Budget 2018 proposed long-term capital gains tax on equity investments. The very next day, the insurance companies were out with advertising campaigns highlighting the tax advantage of ULIPs over mutual funds.
Well, mutual funds and ULIPs compete for investor money. And it is not unfair on the part of insurance companies to highlight any demonstrable advantage that they may have over equity mutual funds.
Maturity proceeds from a ULIP (subject to be a few conditions) are exempt from tax. On the other hand, long-term capital gains in equity funds are taxed at 10% (from FY2019) while long-term capital gains in debt mutual funds are taxed at 20% after indexation. I have discussed on the impact of tax on LTCG on returns of equity funds in another post.
In this post, let’s look at if a ULIP makes for a better choice as compared to equity mutual funds. I had done a detailed comparison between ULIPs and mutual funds in a very old post. However, given the recent proposal about LTCG taxation and a few queries from readers and friends, I think this topic needs a revisit.
In my opinion, mutual funds are still a better investment choice as compared to ULIPs (even after the introduction of tax on LTCG). However, you can expect my opinion to be quite biased. Therefore, rather than trying to prove equity MFs better than ULIPs, I will present points in favour of and against ULIPs.
The choice is yours.
I will not go into aspects such as discipline. ULIP supporters argue that annual premium results in discipline. There is some penalty too for early exits in the form of claw-back of tax benefits. You will also not be able to take out money before 5 years. However, you can do something very similar (and with greater flexibility) through SIPs in case of mutual funds too. I will also not get into who has better stock-picking or investment management skills.
I will look at pros and cons in terms of product structures and taxation.
Let’s first talk about the benefits that ULIPs offer.
Where Unit-Linked Insurance Plans (ULIPs) score over mutual funds?
- The maturity amount in ULIPs is exempt from tax. In case of mutual funds, the long-term capital gains resulting from sale of equity mutual funds units is taxed at 10%.
- Even if you hold your entire money in a debt ULIP fund, the maturity proceeds are still tax free. In case of a debt mutual fund, you will have to pay long term capital gains tax at 20% (after allowing for indexation).
- If you switch to another fund within the same ULIP, it does not give rise to any tax liability. For instance, you can shift from Aggressive Growth (equity) fund to a conservative fund (debt) or vice-versa within the ULIP. There will not be any tax liability.
- However, in case of mutual fund, if you switch from one fund to another, it is equivalent to redemption from one fund and purchase in another fund. And redemption gives rise to both exit load and capital gains tax implications.
- Therefore, if you want to rebalance your portfolio, it is much easier to do in case of a ULIP. Or rather, the cost of such rebalancing will be much lower in ULIPs.
Before I write about the various drawbacks of ULIPs, it is important to understand how ULIPs work.
How ULIPs work?
ULIPs are investment and insurance combo products.
Therefore, a portion of your premium/accumulated wealth goes towards providing life cover while the remaining gets invested.
A ULIP can have multiple types of charges.
ULIP charges can fall into 4 broad categories.
- Premium Allocation Charges (as a percentage of annual premium. Higher in the initial years. Typically, goes away after a few years)
- Policy Administrative Charges (Typically, an absolute amount. Recovered through redemption/cancellation of fund units)
- Mortality Charges (Provides life cover. Charged by cancelling/redeeming fund units)
- Fund Management Charges (Charges towards management of your funds. As percentage of your wealth. Inbuilt into fund NAV)
When you pay your premium, premium allocation charges are deducted upfront from the premium. The remaining portion of the premium gets invested. You will have a choice of funds. You can choose as per your requirement.
Your fund value (corpus) keeps increasing gradually through accrued returns and premium paid over the years. Policy administration and mortality charges are recovered through cancellation/redemption of units.
There are two types of ULIPs: Type-I and Type-II ULIP.
Under Type-I ULIP, in the event of the demise of the policyholder, your nominee gets the higher of Sum Assured or the Fund Value. Higher of (Sum Assured, Fund Value).
Clearly, since the Sum-at-risk (the amount that the insurance company has to pay from its pocket) goes down as your fund value grows with time. Therefore, the impact of mortality charges is lower in case of Type-I ULIP.
Under Type-II, your nominee gets the Sum of Sum Assured and Fund Value. Sum Assured + Fund Value. Since, in this case, the Sum-at-risk for the insurance company is always the Sum Assured, the premium and the impact of the mortality charges is higher.
You may have seen that the plans that the insurance companies present as investment plans are Type-I ULIPs. Now, you know the reason. Once the fund value exceeds the Sum Assured (and this may take many years), no amount is deducted towards mortality charges. Therefore, the returns at maturity are likely to be much better than Type-II ULIPs.
Now, to the problems with ULIPs.
Where Unit-Linked Insurance Plans (ULIPs) struggle against mutual funds?
#1 The performance of ULIP funds may be misleading
Mortality charges and policy administration charges are deducted by cancellation of units.
In case of mutual funds, the performance that you see is net of all the charges (expenses). Of course, taxes have to be paid.
