Have ULIP plans become attractive now because of LTCG tax on Mutual Funds?
There could be a rush to push ULIP insurance plans as the Union Budget 2018 kept insurance products out of the new LTCG tax imposed on equity mutual funds. Is the excitement justified and should you invest in ULIP instead of mutual funds? The answer is that ULIP continue to be inferior to mutual funds for investing and inferior to term insurance plans for life insurance. Let us see how.
ULIP as investment is inferior to Mutual Funds
Let’s imagine you had invested the ₹2 lakh in a ULIP and mutual fund over 5 years. Unit linked Insurance Plan (ULIP) have typically given around 7% returns while mutual funds have generated 15% in the long run. In 5 years, ULIP would given ₹80,000 returns while mutual fund would have given ₹1.92 lakh return. Thus ULIP returns underperform mutual funds by more than 60% in 5 years even after deducting LTCG tax from mutual fund returns!
Also, the returns from a ULIP will start decreasing as the age of the investor increases because of higher mortality charges. The returns will decrease even more if the investor is a smoker or suffers from chronic disease. There are no such limitations for mutual fund investments. Moreover, if you buy a ULIP offline, several costs like premium allocation charge and others will add up. We will discuss more about costs later in this article.
ULIP as Life insurance is inferior to Term plans
A ULIP gives customers both insurance and investment under a single integrated plan. While this may appear convenient, ULIPs do a bad job at both insurance and investment. While we have seen their investment performance above, let us see how ULIP perform as an insurance instrument.
An established thumb rule says that your life insurance cover (sum assured) should be at least 10 times your gross annual income. So, if your annual income is ₹10 lakh, you would need a minimum life cover of ₹1 crore. For a typical ULIP plan, the life insurance sum assured is around 15 times the annual premium for investors below the age of 45. To generate a life cover of Rs 1 crore, you would be required to pay a ULIP annual premium of Rs 6.7 lakh. To get the same cover of Rs 1 crore with a term life insurance plan, you would only need to pay a premium of Rs. 8,000 per annum. Thus ULIP is costlier by 80 times to a competing term plan for life insurance!
From the above example, it is clear that term insurance should be your default option for life insurance needs.
Costs and more costs in ULIPs
ULIP deduct various charges from your monthly or annual premium which reduce the amount actually invested. Because of these charges, ULIP returns become inferior to mutual funds and costlier to term plans.
· Premium allocation charges
· Policy administration charges
· Mortality charges
· Fund management charges
· Surrender charges
Let’s focus on the impact of these costs on yield of ULIPs. As per IRDA regulations, the ‘Maximum reduction in yield’*, excluding mortality charges, due to ULIP costs are capped as follows:
· First 5 years: Maximum reduction in yield is capped at 4%
· Years 5–10: Maximum reduction in yield is capped at 3%
· Year 10 onwards: Maximum reduction in yield is capped at 2.25%
* Maximum reduction in yield is the maximum amount your gross returns can go down due to costs.
It is important to add that the Maximum reduction in yield excludes mortality charges (the cost of life insurance cover). The reduction is yields would be even higher if we were to include mortality charges.
Costs involved with Mutual funds
This can be measured with a simple number — Expense Ratio. Expenses in mutual funds are regulated by SEBI. Expense ratios in equity funds average around 2%. In debt funds, the average expense ratio is lower is at 1%. As you can see, mutual funds are cheaper than ULIPs.
Mutual fund companies are expert in managing and growing investments while the primary function of an insurance company is to manage risk. Therefore, an investor is better off with mutual funds for investments and term plans to cover for unprecedented loss of life. A mutual fund investor has the option to redeem his investments from one mutual fund company to another. In ULIP on the other side, you have to stick to the same company for at least five years. The only option is to switch from one fund to another of the same insurer. Also, the cost structure of ULIPs is not transparent. ULIPs have a lock-in of 5 years, whereas an investor can exit mutual funds anytime completely free of cost after 1 year and with a small 1% exit load if redeemed within 1 year. It is not certain that the tax advantage enjoyed by ULIPs will continue. There could be similar tax on ULIPs in the future. To sum it up, it is always better to keep your investments and insurance separate and go for products which are experts in their categories.