Every parent wants the best for his/her child. It is every parent’s wish that financial constraints do not come in way of his/her child’s education or career. Hence, when you are approached with a specific investment plan to provide for your child’s future education or wedding expenses, the product becomes too irresistible to ignore. The sales pitch is so strong that you start to feel guilty if you choose not to invest in such a product. After all, the product has everything. It has an element of insurance, offers attractive returns and if the most unfortunate were to happen, the insurance company pays all the future premiums on your behalf. How could a parent say no to such a product? As a parent, you realize that, unlike other financial goals such as purchase of a house or a car or a vacation abroad, child’s education is one goal that cannot neither be compromised nor postponed. You fall prey to your emotions and immediately sign up for the product. These combined insurance and investment products discussed above are advertised as child plans. Child plans are insurance (and investment) products that are structured to help you save for your child’s future.
There are many child plans offered by various life insurance companies. All such products have a similar structure although specifics might vary a bit. Child plans come in two variants: Unit linked insurance plans (ULIP) and Traditional (guaranteed payout) plans. Unit linked child plans provide market linked returns.
Should every parent buy a child plan for his/her child? Or are there better products available? Is a simple combination of term insurance plan and mutual funds better than a child plan? We have always maintained that you must buy those financial products that you need to buy, not what the intermediary (agent/broker) wants you to buy. Therefore, before you purchase any financial product, you must understand all its costs and benefits and compare its performance against the competing products. In this post, we shall focus on unit linked child plans and do an objective assessment of the product features and performance and assess whether such plans should be part of your portfolio. We shall discuss about traditional child plans in a subsequent post.
Similarities between unit linked child plans and regular ULIPs
Like regular ULIPs, unit linked child plans are insurance cum investment products. A part of the premium goes towards life cover (mortality charges) and other policy charges (premium allocation, administration, fund management etc) and the remaining is invested in funds as per policy holder’s discretion. Invested funds provide market linked returns. If the policy holder survives the term of the policy, the fund value is paid to the policy holder. Taxation benefits (entire premium counts under IT section 80C), liquidity restrictions (no withdrawals allowed for 5 years) and cap on charges are same as regular ULIPs. You can read about ULIP features in detail in our post here.
Unit linked child plans are, in fact, a variant of type II ULIPs. Under type II ULIPs, in the event of death of the policy holder, the insurance company pays the beneficiary both sum assured and fund value. Under type I ULIPs, in the event of death of policy holder, the insurance company pays only the higher of sum assured and fund value.
How unit linked child plans differ from regular ULIPs?
Under regular ULIPs, both death benefit(sum assured) and the accumulated fund value are paid to the beneficiary upon death of the policy holder and the policy ceases upon payment of such benefits. Under a child plan, only the sum assured is paid to the beneficiary upon demise of the policy holder and only the risk cover ceases. The fund value is paid to the beneficiary only at maturity of policy. The family of the policy holder need not pay any further premiums to the insurance company. The insurance company will pay the entire or part of all future premiums. These premiums, like other premium installments, will get invested and the beneficiary will receive the accumulated fund value at maturity.
This helps in two ways. First, this structure ensures that the proceeds from the policy do not get utilised (or diverted) towards other uses. Secondly, the fund value continues to grow even after demise of the policy holder. However, since the insurance is taking on additional risk by promising payment of all future premiums, you can expect mortality charges (charges for life cover) to be much higher than in case of a regular ULIP. Be advised, higher the amount that goes towards policy charges, the less is left for investment. Additionally, under a child plan, the policy holder or the beneficiary has an option of taking the maturity benefit as lump sum or in instalments over a few years.
Comparison with a combination of term plans and mutual funds
We have already established that a combination of term plan and mutual funds gives better performance than a regular ULIP plan in a previous post. Let’s see how a unit linked child plan fares against this combination. We will first do a qualitative assessment of how various product features will impact product performance.
Unit Linked Child Plan as an insurance product
Under a unit linked child plan, maximum sum assured is capped at a certain multiple of annual premium. Sum assured allowed under the child plan typically varies from 10 times annual premium to 40 times annual premium for people with age less than 45 years at the beginning of the policy. This is a limitation as your ability to pay premium restricts your life cover. However, your child’s future needs do not depend upon your payment ability.
Additionally, mortality charges for a unit linked child plan (for the same sum assured) are higher than a pure term insurance plan. There are two reasons behind this. First, ULIPs, in general, follow relaxed underwriting norms. Secondly, under unit linked child plans, in event of death of the policy holder, the insurer has to pay for all the future premiums. That increases the sum-at-risk for the insurance company. Thus, the cost of insurance is higher in a child plan than a pure term plan.
