A few months back I attended a dinner party at an ex-colleague’s place in Gurgaon. One of the invitees to the party was a chartered accountant cum financial planner, who runs a very successful tax and financial advisory practice in the National Capital Region. As I was chatting with my friends and ex-colleagues on a variety of topics, related mostly to capital market and investments, this gentleman said that while mutual funds are good investments, Unit Linked Insurance Plans, popularly known as ULIPs, do not deserve the flak they receive in the investment community. In fact, he said that, ULIPs can be very good investments with the added benefit of giving life insurance cover to the investor. He admitted that, ULIPs earned a bad name for itself, 8 – 9 years back, but with revised Insurance Regulatory and Development Authority (IRDA) regulations, ULIPs have much lower costs and in the long term can give as good returns as mutual funds, if you factor in the benefit of the life insurance cover as well.
His argument was that, after the first 5 years or so for many ULIPs, the only cost that applies in addition to the mortality charge (for life insurance cover), is the fund management charge. Some of the more recent ULIPs do not levy premium allocation charges above a certain annual premium amount. Some ULIPs do not charge policy administration fees. The HDFC Click 2 Invest ULIP, as a matter of fact, levies only the fund management charge, in addition to mortality charges. The fund management charges in ULIPs are capped at 1.35%. Mutual fund expenses can range from 2.5 to 3%. The financial planner gentleman, therefore, argued, how can we say that ULIPs are not as good as mutual funds? Now readers who are familiar with my blog know that I favour mutual funds. But the question in today’s blog post is, whether the malice for ULIPs is exaggerated? In the second part of this blog post, we will compare ULIPs and mutual funds. The views in this post reflect my personal opinion. Investors should consult with their financial advisors before making investment decisions.
Are ULIPs over maligned?
ULIPs were very popular until the financial crisis of 2008. They were aggressively sold by insurance agents riding the bull market wave from 2004 to 2007. Even though the expenses of ULIPs were astronomically high during that period, investors did not mind because the handsome returns from equity market masked the high costs when investors looked at their fund values during those bull market years. But when the market crashed in 2008, investors realized that units owned by them were not commensurate with the premiums they had paid and the net asset values of the units themselves were lower than purchase value. As such, it was not just the ULIP investors who lost money in 2008; many mutual fund investors lost money too in the crash. It was just that, the ULIP investors lost much more because they did not own that many units of the ULIP funds they were investing in because of the high costs. Many investors were particularly miffed with the fact that, they were not even aware that, such a large portion of their premiums would go towards costs of the ULIPs and not get invested in units. However, in 2010 the Insurance Regulatory and Development Authority (IRDA) stepped in and several important reforms with respect to of ULIPs were instituted. Among the several new regulations announced by the IRDA with respect to ULIPs, the three most important ones, relevant to this post were:-
Minimum Mortality Cover: Mortality cover is basically your life insurance cover, or in life insurance parlance is commonly known as the sum assured. One of the criticisms which ULIPs faced was that, even though they were sold as combined life insurance and investment plans, the life covers of ULIPs in the earlier period were simply not sufficient to meet the needs of the insured in the event of an untimely death. The minimum life cover as a ratio of annual premium was raised substantially under the new regulations. Whether the increased life cover under the new regulations is now sufficient to meet the needs of the insured is something that needs to be examined, but there is no doubt that this was a good development over what existed earlier.
Surrender of ULIP policies: Changes were introduced by the IRDA with respect to how the insurer treated surrender or discontinuation of ULIP policies within the lock in period. The regulator also introduced a cap on surrender charges, based on the year of discontinuance and annual premium. The surrender charges within the lock in period are now substantially lower than what it was in the pre 2010 period.
Cap on ULIP charges: The IRDA also introduced caps on ULIP charges. These caps are in the form of maximum net reduction in yield due to the ULIP costs. We will discuss more about these caps later in this post, but suffices to say at this stage, that with the cap on charges, the cost structure of ULIPs have been substantially rationalized. With lower costs the returns of ULIP policies have improved substantially. Whether the new regulations have made ULIPs as attractive as mutual funds is something we will examine later, but again there is no doubt that, ULIPs are now much better investments than they were before 2010.
A lot of criticism directed at ULIPs within the investment community even now is still based on the pre-2010 situation. We should recognize that, under the 2010 IRDA regulation ULIPs are much better products than they were before. Therefore, it is possible that some of the malice towards ULIPs is over-exaggerated. I realize that from a strict grammatical perspective, “over-exaggerated", is an incorrect usage, yet I deliberately used the word to counter, what I sometimes perceive, is an over-critical narrative towards ULIPs. But just because I am not over-critical towards ULIPs, it does not imply that, I agree with the financial planner gentleman, mentioned earlier in this post, that ULIPs are as good as or even better than mutual funds. We will discuss that later. Let us first discuss if ULIPs are better than traditional life insurance savings plans.
Are ULIPs better than traditional life insurance savings plans?
