It is that time of the year again when you have to submit investment proofs to your employer to get tax benefits under section 80C. In this article, we discuss ULIP (Unit Linked Insurance Plans), insurance cum investment products that qualify for tax benefits under section 80C and whether you should go for ULIPs. We will discuss various cost elements, maturity and death benefits and also compare their performance against a combination of term insurance plan and mutual funds. Lets first start with what ULIPs are all about.
Brief background about ULIPs
With ULIPs, you get the dual benefit of insurance and investment. In a ULIP, premium is allocated towards life cover and investment (as per choice of the investor). ULIPs were quite a rage during the last bull run in mid 2000s. However, ULIP came with a number of charges such as premium allocation charges (towards distribution expenses), mortality charge (for insurance cover), policy administration charge, fund management charge, surrender charge and switching charge. Premium allocation charge could go as high as 70% of the first premium instalment (this charge went down in the subsequent instalments). With such high distribution commissions, unscrupulous insurance agents made money at the expense of the customers. Of course, insurance companies cannot be absolved of their responsibility too.
Everything went unnoticed till the market crash of late 2008. To add to investors’ woes, when they realized they had purchased the wrong products and tried to surrender the products, they were greeted with high surrender charges. There were many complaints from aggrieved customers. Even the Allahabad High Court took exception at the complaint of a 72 year old man where his Rs 50,000 investment (premium) in a ULIP became Rs 248 in five years. You can read the full story here on Mint’s website.
Modified ULIP guidelines
IRDA, the insurance regulator, taking cognisance of such complaints, modified the ULIP guidelines in 2010 to curb this rampant mis-selling, make ULIPs customer friendly and promote ULIPs as a long term protection and savings tool. IRDA increased the lock-in period, mandated the minimum sum assured and more importantly rationalised the charges by capping the difference between the gross yield and net yield (yield after accounting for various charges) for various policy tenors. With this, insurance companies could no longer front load the charges (distribution and other policy expenses) to the customers and the charges had to be smoothened over the entire policy term. With lower charges (and that too not front loaded), the new ULIPs (to be issued under modified guidelines) were a vast improvement over the older counterparts and were a far better protection and savings tool.
However, with the great incentives of the past gone, insurance agents stopped promoting ULIPs and shifted to selling traditional insurance plans as the latter offered better commissions. Additionally, with the stock markets not performing well, ULIPs fell off from the investment radar.
Should you buy these new ULIPs?
With the stock markets making a comeback this year, there have been a slew of ULIPs launched this year. With the modified ULIPs guidelines in place, does it make sense to opt for ULIPs now? As ULIPs provide insurance and meet investment needs, we compare two ULIPs (HDFC Life Click2Invest ULIP and ICICI Pru Wealth Builder II) with a combination of a term insurance plan (HDFC Life Click2 Protect) and mutual funds (for investment). HDFC Life Click2Invest ULIP (HDFC ULIP) is a purely online plan while ICICI Pru Wealth Builder II (ICICI ULIP) is available through both online and traditional channels. HDFC ULIP is a Type I ULIP while ICICI ULIP is a Type II ULIP. 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.
We shall see how the new ULIPs fare against this combination against various parameters. To facilitate comparison, we consider a 30 year old male looking for sum assured of Rs 50 lacs and policy term of 20 years. Additionally, we have taken the premium/investment in the two ULIPs as Rs 5 lacs. In the term plan and mutual fund combination, a part will go towards insurance premium while the remaining gets invested in the mutual funds.
For the returns on the invested funds, we have assumed return of invested funds in ULIPs and mutual funds to be same. In this post, we put greater importance on what percentage of your total funds gets invested.
Areas where ULIPs score over the term plan and mutual fund combination
- Tax benefits: Entire premium amount is eligible for tax deduction under Sec 80C (subject to a maximum of 10% of Sum Assured). Investment in only tax saving mutual funds (Equity linked saving scheme) or ELSS is eligible for tax benefits. Please note that the tax benefits are subject to a maximum of Rs 1,50,000 per financial year under Sec 80C.
