Many of us have fallen prey to false promises and inadequate disclosures while buying financial products.
Last year, the Ministry of Finance set up a committee under former Union Finance Secretary Sumit Bose to look into various financial products and suggest measures to curb mis-selling.
One of the main reasons for mis-selling has been front-loaded commissions. While the Sumit Bose committee report recommends trail commissions on all products, how can you plan your investments to make the best returns with the current commission structure?
An illustration in the Sumit Bose panel report makes this point clear. Over a 15-year tenure, while a mutual fund distributor earns only 1.11 per cent of total commissions in the first year, a ULIP distributor earns 22 per cent and a distributor of traditional plans earns 26 per cent. So, on exit at the end of say, three/five years, your returns will be meagre. You can even end up with a loss as surrender charges are steep in insurance products.
ULIPs for the long haul If you want to invest for tenures of 25 years or more, ULIPs work out far cheaper than mutual funds.
This is because in mutual funds commissions depend on the assets under management (AUM).
A distributor’s earnings increase as the AUM of the fund grows (in the first year, commissions are paid out of the capital or profits of the AMC). The Sumit Bose panel report shows that if an individual invests ₹1 lakh in a mutual fund SIP for 25 years (and makes an annualised return of 8 per cent), on a net present value (NPV) basis, the distributor earns a total of ₹97,195 as commission. But, had he sold a ULIP he would have earned a lower ₹29,058.
In life insurance, commissions are a percentage of premiums and are front-loaded. The distributor thus earns most of his commissions in the early years of the policy and has no incentive to service the clients in later years.
This leads to distributors churning their clients’ portfolios frequently, says the Sumit Bose committee report.
While the agent gets his due in the early years, an investor earns higher returns only if he stays invested for the long term because of the compounding effect of investments. So, if you are looking to invest for the long term, ULIPs are a better bet under the current incentive structure. In traditional plans, the commission outgo is higher than in ULIPs but lower than in mutual funds.
NPS for retirement Wondering why your agent has not made a strong pitch for NPS so far? Well, that’s because he earns a paltry commission on it.
The incentive for the distributor comprises a flat fee of ₹100 on initial investment plus 0.25 per cent of the investment amount.
On subsequent investments, you will be levied a transaction charge of 0.25 per cent plus a small annual fee.
Proposed tweaks It is clear that agents peddle products that earn them good commissions, seldom keeping the investors’ interests in mind.
To streamline such issues, the Sumit Bose Committee suggests that all investment products should move to a trail model in commissions. This would mean that commissions would be kept constant across the tenure of your investment or tapered over that period.
The advantage of a trail model is that the investor’s expenses will be tied to the performance of the fund.
If the suggestions of the Sumit Bose committee are accepted, ULIPs will also move to a trail model with respect to commissions and the choice between MFs and ULIPs will hinge only on the track record of returns.