By traditional life insurance savings plans, I mean non term traditional life insurance savings plans. In these plans, the insured gets sum assured in the event of an unfortunate death. If the insured survives the policy term, he or she gets the sum assured plus bonus and some guaranteed additions. The difference between these plans and ULIPs are that, these traditional plans are not market linked unlike ULIPs. In the traditional non term insurance plans, if the insured survives the policy term, the sum assured is roughly equal to the premiums paid by the insured over the policy term. Therefore, if the insured survives the policy term, he or she gets back the premium he or she would have paid to insurer over the policy term and some extra in terms of bonus and other additions, if applicable. The most popular traditional life insurance savings plans are known as endowment plans. The other popular traditional life insurance savings plans are money back plans, children’s plans, pension plans etc. While as an insured in traditional life insurance savings plan, you will get back the premiums paid over the policy term and something extra in the form of bonus, loyalty additions etc, the return on your investment is not assured. Bonuses are declared at the discretion of the insurer. For example, if you look at the bonuses of endowment, money back and other traditional life insurance savings plans declared by Life Insurance Corporation of India (LIC) over the years, you will observe that the bonus per
र 1000 of sum assured is going down over the years.
Therefore, even if your capital safety is assured in traditional life insurance savings plans, your returns are certainly not guaranteed. Now if you see the historical internal rate of returns on your premiums projected into the future over your policy term, the return of your traditional life insurance savings policy will find it difficult to beat the inflation rate, particularly that of a consumption basked of a typical urban or semi urban investor. If any investment fails to beat inflation in the long term, it is definitely not a great investment. Some insurance agents will argue that, do not just look at investment returns of life insurance plans; also consider the fact these plans provides financial protection against an untimely death. My response is that, if I need to get life cover, I can get adequate life cover or sum assured at a small fraction of the premium paid for traditional life insurance savings plans, by investing in a term life insurance plans. I can invest the savings in premium in investment products which will give me much higher returns than a traditional life insurance savings plan (please see our post, Why are non term life insurance plans detrimental to your financial needs).
How does ULIP compare to traditional life insurance savings plan? Let us look at returns in the first five years of a ULIP versus a traditional life insurance savings plan. Firstly, we have to recognize that, ULIPs are market linked investments, whereas traditional life insurance savings plans are not market linked. Market linked investments are more risky than non market linked investments. However, we have discussed a number of times in our blog that, equity as an asset class, can beat inflation and outperforms other asset classes over the long term. Therefore, for younger investors, it makes sense to invest in equities for their long term goals.
Let us now see, how much return traditional life insurance savings plans can give compared to ULIPs. The internal rate of return of a traditional life insurance savings plan is around 6% (that too on the higher side). The net reduction in yield of an ULIP in the first 5 years is capped by IRDA at 4%, excluding mortality charges. Now we have to factor in mortality charges, if we are to compare ULIPs with traditional life insurance savings plans, because the returns of traditional life insurance savings plans include the cost of life cover. Mortality charges differ from insurer to insurer and are calculated based on the age of the insured. On an average, for a 30 year old healthy male, it can be in the range of
र 1 – 1.3 per र 1,000 of sum assured. If we assume that, the sum assured to premium ratio is 10, which is the minimum as per the IRDA guidelines, then the mortality charge as a percentage of the annual premium works out to be about 1.3%. Therefore, in effect, after including mortality charges the net reduction in yield is about 5.3%.
In the last 20 years, Nifty has given around 11% annualized returns. Even if we assume that the cost of ULIP is the maximum as per the 2010 IRDA regulations, the returns of your ULIP in the first 5 years, if the ULIP fund simply tracks Nifty, is around 5.7%, which is almost the same as the returns of the traditional life insurance plan. Note that the ULIP costs may be lower than the IRDA cap and that it can very likely outperform the Nifty also. Also remember that the cost of ULIP goes down over time. Let us now look at the returns in the next 5 years. Again assume Nifty gives 11% annualized returns and that the ULIP fund simply tracks the Nifty. From years 5 to 10, the net reduction in yield due to ULIP costs are capped by IRDA at 3%, by the IRDA. If the Nifty gives 11% returns and ULIP fund simply tracks the Nifty, the net returns of your ULIP will be 6.7%, factoring in mortality charges based on the assumptions made above. Now ULIP returns start to beat the returns of traditional life insurance savings plan. From year 10 onwards, the net reduction in yield due to ULIP costs are capped at 2.25% by the IRDA. Nifty gives 11% returns and ULIP fund simply tracks the Nifty, the net returns of your ULIP will be almost 8%. We can see that, even on a conservative basis, ULIPs can give about 1% higher compounded higher annual returns than traditional life insurance savings plans. Even though ULIPs are more risky than traditional life insurance savings plans, over a 15 to 20 year policy term, 1% higher yield can result in substantially higher corpus. For example, if your annual premium is
र 1 lac, over a 20 year policy term, if the average difference in annual yield between a ULIP and a traditional life insurance savings is 2%, your policy maturity amount in ULIP will be higher by more than र 21 lacs compared to your maturity amount in a traditional life insurance savings plan. Clearly for young investors, ULIPs make more sense compared to traditional life insurance savings plans.
Some regular readers of my blog may, by now be wondering, if I have become a fan of ULIPs. I have only compared ULIPs with traditional life insurance savings plans (traditional non term life insurance plans) so far in this post. In the next part of our post, we will compare ULIPs with mutual funds.