Tax-Free ULIPs vs. Mutual Funds with LTCG tax: Which is better?

In Budget 2018, Long term capital gains tax on equity mutual funds was introduced. Prior to the change, the LTCG on sale of equity mutual funds was exempt from tax. This change brought an interesting taxation arbitrage. Taxation of maturity proceeds from Unit Linked Insurance Plans (ULIPs), offered by insurance companies, was left untouched and the maturity amount from ULIPs was left untouched.

While I tried to address this issue through qualitative arguments in a post (After tax on LTCG, after ULIPs better than mutual funds?) in early 2018, I have continued to receive investor queries in this regard. Thus, I thought of doing quantitative analysis and see what the numbers show.

Disclaimer/Disclosure/Assumptions

1. I remain biased towards mutual funds. Thus, I may be inclined to twist facts to suit my notions. Suggest you view this analysis in this regard.
2. Each ULIPs has a different cost structure. Hence, it is not possible to compare each structure with equity funds. I pick a low-cost Type-I ULIP.
3. I work with the assumption that ULIP fund managers and mutual fund FM are equally competent, and both will generate equal returns at the gross level. The net returns will be different because of costs. Now, both the ULIP and the mutual fund industries are dominated by actively managed funds. You may argue that a particular ULIP fund or mutual fund scheme has done better, and I should consider such funds. We will miss the points if we do that. I assume that both ULIP fund and MF scheme will replicate the performance of Nifty 50 TRI at gross level.
4. I consider a 20-year ULIP (monthly premium payment of Rs 10,000) and a 20-year SIP in a mutual fund scheme.

Which ULIP to pick for comparison?

I pick up a low-cost ULIP. HDFC Click 2 Invest in this post. This is an online plan. It has no Premium allocation or administration charges. You have to pay only Mortality Charges or Fund Management Charges (FMC). Mortality charges are recovered through the cancellation of units. FMC is in-built into the NAV.

HDFC Click 2 Invest is a Type-I ULIP.  In a type-I ULIP, in the event of policyholder demise, the nominee gets the higher of Sum Assured or Fund Value. Thus, as the fund value grows, the Sum-at-risk (the amount insurer must pay from its pocket in the event of policyholder demise during the policy term) keeps going down.

There are type-II ULIPs too. In such ULIPs, in the event of policyholder demise, the nominee gets the Sum Assured + Fund Value. In this case, the Sum-at-risk remains constant.

Since the mortality charges (charges to provide you life cover) are charged on the Sum-at-risk, the impact of mortality charges on net returns is higher in Type-II ULIPs.

Costs matter.

Hence, if you are keen to buy a ULIP as an investment, pick a

1. Low-cost Type-I ULIP (preferably the one without premium allocation and policy administration charges)
2. If possible, buy the plan online. An offline ULIP plan is unlikely to be low cost.

I have written about this in this post (How to select the Best ULIP?)

I also compared the performance of online and offline Type-I ULIPs in this post (How various charges impact ULIP returns?).

HDFC Click 2 Invest is not the only low-cost Type-I ULIP. There are many others. Other plans might provide features as loyalty benefits, return of mortality charges etc. I wouldn’t compare such plans. As I see, nothing comes free.

The way costs are accounted for in ULIPs and Mutual Funds

With mutual funds, what you see is what you get. You have the purchase NAV and you have the sale NAV.  You invest Rs 1000 when the NAV was 10. You get 100 units. At the time of sale, the NAV is 15. You will get Rs 1500 (100 units X 15). All the costs (expense ratio) are built into the NAV.

ULIPs work in a different manner. The fund NAV reflects the gross returns (FMC is adjusted). The mortality charges are recovered through the cancellation of units. For instance, you invest Rs 1000 at NAV of 10. You get 100 units. After a few years, the NAV grows to 16. However, your fund value won’t be Rs 1,600 (Rs 100 X 16). The number of units will be lower due to the cancellation of units to recover mortality charges. It is possible that you have only 90 units left. Thus, the fund value will be Rs 1,440 (90 units X 16).

Both expense ratio in a mutual fund and FMC are inbuilt into the NAV.

IRDA caps the Fund management charges in a ULIP fund at 1.35% p.a. GST is applicable on this. I am yet to see a ULIP in which the insurance company charges less than 1.35% p.a. in a ULIP equity fund. That’s where the insurance companies make money. Hence, I will assume fund management charge to be 1.35% p.a. for a ULIP equity fund.