This is not the case with ULIPs. The performance that you will see on brochures and MorningStar is before applying mortality charges and policy administration charges. For instance, you may have 1,000 units of Fund A in your kitty. During the year, some of these may be cancelled/redeemed to finance mortality charges. So, at the end of the year, you may be left with only 980 units. It is possible that your Fund A returned 15% next year. However, the net return to you will be only 12.7%.
15% is what will be shown in the brochures. 12.7% is what you will get.
Mutual funds do not show results in such convoluted manner. The mutual fund NAV is net of all the expenses. What you see is what you get.
#2 You pay a way lot more for life insurance
I am sure you can find fault in the above argument. You can say that this portion of the money that goes towards life insurance shouldn’t be compared because mutual funds are pure investment products. On the other hand, ULIPs provide both investment and life insurance benefit.
And it is unfair to expect a ULIP to provide life cover free of cost.
However, instead of purchasing a ULIP, you could have gone for a term insurance plan. And as I have shown (with the help of an example) in one of my earlier posts, term insurance (which is pure mortality charge) has much lower mortality charges as compared to a ULIP.
As I understand, the underwriting norms in ULIPs are quite relaxed.
In a way, you end up paying much more to get the same level of life cover in a ULIP.
And there is more to it.
In a term life insurance plan, the annual premium is fixed. Of course, the fixed premium takes into account all the years.
In case of a ULIP, you are charged as per mortality table provided in the policy wordings. And mortality charges increase with age. As you grow older, more money goes towards mortality charges. Each year, you pay greater and greater amount towards mortality charges.
This is why your age affects your returns in a ULIP. I have discussed this aspect in greater detail in another post.
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 lesser (for the exact same investment performance).
In exceptional cases, mortality charges may eat away almost all your wealth. I discussed an example where a senior citizen ended up with Rs 11,000 after investing about Rs 3.2 lacs over six years.
Reason: Mortality charges were very high due to old age and an existing condition and ate up all the investment.
In case of mutual funds, the returns do not depend on the age.
#3 You can’t exit an underperformer in ULIP
In one of your MF investments were under-performing, you would probably exit the investment and invest the proceeds elsewhere.
How do you do that with ULIP?
You have a choice of 4-5 ULIP funds from the same insurance company. However, those are different types of funds. For instance, you invested in a ULIP from HDFC Life and invested the bulk of your money in the multi-cap fund. If the fund underperforms, you can perhaps switch to a balanced fund from the same list of 4-5 funds. However, you cannot switch to a fund from say ICICI Prudential.
And this takes away your flexibility.
You can always exit the ULIP from HDFC Standard Life and purchase another from ICICI Prudential. However, there are restrictions on when you can exit. Moreover, when you invest in a new ULIP, the lock-in period starts again.
In case of mutual funds, you could have simply sold your investments and shifted to say a fund from ICICI AMC.
Please understand I am not saying that you should keep hopping funds at the slightest sign of underperformance. This may, in fact, turn out to be counterproductive. All I am saying is you have lesser flexibility in case of ULIPs.
#4 The Fund Management Charges(FMC) may not be as low
One of the prominent arguments used by life insurance industry in favor of ULIPs is that ULIPs have very low charges.
FMC in ULIPs is capped at 1.35% p.a. There is also a cap of difference between gross yield and net yield.
At the same time, expense ratio in mutual funds can be as high as 2.5%-3% p.a. for an equity fund. However, do note it is not that the expense ratio is as high for all the funds. In case of debt funds, you can expect the expense ratio to be lower. The expense ratio is further lower for direct plans (in both equity and debt funds).
Now, 1.35% p.a. may look like a good number for an equity fund. However, if the same FMC were to be charged for say a liquid or a short-term bond fund. Not so low, right? By the way, I am not saying that the FMC for debt funds too is 1.35% but it is quite high.
Moreover, these are not the only charges that you incur (as we have seen above).
#5 You can’t top up the premium without purchasing additional cover
If you want to invest more in mutual funds, you can do that whenever you want. You can make lump sum investments or you can increase your monthly SIP amount.
However, in case of ULIPs, you can’t do that easily. Even though you can top-up your premium, you can’t do that without purchasing additional life cover. I have discussed this aspect in another post.
Therefore, if you want to invest more than the usual amount in a ULIP, you have to bear mortality charges for additional life cover too. It does not matter whether you need additional life cover or not.
Moreover, there could be ancillary charges on your top-up premium too. For instance, you may have to cough up premium allocation charges for your top-up premium.
Despite the introduction of tax on long-term capital gains on the sale of equity mutual funds, I will still go with equity funds over ULIPs. You may call it my bias or may attribute it to my dislike for bundled products like ULIPs and traditional life insurance plans.
However, I am more concerned about lack of flexibility and paying through the nose for the life cover I may or may not need.
I believe in keeping insurance and investments separate. You can’t do that with ULIPs.
What do you think?