Most mutual fund schemes have not performed well since the start of 2018. This is broadly in line with the overall performance of the markets. Over the past few months, I have started receiving interesting queries from clients/readers. This happens more with clients who have started investing recently, i.e in the last 2-3 years. Should they start investing in ULIPs and traditional plans? Along with their message, they mention the plan’s name or attach the plan’s brochure. Fair enough.
While it is normal to explore other investments when your existing investments have struggled, we must take a deeper look at the facts. You can’t do the same thing and expect different results.
What are the facts?
You must understand that ULIPs invest in markets too (just like mutual funds). When you invest in a ULIP, a portion of your premium/accumulated fund value goes towards providing you life cover (mortality charges) while the remaining gets invested in a fund of your choice. Now, this ULIP fund (where the money is invested) is no different from a mutual fund. The money is pooled and invested as per the fund’s mandate.
A ULIP provides two services, investment and life insurance. This insurance does not come free. You have to pay for it in the form of mortality charges. Therefore, if you want a pure investment product, picking up a ULIP is a bad choice. You will unnecessarily pay for life insurance you don’t need. And the life insurance in a ULIP can be expensive.
By the way, I am talking about a low-cost ULIP. A high-cost ULIP will have even more charges. If you are being aggressively pushed one, you are likely getting a high-cost ULIP.
Low Cost ULIP = ULIP fund (Similar to mutual fund) + Mortality Charges
High Cost ULIP = ULIP fund (Similar to mutual fund) + Mortality Charges + Many other charges
In a low-cost ULIP, the recovery of mortality charges will impact the performance i.e. performance you experience = Performance of ULIP fund – Impact of recovery of mortality charges.
In a high-cost ULIP, the impact is even higher since there are many more charges. For more on how various ULIP charges affect the returns, refer to this post.
Unless you believe that ULIP fund managers have special gifts (no reason to believe so), the odds are stacked against you.
From what I have observed, the Fund management charges (FMC) of ULIPs are higher than expense ratios of direct plans of mutual fund schemes. For most ULIP equity funds, the FMC is 1.35% p.a., the maximum allowed by IRDA. For direct mutual funds, the expense ratio is likely to be lower.
The performance of ULIP funds you see on insurer website is before adjusting for all the charges. It can be misleading. What you get is after all the charges are recovered.
Everything else being same, ULIP funds must do much better than a mutual fund to deliver the same level of investment performance. This is because ULIPs will have a more expensive cost structure than equity mutual funds. You may argue that ULIP maturity proceeds are tax-free while LTCG from equity funds will be taxed at 10% p.a. Despite the tax advantage, my vote still goes to equity mutual funds. For a detailed discussion on ULIPs and mutual funds, refer to this post.
There is an issue with the sales message too. One of the clients mentioned that they were told XYZ ULIP will provide a guaranteed minimum return of 8%. We know that insurance companies cannot guarantee returns in linked plans (ULIPs) or participating plans (Traditional). If there is indeed a mention of the return guarantee, it is mis-selling.
Coming to traditional life insurance plans
There is another set of queries regarding traditional plans. A certain traditional plan is giving guaranteed returns of 7-8% p.a. FD interest rates have gone down and are expected to go down further. With traditional plans, you will at least get 7-8% p.a. Should I invest?
That is not the case.
If the interest rates in the economy move down from there, the bonus on your LIC policies will eventually start suffering. After all, the LIC will invest in the same bonds, right? Lower interest means existing bonds will see an uptick but the new investments/re-investments will be made at lower interest rates.
As recently as November 29, 2019 the 7.72% p.a. 30 year Government Bond was auctioned (re-issuance) at a yield of 7.18% p.a. Now, this is one of the instruments with Sovereign backing. If an insurance company invests in this bond, how can it deliver 8% p.a. per annum after costs? The costs include very heavy upfront commissions, life coverage costs, administrative charges etc.
Since the traditional plans are opaque (unlike ULIPs), it is difficult to break down each component. However, you can assess the impact from the fact that these products have delivered 4-6% p.a. till now (when the interest rates have been much higher). With respect to commissions, you must note that you don’t get anything back in traditional plans if you surrender the plan before paying the premium for 3 years (now reduced to 2 years). I agree this is partly to deter investors from exiting the product too soon. However, in my opinion, the primary reason is that the bulk of the initial years’ premium goes towards commissions. The insurance company does not have much left to give back to you if you exit too early.
You can say that insurance companies can take credit risk or active interest rate risk to deliver better returns. I wouldn’t bet on this. Seems like a very tall order. Moreover, with credit risk, there can’t be any guarantee of returns.
Before making a decision, consider these points
1. ULIPs and traditional plans do not invest on a different planet. They invest in the same equity and bond markets as mutual funds. Therefore, the gross investment performance (before costs) should be similar to that of equity or debt mutual funds.
2. Higher cost structures of ULIPs and traditional plans will eat into the returns you experience.
3. The performance is ULIP funds is reported at the gross level (except for FMC). Mortality and other charges will eat into the returns.
4. Giving return guarantees on ULIPs or participating traditional plans is not permitted. Therefore, be suspicious if somebody mentions guaranteed investment returns.
5. Comparing past 2 year returns of your mutual funds with 10-year-return from a ULIP fund is like comparing apples and oranges.
6. Your age will affect your returns in ULIP and traditional plans. Everything else being the same, a 30-year-old investor will earn better returns than a 50-year-old. This will be the case even if they invest the same amounts in the same ULIP, in the same ULIP fund, and on the same date. Therefore, if you are old and are suddenly finding merit in ULIPs and traditional plans, think again.
My intent is not to influence you to stick to mutual funds. The intent is to help you make an informed decision. When your investments have not delivered the returns you expected, it is normal to get disappointed and explore other investment opportunities. However, it is important to understand how the new product works and make an informed decision. Purely as an investment product, a ULIP or a traditional plan is not a better choice as compared to mutual funds.