The ULIP-Mutual Fund face-off

Unit-Linked Insurance Plans, in their first avatar prior to 2010, were the retail investor’s nightmare — high front-loaded expenses, high surrender charges, opaque structure and poor returns. This compared unfavourably with the far more transparent and cost-effective mutual funds. But a regulatory crackdown in June 2010 has made ULIPs far more investor-friendly than before.

First, their costs have been curtailed. Now, policies with terms of 15 years and above are mandated to keep their costs at 2.25 per cent of gross return. These costs have to be evenly distributed over the lock-in period of five years. Two, surrender charges, which used to take away 30-40 per cent of the premiums, are now capped too. If the policy is discontinued in the first year, the surrender charge is 20 per cent of the premium or ₹3,000, whichever is lower (for investment amount up to ₹25,000). This reduces with every year and becomes nil after five years.

Three, the regulations also increased the insurance component in ULIPs, requiring a minimum life cover of 10 times the annual premium, where the individual is below 45 years of age. Earlier, the insurance component on ULIPs was just five times.

In practice, most ULIPs now cap their expenses at 1.8 to 2 per cent of their gross returns, far lower than the regulatory cap. The launch of online ULIPs may take these costs even lower.

Recently, HDFC Life launched an online ULIP which only charges fund management and mortality costs, resulting in a cost of 1.66 per cent of gross returns. This is much cheaper than most equity mutual funds, which today have an expense ratio of 2.5 to 3 per cent. The tax benefit that ULIPs offer is another big plus over a mutual fund. Any investments in ULIPs qualifies for tax benefits under Section 80C of the Income Tax Act, while among mutual funds, only equity-linked savings schemes are eligible for this benefit.

Making the choice So, now that ULIPs come with lower costs, more insurance and tax benefits, should you prefer them over mutual funds? The decision boils down to just one factor — returns. If a ULIP scores over a mutual fund on returns after netting out expenses, you should certainly go for it. But it is hard to unearth such plans for several reasons.

For one, if you’re looking to gauge their returns by their track record, ULIPs have a far shorter track record than established equity funds. Today, some of the good equity funds have a 10-year or even 20-year track record of beating their benchmarks, helping you to evaluate them. But this is not so for most ULIPs. There are just a handful of ULIPs with a five-year record.

Two, there’s no way of comparison amongst ULIPs. While there are quite a few third-party rankings of mutual funds, which compare their returns, category-wise, on a day-to-day basis, there are hardly any independent rankings of ULIPs. This makes the choice much more difficult.

Yes, most insurers offer many more disclosures about their portfolios and NAVs than a few years ago. But you will still not be able to access reviews or research on ULIPs the way you can for MFs. There is very little such information in the public domain. So that means you need to be savvy enough to pick the right ULIP for your portfolio without these aids. Three, don’t plump for ULIPs simply because they offer insurance cover or tax benefits. If insurance is what you want, then plain vanilla term covers are the cheapest and ULIPs are a sub-optimal way to buy into them.

Most ULIPs give a sum insured of only 10 times the premium which may not be adequate to cover you against adversities. It is a thumb rule that life cover should be at least 10 times the annual income. If you earn ₹7 lakh a year, your cover should be at least for ₹70 lakh. A cover for ₹70 lakh from a ULIP would require you to pay an annual premium of ₹7 lakh!

Nor should you buy ULIPs just to save on taxes. Given the ups and downs in the stock market, you would be risking your capital for upfront savings on tax.

Should you exit? This is an even more important question than the one we addressed above. If you want to exit the policy due to non-performance, then go ahead. At least you can cut future losses and invest the premium amounts elsewhere. However, if you are in the initial years of the policy and it is the charges that are bothering you, hold on.

In pre-2010 ULIPs, as charges are levied entirely upfront, it is only by holding on that you can reap the rewards of your investment. If yours is a policy taken after 2010 and you have not yet completed the five-year lock-in period but find the fund delivering paltry returns, then stop paying premiums and surrender the policy. The insurance company will transfer your money into the ‘discontinued policy fund’ after deducting surrender charges.

Insurers are required to give an interest of 4 per cent per annum (currently) on the amount in the discontinued policy fund.

This amount, according to rules, can be invested only in government securities and money market instruments. The fund value will be paid to you after the completion of the five-year lock-in period.

Note that when you discontinue the fund, the risk cover will also cease, so before you surrender the policy take another term insurance cover.

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