The withdrawal of tax-break on Unit Linked Insurance Plans (ULIPs) in the latest union budget has reignited the debate between the ULIPs and tax-saver equity funds also called Equity Linked Savings Schemes (ELSS).
Until now, there was no capital gains tax on the ULIP proceeds on maturity.
However, there won’t be any tax on the sums received on the death of the insured. Given the high threshold, the tax will largely affect high income earners and savers.
Equity mutual funds including ELSS attract a long-term capital gains tax of 10 percent. The new tax on ULIPs will however only apply to policies bought after February 1 this year. Older ULIPs will continue to be tax-free.
Both ULIPs and ELSS offer tax deductions as per Section 80C of the Income Tax Act.
What are ULIPs?
ULIPs are popular with investors and savers who like the assurance of a life insurance policy but want a piece of the capital appreciation opportunity offered by equity markets.
This opens the possibility of high double digit returns over 10-15 years just as in equity mutual funds.
Every ULIP specifies a death benefit - the amount the nominee will be paid if the policyholder passes away during the term of the ULIP. And if the policy holder survives the term of the ULIP, he/she will get the maturity value of the plan.
Unlike traditional money back or endowment plan where sum assured is generally fixed at the time of the buying the policy, the maturity value of ULIP is not guaranteed but depends on the market performance of the plan during its term.
However, truth be told, ULIP is largely sold as a savings and investment instrument by the insurance industry rather than a life-insurance product. This is because the life cover is very modest compared to the premium paid by the policyholder. Life cover is typically around 10 times that of annual premium paid by the policyholder.
For comparison, one can buy a term plan with a life cover of around Rs1 crore (Rs10 million) by paying a monthly premium of around Rs1000 or even less if you are in late 20s or early 30s.
ULIPs as cousins of mutual funds
Given the modest life cover offered by ULIPs and the emphasis on savings and investment, it’s fair to compare ULIPs with equity mutual funds or ELSS rather than other life insurance plans.
For comparison, ULIPs have a lock-in period of 5 years while the money in ELSS gets locked-up for three-years. In a typical open-ended debt or equity mutual fund, however, investors can redeem their unit anytime by paying a small exit load.
Charges or Deductions
For a general investor, ULIPs are mutual funds with the added benefit of a life cover. The life cover however comes with a cost called the mortality charge. Mortality charge is front loaded and a significant portion of premium in the initial years goes towards it, reducing the portion of premium invested in the equity or the debt market. This brings down the overall financial returns or the maturity value of the ULIPs if compared to a mutual fund with a similar asset allocation and risk profile.
According to the insurance regulator IRDAI rules, the total effective charges on ULIPs should not exceed 2.25 per cent.
In mutual funds (MF) however the bulk of the investment (or the subscription amount) is invested in the markets from the first month itself. This may translate into higher returns and the maturity amount for MFs investors.
Mutual funds however levy a fee for managing your money and an exit fee, which is the penalty for selling units soon after you invest in the scheme. Total management fee for equity MFs works out to be around 2.5 per cent of the invested amount.
However, most insurance companies pay-back or return the mortality and policy administration charges at maturity provided all due premiums have been received.
So, in the long run, the total charge in ULIPs could be lower than that in equity MFs and returns could be equal or even higher than in the case of MFs.
ULIPs Vs Mutual Fund: What should you choose?
Given the insurance component and a longer lock-in period, ULIPs are best for longer-term or patient investors. Anyways, short-term returns on ULIPs are far less than that in equity MFs due to the mortality charges. Typically, ULIPs are designed in such a way that the maximum gains for investors only come after she stays invested for 10 years or more.
In comparison, ICICI Prudential Life Bluechip Fund has delivered 11.35 percent returns in the last 5 years and 6.01 percent in the last three years respectively.
The picture could change completely or the performance gap may vanish if one holds ULIPs for 10 years or more.
But if your investment horizon is less than 5 years or so stay with mutual funds and don’t look at ULIPs at all.
One can invest in both ULIPs and mutual funds but don’t try to substitute one for the other.
(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).