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.