Unit Linked Child Plan as an investment product
Under unit linked plans, policy holders have multiple fund options (equity, balanced, debt, money market) etc for parking their investment amounts. For comparison as an investment product (with mutual funds), you need to compare the charges because charges eat into the amount that gets invested. There is no reason to believe that the investment returns will be higher in a particular product. Hence, the more funds that get allocated towards investment, the more you get in terms of maturity benefits. Under ULIPs, there are many types of charges including premium allocation, policy administration etc that will eat into the investment amount. Though the charges vary across policies, it will be around 7-8% of the premium amount in the initial years but tapers down in the later years. In addition to this, there will be annual fund management fees (capped at 1.35%). In comparison, equity mutual funds (regular plans) have expense ratio of 2-2.5%. The expense ratio for debt mutual funds and liquid funds is much lower. Under direct plans (where distributor is bypassed), the expense ratio is likely to be lower by around a 0.5-1%for both equity and debt funds. Please note that fund management charges and expense ratio are expressed as a percentage of fund value while the other charges are expressed as a percentage of annual premium.
Though it appears that the child plan has higher costs and is an inferior investment product, but we would do spreadsheet analysis and consider various scenarios to verify.
We compared the performance of a specific unit linked child plans against a combination of term plan and mutual funds. We picked HDFC SL Young Star Premium plan (a unit linked child plan) and HDFC Click 2 Protect Plus term plan (a pure term insurance plan). We kept annual sum assured at Rs 30 lacs, policy term of 15 years and an annual premium of Rs 75,000. Customer is a 30 year old male and a non-smoker. Under the combination of term plan and mutual funds, only a part goes towards term plan premium and the remaining is invested in mutual funds.
The child plan has premium allocation charge of 4% of the premium for the first seven years and 1% thereafter. Additionally, policy administration charge is capped at Rs 500 per month. Fund management charge is 1.35% p.a. The permissible sum assured varies from 10X annual premium to 40X annual premium for age less than 45 years. Insurance company pays all the future premiums in event of death of the policy holder. Let’s look at various scenarios.
Results are surprising for most of us. Unit linked child plan underperforms in terms of benefits if the policy holder survives the policy term. However, child plans are far ahead if policy holder dies during the policy term. The outperformance (in event of death) stems from the policy feature where the insurance company pays all the future premiums on behalf of the policy holder in event of his/her death during the policy term. Under a combination of term insurance and mutual funds, no additional investments in the fund will be made post the death of the policy holder.
All these years, you have been reading in the newspapers that the investment and insurance needs must be kept separate but here is an insurance and investment product that clearly outperforms the combination of term insurance and mutual funds. Though child plan is behind if policy holder survives the policy term, but don’t we buy insurance to ensure that our dear ones don’t suffer financially after we are gone? It is in that situation (death of policy holder) that child plan outperforms the combination of term plan and mutual funds.
So, are all the financial planners who have been deriding child plans wrong? Going by the illustration, that seems the case. Well, let’s not jump to the conclusion. Let’s consider an alternate set of scenarios. We increase the sum assured in case of term plan to Rs 45 lacs. Sum assured in case of unit linked plan remains Rs 30 lacs. Annual premium is retained at Rs 75,000 and policy term is 15 years.
In all these scenarios, the combination of term plan and mutual fund outperforms the unit linked child plan. By going for a higher sum assured (in case of pure term plan), policy holder has ensured higher death benefits, which is what you need from an insurance product. You can argue that we could have gone for higher sum assured in case of child plan too. Yes, we could have but then annual premium amount would have risen to Rs 1,12,500 (since this child plan allows sum assured up to a maximum of 40XAnnual premium). Not every parent may have this extra amount (Rs 37,500 = Rs 1,12,500 – Rs 75,000) for investment but the child’s financial requirements do not change with your ability to pay premium. Even if one has resources to pay such premium amount, we can easily outperform (through term plan and mutual funds) by using an even higher sum assured in the pure term plan. You don’t have such restrictions (on sum assured) in case of pure term plans. It is this flexibility and low cost structure in the combination of term plan and mutual funds that scores over all other insurance cum investment products.
Unit linked child plans are certainly not as bad as they are made out to be by most financial planners. Most of us struggle with discipline in our investments. Investment in such plans can enforce serious investment discipline in customers. People find it easier to save when they have a goal in mind. Moreover, with modified ULIP guidelines by IRDA in place, these plans are not too far behind term plan and mutual fund combination in terms of overall costs and investment returns, especially over the long term. You must note all unit linked child plans are not alike and come with different cost structures and conditions. This adds to the complexity and makes it difficult to assess and compare product performance. However, the biggest disadvantage is the cap on maximum sum assured as a multiple of annual premium. In addition to cost structure, it is the lack of flexibility (beyond a point) in the choosing the sum assured that makes a child plan lose out to a term plan and mutual fund combination. Since premium paying ability of a customer may be limited, by opting for child plans, one runs the risk of remaining under-insured (too low sum assured). Hence, for its simplicity, inherent flexibility and low cost structure, term plan and mutual fund combination is a clear winner.
Be advised your child’s education is not your only financial goal. You may have more than one child. You may want to provide for your wife, siblings and parents after you are gone. So, there will be other financial goals too. You cannot buy a separate insurance policy for every possible financial goal. Hence, do not fall prey to your emotions. We recommend that you purchase a single term insurance plan that caters to all your insurance needs. You can seek advice from a financial planner or registered investment advisor to work out your insurance requirements, purchase a cheap term plan and invest the remaining funds into a mix of 4-5 mutual funds through systematic investment plans (SIP).
Deepesh is Founder, PersonalFinancePlan.in