Monday, August 3, 2009

Merits of Mutual Funds and ULIPs

“Its success lies in the fact that it is an insurance plan and not an investment or a welfare plan,” said James Franklin Roosevelt

Sorry Mr Roosevelt, but insurers here would beg to differ. Thanks to an array of ‘insurance cum investment products’ , the idea of a complete insurance product for investors seems to have diluted.

Yes, you have guessed it right. We are talking about Unit Linked Insurance Plans (ULIPs), which are currently the most popular of all insurance schemes available in the market. But why, as someone would rightly point out, is an ULIP being discussed in an Investor’s Guide edition purely dedicated to the Mutual Funds (MFs)?

ULIPs and MFs, have locked horns against each other for quite some time now. The recent debate roots from scrapping of the entry load from the MF schemes, closely followed by Insurance Regulatory & Development Authority (IRDA) capping the ULIP charges.

But why, after all, are MFs and ULIPs, up against each other?

The answer, though simple is highly complex to deal with. And the answer lies in the manner in which the ULIPs are sold. Investors here are perceived to believe that they are buying an insurance plan with a built-in add-on feature of mutual fund investments. Thus prima facie this product seems an attractive ‘buy one get one free’ offer. But this perception goes for a toss when the investor realises that the element of insurance is just miniscule. And this revelation pops only after the scheme is bought.

Most ULIPs available in the market today offer an insurance cover in the range of 5 -10 times the amount of annual premium. Thus, for an investor paying a premium of Rs 20,000 per annum, the embedded value of insurance is simply a lakh to two lakh rupees. In a stark contrast, a traditional pure term insurance plan can fetch an insurance cover of about Rs 50 lakh with the same amount of premium.

Moreover, unlike a traditional endowment or money-back policy, ULIP does not pay back the amount of sum assured if the holder survives through the policy term. The amount receivable on maturity is purely the fund value whose growth is directly linked to the markets. There is thus a very thin line of distinction between an MF and a ULIP as far as the structure and investment strategies are concerned.

Another concern surrounding the ULIP is the fact that if at the time of maturity of the policy, the markets are sailing in troubled waters, investors have no option but to accept the returns as determined by the market then. Unlike an MF, they do not have an option to hold on to their investment until the markets recover.

Thus, though MFs and ULIPs are said to be similar, the similarity is restricted to the product structure and investment strategies. The point where this similarity ends, the dissimilarities begin.

The starting point of this dissimilarity is the extent of charges levied by both these products. An ULIP is normally loaded with a number of charges ranging from premium allocation charge to fund management fees to policy administration charge, mortality charge, top-up premium charge, switchover charges and so on. Of these, the premium allocation charge, which usually varies from about 10% to 100%, is the prime source of income for insurance distributors and is highly criticized for robbing the investor of his invest-able surplus.

On the other hand, the prime source of revenue in case of an MF is the fund management charge, which is currently capped at 2.5% per annum. There is also a small percentage of penal charge, ranging from 0.5% - 1% called as exit loads, levied in case of premature withdrawals. Premature withdrawals here generally refer to withdrawals within one year from the date of investment. The net amount invested is thus much higher in case of an MF vis-à-vis a ULIP. However, having said that, it would be wrong to conclude that ULIP is a bad product and that a MF scores over an ULIP at all times.

ULIPs are known to be tax-friendly since both the investments and the returns are fully exempt from tax. Moreover, ULIPs offer flexibility to switch between the equity and the debt investments, which are currently absent in case of an MF. This switchover, though, attracts some cost. But then ULIP is beaten by an MF when it comes to liquidity, as an early exit from an ULIP is nothing less than suicidal.

To prove this thesis, ETIG analysed two investment options – one in a ULIP and the other in an MF to analyse the returns from these two competing products over a period of time. And the results are interesting indeed. Under both the options we have assumed the age of the investor to be 30 years and annual amount of investment is Rs 20,000 for 20 years. Under the first investment option, we have assumed a ULIP scheme with a 100% exposure to equity markets.

Assuming the risk cover to be five times the first premium installment, the sum assured is Rs 1 lakh. As far as charges are concerned, we have assumed a Premium allocation charge (PAC) of 20% for the first two years and 10% for the third year. Thereafter, PAC is uniform at 2% p.a. throughout the policy term. Policy administration charge is fixed at Rs 60 per month throughout the policy term while mortality charge is based on the age of the policyholder and the amount of risk cover. The same thus increases with the age of the policy holder during the policy term.

Another charge factored in is the fund management fee, which is 1.5% p.a. and gets deducted from the fund value on a regular basis. Thus, in the first three years of the policy, almost 25% of annual premium is deducted towards these different charges.

Under the second investment option, the premium paid towards a pure term insurance plan of Rs 1 lakh is mere Rs 417 per annum while investment in equity mutual fund will attract an annual fund management charge of about 2.5% of the fund value. (While we have assumed a pure term cover of Rs 1 lakh, investors would do well to note that a pure term plan with such small cover is currently not available in the market. We have assumed the same to make investments under both the options comparable).

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