In the first part of this post, Should you invest in ULIPs, we had discussed that Unit Linked Insurance Plans, popularly known as ULIPs, are now much better products than what they were before 2010. The IRDA regulations with respect to ULIPs in 2010 made significant changes with respect to the life cover of ULIPs as ratio of annual premium, policy surrender procedures (including charges) and most importantly with respect to the rationalization of costs of ULIP policies. In the first part of this post, we have also discussed that, ULIPs can be much better investment options than traditional life insurance savings plans for younger investors, who have higher risk appetites.
Despite these changes, which have certainly made ULIPs better life insurance cum investment products than before, I must tell you that, I remain a fan of mutual funds. I mentioned why, to the chartered accountant and financial planner gentleman, mentioned earlier in the first post, in my friend’s dinner party and I will explain again in this post. The financial planner argued with me that, we should not forget ULIP gives life insurance to the investor. It is a fair point; after all life insurance is an important financial need for all of us, but let us deliberate on that point. The minimum life cover or sum assured in ULIP as per IRDA regulations is 10 times the annual premium for investors below the age of 45. But is a life cover of 10 times your annual premium adequate? Life insurance thumb rules suggest a minimum life cover of 10 to 12 times your gross annual income. Your annual ULIP premium is only a fraction of your gross annual income. Therefore, it is clear that your ULIP policy will not be able to meet your life insurance needs. You have to buy additional life insurance to get adequate financial protection in the event of an unfortunate death.
Let us now compare the costs of ULIPs and mutual funds. We had earlier discussed in our life insurance blog that there are different costs in ULIPs. They are:-
- Premium allocation charges
- Policy administration charges
- Mortality charges
- Fund Management charges
- Surrender charges
In this article, we will not go into a discussion of these different costs (for detailed understanding of the ULIP costs, please see our article, Demystifying Unit Linked Insurance Plan Charges and Returns). We will simply focus on the impact of these costs on yield of ULIPs. As per IRDA regulations, the maximum reduction in yield, excluding mortality charges, due to ULIP costs are capped as follows:-
- In the first 5 years, maximum reduction in yield is capped at 4%.
- From years 5 to 10, the maximum reduction in yield is capped at 3%
- From year 10 onwards, the maximum reduction in yield is capped at 2.25%
By maximum reduction in yield, we mean the maximum amount your gross returns can go down due to the costs. It is important to reiterate here that, the maximum reduction in yields exclude mortality charges (the cost of life insurance cover). Therefore when we compare the costs of ULIPs without mortality charges and mutual funds, we are making a like to like comparison.
What is the cost in mutual fund?
The cost in mutual fund is expressed in one simple measure, the Total Expense Ratio (TER) or simply expense ratio. Expenses in mutual funds are regulated by the market regulator SEBI. Expense ratios vary from one mutual fund scheme to another, based on the expenses of the scheme and the assets under management. Expense ratios in equity funds can range from 1.5 to 3%. In debt funds it is usually much lower. For the purpose of comparison of ULIP and mutual fund expenses, let us assume that the expense ratio is 2.5%. You can see that compared to the maximum expense cap specified by IRDA, a mutual fund with 2.5% expense ratio is significantly less expensive than ULIPs in the first 5 years. It continues to be less expensive than ULIPs from years 5 to 10 too. However, from year 10 onwards, ULIPs will be less expensive assuming that the mutual fund expense ratio does not change.
What is the impact of difference in costs on returns? To quantify this, let us assume that fund performances of both the mutual fund and ULIP are exactly the same. Assume that the gross return given by both the ULIP and the mutual fund is 12%. Let us assume your annual premium in the ULIP is
र 1 lac. Similarly you make an annual investment of र 1 lac in the mutual fund. Assume that the policy term of the ULIP is 20 years. Let us now see the difference in final fund values at policy maturity / investment term of 20 years.
First 5 years: The fund value of your mutual fund investment will be higher than the ULIP fund value by
र16,000 at the end of the first five years. Please note that, once you factor in mortality charges the fund value of your mutual fund investment will be higher by a bigger amount than the ULIP, but we are excluding mortality charges to make apples to apples comparison. So at the end of 5 years, your mutual fund investment will be higher by र16,000 compared to your ULIP investment and this difference will continue to compound over the investment / policy term. Assuming 12% returns on investment mentioned above the र16,000 difference will grow to र28,000 difference by the end of the 10th year.
Years 5 to 10: The fund value of your mutual fund investment will be higher than the ULIP fund value by
र5,300 in years 5 to 10 years. If you add the र28,000 difference at the end of year 10, due to the higher mutual fund net yield in the first 5 years, the total difference in fund value at the end of first 10 years be र33,500. This difference compounded at the rate of 12% over the next 10 years will be र104,000.
Year 10 onwards: In this period the ULIP is cheaper. Assuming same gross performance, the fund value of your ULIP investment will be higher than the mutual fund by
र12,800 in years 10 to 20 years. But still at the end of 20 years, the mutual fund investment will be of higher value. The र104,000 difference in fund value due to higher ULIP costs in first 10 years is offset only to the extent of र12,800. The net difference is still over र90,000.
Some readers may argue that, we have been unfair towards ULIPs by taking the highest possible costs for ULIPs while comparing with mutual fund costs. We should understand the mechanics of how the costs work. The various expenses of a mutual fund scheme are charged proportionately against the assets under management of the scheme. Some of these expenses are variable, while others are fixed. Therefore, when the assets under management grow the expense ratio comes down over time. If you look at the expense ratios of some large sized mutual fund schemes, you will observe that they are much lower than average expense ratios. Over a period of time as the assets under management of a mutual fund scheme grows one can expect the expense ratio to come down. The mechanics of ULIP expenses are different. If you go through the product brochure of different ULIPs, you will see that premium allocation and policy administration specified, usually as a percentage of your premium. In fact, in many ULIPs the total expenses are closer to the IRDA cap unlike large sized mutual fund schemes where the expense ratios are much lower than the SEBI cap. However, in the recent years, several low cost ULIPs have been launched where over a long investment horizon the costs might be comparable or even slightly lower than mutual funds. However, we do not have long term performance track record of these ULIPs and therefore it is difficult to gauge how these ULIPs will perform in the long term.
Comparison of ULIP and Mutual Fund performance
So far, we have discussed only the impact of costs. We will now see how ULIP funds have performed versus mutual funds. Some personal finance experts have mentioned to me that, mutual funds are more actively managed compared to ULIP funds. I do not know for sure whether that statement is true and therefore I will not assume that mutual funds are more actively managed than ULIP funds. We will look at the actual historical returns of top performing mutual funds and ULIP funds in different categories over the last 10 years.
From the table above we can see that, while ULIP funds have matched mutual fund returns for some categories, mutual funds have outperformed ULIP funds in many categories. If we combine the impact of costs and potentially higher returns, mutual funds do make more attractive investment choices compared to ULIPs.
In Advisorkhoj we get many queries asking whether investors should continue with their ULIP policies. It is not always an easy decision. If you surrender or discontinue your ULIP policy within the lock in period, your fund value gets transferred to a discontinued fund after deduction of surrender charges. The final fund value of your units will be paid to you on the completion of the lock in period. Though the units in the discontinued fund earns interest at a rate specified by IRDA, the amount of value you lose in surrender charges can be substantial depending on when you surrender your policy. Therefore, you should do your homework properly before investing in ULIPs. We have discussed in this two part series that ULIPs are not as bad as it is made out to be by some quarters in the investment community, but a combination of term life insurance plan and good mutual funds can give better results than ULIPs.