- Fund management charge: Equity mutual funds typically have an expense ratio (includes fund management and other expenses) of 2%-3%. Debt funds have slightly lower expense ratios. Hence, compared to mutual funds, FMC is lower at 1.35%. ICICI ULIP scores over HDFC ULIP as it has even lower FMC for debt funds. Please note that all the expenses charged by mutual funds (including distributor commissions) are covered under the expense ratio.
- Fund Switching: Each ULIP provides policyholder/investor to select a fund (out of 6-8 funds offered under the ULIP) for investment. The policyholder can transfer/switch the accumulated amount among any of those funds. Generally a fixed number of switches are provided free of cost (a nominal amount is charged for subsequent switches). However, there are no tax implications during fund switches in case of a ULIP. In case of mutual funds, apart from exit loads, there can be tax implications arising out of short term/long term capital gains (while liquidating or transferring money to a new mutual fund).
Areas where term plan and mutual fund combination is better than ULIPs
- Premium amount: Under the HDFC ULIP, maximum sum assured is 10 X Annual premium while maximum sum assured is 25X for ICICI ULIP. Hence, for a cover of Rs 50 lacs, you have to shell out Rs 5 lacs as premium in HDFC ULIP (Rs 2 lacs in ICICI ULIP). However, your insurance cover requirement depends upon your financial goals and responsibilities (and not your premium paying ability). If you had only Rs 1 lac for investment/insurance in a particular year, you can only go for a maximum cover of Rs 10 lacs under the HDFC ULIP (Rs 25lacs in ICICI ULIP), which clearly does not meet your insurance requirement. If you go for a term plan and mutual fund combo, you can buy insurance cover of Rs 50 lacs for Rs 5,163 and invest the remaining amount in mutual funds. Thus, a term plan and mutual fund combination provides you greater flexibility.
- Liquidity: Under ULIPs, you cannot withdraw the funds before the end of 5th policy year (not even in case of discontinuation/surrender of policy). This is a requirement by IRDA and is intended to promote ULIP as a long term savings tool (avoid premature withdrawals from the plan). Mutual funds have no such restriction expect in case of ELSS where there is a lock of 3 years.
- Mortality charges: ULIPs follow slightly relaxed underwriting norms and hence mortality charges (to provide for insurance cover) are higher as compared to term plans. Additionally, under the term plan, you pay the same premium (or mortality charges) for the entire duration of the policy. In case of ULIPs, since mortality charges are dependent on age of the policyholder, these keep increasing every year. Please remember the more funds go towards different charges, the less is left for investment. The difference is not very significant though. An additional point to consider is that HDFC ULIP, being a Type I ULIP, pays only the higher of fund value or sum assured in the event of death of the policy holder (Refer comparison table). Hence, sum-at-risk (amount insurer has to pay from its pocket in case of death of policyholder) is lower (sum assured minus fund value). Since mortality charge is a function of sum-at-risk too, mortality charge for HDFC ULIP will keep going down as the fund value grows and will eventually become nil when fund value exceeds sum assured. Though one can argue that the HDFC ULIP has the lowest mortality charges over the policy term, the structure of the plan adversely affects its death benefit too. We shall elaborate further under the section “Death Benefits”.
- Overall Charges: HDFC ULIP is purely online plan scores over ICICI ULIP and even over mutual fund and term plan combo. HDFC ULIP charges only FMC, which at 1.35% is extremely competitive. ICICI ULIP has high charges in the initial years with PAC at 4-6% of premium tapering down to 2% in the later years. We need to mention some charges such as premium allocation and policy are a percentage of premium while others such as fund management charges are a percentage of fund value. Hence, as the fund value increases, the fund management charges tend to dominate the overall charges. Mutual funds have an expense ratio of around 2-3% (includes fund management, distribution expenses etc) of the fund value. Please note the expense ratio mentioned is for regular plans (going though distributor). For direct plans, the expense ratio is likely to be lower by up to 1%.
- Death benefits: In case of term plan and mutual fund combination, your nominee gets the sum assured under the term plan and mutual fund investments can be liquidated to get the fund value. ICICI ULIP is a type II ULIP and the nominee gets the sum assured and the fund value (of the investments). However, under the HDFC ULIP, the nominee gets the higher of sum assured and fund value. This was the reason mortality charges under the HDFC ULIP go to NIL as the fund value exceeds the sum assured. Let’s consider a scenario. Assuming an investment return of 8%, the fund value by the end of 7th year would have grown to ~Rs 44.0 lacs. However, in case of death of policy holder at the end of seventh year, the nominee would get only Rs 50.0 lacs (higher of sum assured and fund value). The fund value counts for nothing. According to us, this is a big negative for HDFC ULIP.
