Many investors are worried about their debt fund investments. You cannot fault investors. Their hard-earned money is at stake. Moreover, when some of the AMC CEOs are busy peddling their credit risk funds despite the Franklin mess, it is not easy to trust the industry. Your confidence is likely to suffer.
How do you build you fixed income portfolio without debt mutual funds?
There are a few ways, but a very fancy idea has been floating around that you can use ULIPs for your fixed-income portfolio. I use the word “floating” because a couple of investors have asked me this. A leading business daily sought my opinion on this. The idea was also discussed in a group of investment advisers. I am inclined to believe that the insurance industry is pushing this fancy idea. Clearly, this is one industry that is not letting this crisis go waste.
To me, using ULIPs for your fixed income portfolio makes no sense.
In this post, we will see why.
First, let’s begin with the merits of using ULIP for your fixed income portfolio and we get down to the problems later.
Why would you build a debt portfolio using ULIPs?
Here are a few plausible reasons.
- ULIP bond (debt) funds are safe (that’s a misconception)
- The maturity proceeds are exempt from tax. Yes, a big positive. However, there are a few conditions to be met and extra costs to be incurred.
- You can do tax-free switches between various ULIP funds. Again, a big positive for smart investors. However, since we are talking about building a fixed income portfolio, this is not relevant.
What are the problems in building a debt portfolio using ULIPs?
Let’s look at the shortcomings now.
#1 ULIP bond funds are safer. What!!!
Neither do ULIP fund managers come from Mars, nor do they make investments on another planet.
There is absolutely no reason or evidence to believe that ULIP fund managers are better than mutual fund managers from AMCs.
And the ULIP fund managers buy the same type of securities and can make similar mistakes as mutual fund managers have made.
Just that because of the lack of full portfolio disclosures and lesser media attention, their mistakes may not come out in the open easily.
#2 Lack of adequate portfolio disclosures
The AMCs are required to disclose portfolios for each scheme every month. The AUM for each scheme is available daily.
As I understand, IRDA only mandates that the latest information be available for ULIPs on respective insurer websites (IRDA Linked Insurance Product Regulations, 2019). I do not know how subjective “latest” is and how subjective “information” is.
As I see, nothing is standardized.
On the website of one of the insurers, I couldn’t even find the portfolios on the website. For one insurer, only the latest (month-end) data was available. The data was shared in pdf format, which is difficult to process. Or it was simply pasted in a table on the website.
A few insurers provided only Top 5 or Top 10 holdings in the portfolio disclosures. “Others” was frequently used. This is just not enough. You want the complete portfolio.
We must understand ULIP money is likely captive money. Unlike mutual funds where investors can vote by feet (and they have), ULIP money is rather sticky (and perhaps not as closely monitored). You can’t exit a ULIP before 5 years (you can discontinue the policy or shift to another ULIP fund though). I think this can make the fund manager less alert.
I am not comfortable with such a set up.
#3 Various ULIP charges eat into the returns
Your ULIP can have multiple types of charges. There could be premium allocation charges, a policy administration charges, mortality charges, fund management charges and a whole host of other charges.
Some of these charges are recovered from the premium while the others are recovered through the cancellation of units. For more of how various charges can affect ULIP returns, refer to this post (How various ULIP charges affect your returns?).
When we talk of using ULIPs for fixed income portfolio, we know that bond fund/debt funds are low return products. Thus, the cost can eat a bigger portion of your gross returns.
#4 Don’t ignore the impact of mortality charges
Mortality charge is the cost you incur to get the life cover under a ULIP.
Mortality charges are calculated on the Sum-at-risk.
Sum-at-risk is the amount of money the insurance company must pay from its pocket in the event of demise of the policy holder. Mortality charges table in the policy document (policy wordings) express mortality charge per Rs. 1,000 of Sum-at-risk. And this mortality charge increases with age.
