Asset Allocation: An investor must remember that he must not risk everything in one type of investment. He must follow the cardinal principle of diversification of asset allocation and invest in equity as per his risk return profile, which is function of his age, risk appetite and liabilities. Normally you must invest 100 minus your age percentage in equity. Therefore, if your age is 60 then you may allocate up to 40% of your investments towards equity or if your age is 30 then the equity exposure can go up to 70%.

Lessons: Owning shares is ownership of the bank/company and is beneficial in the long-term than merely investing in FDs. Firstly, shares give much higher returns than fixed income instruments. Secondly, shares additionally earn dividend income that does not come with fixed income instruments. Thirdly, shares have lesser tax liability than fixed income instruments. However, while investment in fixed income instruments ensures capital protection, investment in shares is subject to market risk. Therefore, have faith in ownership of shares with a long-term investment horizon of more than 7 years.

Disclaimer: We have obtained the data for the above chart and graphs from Moneycontrol.com and RBI site. This example is to highlight that ownership is better than investment but equity investments are subject to market risks.