We will consider different scenarios and do spreadsheet analysis to see how the different products perform under various scenarios.
As you can see HDFC ULIP does the best when the policyholder survives the term. Being a Type I ULIP, mortality charges are not applicable once the fund value exceeds the sum assured. Thus, more funds get invested resulting in improvement of investment performance. However, it performs poorly if the policyholder does not survive the policy term. Meanwhile, performance of ICICI ULIP and term plan and mutual fund combination is almost similar in all the scenarios. This demonstrates the kind of improvement that ULIPs have undergone. Till now, we had an impression that the ULIPs were high cost products. However, if you look at the overall results, that does not seem to be the case.
The reason is that a number of charges on ULIPs (policy administration, premium allocation) are a percentage of the premium. FMC and MF expense (ratio) are a percentage of fund value. In the illustration, we have taken FMC at 1.35% (as per policy brochures) while expense ratio has been assumed at 2%. As the fund value increases with time, FMC and MF expense (ratio) tend to dominate the other charges. Since expense ratio has been assumed at 2% (higher than FMC of 1.35%), ULIPs have recovered the lost ground with time. MF expense ratio varies across funds and can be much lower for index funds, debt funds and direct plans. If MF expense ratio is assumed lower than 2%, the MF performance will improve considerably. Additionally, the return on invested funds has been assumed same for all the products.
Please note we have picked up just two ULIPs from a universe of ULIPs. Every ULIP may have an entirely different cost structure and hence the performance may vary. If you decide to go with a ULIP, we advise you to go through the plans properly, find out about all the charges and policy benefits. Everything else being the same, go with the plan with the lowest charges. Since insurance agents have a vested interest, we advise you not to rely on them for research. Do your homework, read the policy document properly and make an informed decision.
Comparison between the two ULIPs
HDFC ULIP (a Type I ULIP) has lower overall charges but ICICI ULIP (a Type II ULIP) provides better death benefits. Hence HDFC ULIP is likely to provide better investment results while the ICICI ULIP will provide better death benefits. In any insurance product (with or without investment), we must attach greater importance to its death benefits. Hence, we prefer ICICI ULIP over HDFC ULIP.
It is easy to see that the new ULIPs are a vast improvement over their older counterparts. Additionally, with no liquidity in the initial years and fixed periodic premium instalments, ULIPs, no doubt, can bring serious investment discipline to the customer. As we have seen in the illustration, ULIPs (type II) provide performance (similar to mutual funds) in all the scenarios. However, keeping in mind various restrictions such as limited tenure (25 years maximum for ICICI ULIP) and lack of flexibility in choosing the premium (Sum assured is a multiple of annual premium), by going for ULIPs, you run the risk of remaining under-insured.
Moreover, cost structure and features of a ULIP may not be easy to comprehend for a new investor. If the investor realizes subsequently that he/she has purchased a wrong product and stops paying premium/surrenders the policy before five years, he/she may have to pay the applicable surrender/discontinuance charges. Not just that, aggregate amount of deductions of income (allowed under 80C in earlier years) shall be deemed investor’s income in the year of surrender and taxed accordingly. In other words, the investor will lose deduction benefits. Additionally, maturity amount from ULIPs is tax free only if the annual premium is more than 10 times sum assured (for policies issued on or after April 1, 2012).
You would never face such confusion with a combination of term plan and mutual funds. Hence, for their inherent simplicity and flexibility, we would recommend a combination of term plan and mutual funds over ULIPs.
Do not mix your insurance and investment needs. Your insurance and investment portfolio can better without ULIPs. Go for a pure term insurance to meet your insurance needs and park your investable funds with mutual funds to meet your investment requirements. An additional point to note: Invest in mutual funds through systematic investment plan (SIP). SIPs give the benefit of rupee cost averaging and bring discipline to your investments. Always remember you buy those financial products that you need to buy, not what the intermediary (agent/broker) wants you to buy.
Deepesh is Founder, PersonalFinancePlan.in