Let’s say for the year, the mortality charge is Rs 1 per annum per Rs. 1,000 of Sum-at-risk. And let’s assume that Sum-at-risk is Rs 10 lacs for the year. Over the year, the insurance company will recover 1/1,000*10 lacs = Rs 10,000 (plus 18%GST) to provide your life cover. The mortality charges are recovered through cancellation (redemption) of fund units on a monthly basis.
In case of a Type-I ULIP, the insurance company must pay the Higher of (Fund value, Sum Assured) in the event of policyholder demise.
Fund value is the current value of your ULIP investments.
Sum Assured is the minimum death benefit under the policy.
Thus, for a type-I ULIP, Sum-at-risk = Sum Assured – Fund Value
As the fund value grows with time and returns, the Sum-at-risk goes down. Therefore, with time, the impact of mortality charges will also go down for a Type-I ULIP. Do note mortality charge per unit of Sum-at-risk keeps going up with age, but the Sum-at-risk itself goes down with the increase in fund value.
In case of a Type-II ULIP, the insurance company must pay Fund Value + Sum Assured in the event of policyholder demise.
Thus, for a type-I ULIP, Sum-at-risk = Sum Assured (no relation to fund value)
Thus, mortality charges are eating into your returns all the time and at an increasing pace since charge per unit of Sum-at-risk goes up with age.
Every else being the same (same policy, same variant, same tenure, same funds), a younger investor will earn better returns than an older investor. A 25-year old (at the time of policy purchase) will earn better returns than a 55-year old. This applies to both Type-I and Type-II ULIPs.
Even for a Type-I ULIP, do not underestimate the impact of mortality charges if you are looking for tax-free maturity proceeds. For the maturity proceeds to be tax-free, the Sum Assured must be at least 10 times the annual premium. Thus, it will take a lot of time for the fund value to get closer to the Sum Assured.
If you are still not bothered about the impact of mortality charges, especially for old people, read this (How Rs 3.2 lacs became Rs 11,678 in 6 years?).
#5 Expense Ratio is high
IRDA allows life insurance companies to charge up to 1.35% p.a. as Fund Management charges (FMC) for a ULIP fund scheme. GST is applicable on all the ULIP charges, including FMC and mortality.
Note expense ratio for mutual funds (by AMCs) includes fund management charges (FMC), distributor commissions (for regular plans) and other administrative and operational expenses.
In a ULIP, we are talking just about the fund management charges.
From what I have seen, insurance companies usually charge 1.35% p.a. for all ULIP equity funds, which is quite high. For the debt funds, they charge less than 1.35% but I have never seen them charge less than 0.5% for a ULIP debt fund. Usually, it is about 1% even for a ULIP debt/bond fund. This is expensive for a debt/bond fund.
#6 Tax-Free maturity proceeds
The ULIP maturity proceeds are not always exempt from tax. For this to happen, the Sum Assured (life cover) must be at least 10 times the annual premium. With the change in Sum Assured rules for Linked Insurance products, this may not always happen. It is unlikely to happen with single premium ULIPs.
Here is the catch.
When the Sum Assured is a higher multiple (>=10) of annual premium, the maturity proceeds are exempt, but the impact of mortality charges is higher.
When the Sum Assured is a lower multiple (<10, single premium) of the annual premium, the maturity proceeds are not exempt, but the impact of mortality charges is lower.
What should you do?
I concede there are ills in the mutual funds industry. Moreover, given the mishaps of the recent past in the debt MF space, it is obvious that you are worried about your debt mutual fund investments.
However, your money is not safer in ULIP bond or debt funds. ULIPs must comply with much weaker disclosure and regulatory standards as compared to mutual funds. This, in my opinion, makes your money even more unsafe in ULIP bond/debt funds. Moreover, in a ULIP, you will have to pay for life insurance you may not need. Hence, a ULIP is a very cost-inefficient and a rigid way to build your fixed-income portfolio.
In my opinion, you must first check if your debt MF investments are safe. If you are not comfortable, consider PPF, RBI Savings Bonds, SCSS, Bank fixed deposits, SSY, and other small savings schemes. A ULIP bond fund is not an answer. You incur a much higher cost for no additional safety.