Currently, there are no index fund options in ULIPs. Think IRDA is thinking along those lines. Yet to see what insurance companies will charge for managing those funds.

Equity mutual funds face much higher competitive pressures. Since we are talking about a low-cost online ULIP, we can consider Direct plan of a mutual fund scheme. The Direct plan of an actively managed equity funds costs about 0.5-1% p.a. An index fund will cost only about 25-30 basis points (0.25%-0.3%).

In my opinion, equity funds offer a much cheaper cost structure.

ULIP vs MF: Returns Analysis

In this analysis, I have assumed that even Fund Management Charges (for ULIPs) and expense ratio (in mutual funds) are accounted for through the cancellation of units. This is a big assumption and a flawed one. But I could not think of a simpler way to do this analysis.

I assume that the ULIP and the MF investment started in the year 2000 and the investment completed in 2020. Again flawed. Let’s play along.

1. Investor entry age is 35 years.
2. Policy Term: 20 years
3. Premium Payment Term: 20 years
4. Premium Payment Frequency: Monthly (1^st of every month)
5. Monthly Premium: Rs 10,000
6. Premium Payment started on September 1, 2000 and ends on August 1, 2020. The policy matured on September 1, 2020.

For the MF investor, this is simply a monthly SIP of Rs 10,000 per month for 20 years. I assume that both ULIP fund and the MF scheme will replicate the performance of Nifty 50 TRI at the gross level.

Total Investment in both the cases will be Rs 24 lacs (10,000 X 12 X 20).

I copy the maturity/end values for various entry ages for ULIPs and different levels of expense ratios for the mutual fund scheme.

The difference in end values is due to different cost structures. ULIP has mortality charges and FMC. On the other hand, a mutual fund scheme has an expense ratio that eats into the gross returns.

With the data shown in the above table, MFs look better than ULIPs despite the LTCG tax of 10%.

ULIP cost structure has improved quite a bit over the last 10 years. However, 1.35% p.a. as Fund Management charge is still on the higher side. It is possible that if the ULIP fund management charges drop, my opinion can change. Remember IRDA has specified only the upper cap on Fund management charges. Just that the insurers cling to the upper cap.

Points to Note

1. Everything else being the same (same premium, same fund, same investment date, same payment frequency, same policy term), ULIP returns will be higher for younger investors. Thus, a 35-year old (entry age) will earn better returns than a 45-year old and lower returns than a 30-year old. Thus, if you are old, avoid ULIPs.
2. Mutual fund returns don’t depend on investor age.
3. Portfolio disclosures are much better in mutual funds. The AMCs are required to disclose full portfolios every month. Not sure about disclosure frequency and the quality of disclosures in ULIPs.
4. With ULIPs, you can switch between various ULIP funds without any tax impact. There may be switching charges though. By the way, this can allow you tax-free portfolio rebalancing. No such benefit in mutual funds. If you want to exit one MF scheme and invest in another, there will be a tax impact. Remember you may be able to lower tax liability through tax-loss harvesting.
5. With ULIPs, you can’t exit an under-performer. All you can do is to move to a different ULIP fund from the same insurer. Or you can exit the ULIP completely. There are restrictions there too. You can’t withdraw money before 5 years. And if you move to a new ULIP, the countdown to the completion of 5 years will start again. No such restrictions in mutual funds.
6. I must concede that the insurers have been able to come out with ULIP product structures that the investors can relate to. For instance, you can invest a certain amount every month for your daughter’s education. If you were not around, the insurance company will invest the amount on your behalf. Or the investment for your daughter’s education remains intact whether you are around or not. Forget the extra cost charged for it or the returns you eventually get. When you relate to a product, it is easier to stick with it. For most of us, that is no small feat. Now, mutual funds can’t offer such product structures.
7. I have picked a really low-cost ULIP. If you pick a high-cost ULIP or even a Type-II ULIP, MF results will look even more favourable.

Still, between ULIPs (with tax-free maturity proceeds) and Mutual Funds (with 10% LTCG), my vote still goes to mutual funds. Frankly, it has little to do with the numbers I showed above but much to do with the lack of flexibility in ULIPs.

But that’s just me, trying to optimize everything.

What do you think?