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Concepts & Tutorials

How ULIPs and Mutual Funds make you pay

When you buy at the supermarket, you cringe if the cashier adds one item with the wrong price. You say “But it says 20% discount!”, and ensure that the cashier books the discount, changes your bill amount and pay accordingly. You would never let a petrol pump operator fill even 100 ml. less than you pay for. But when it comes to financial products, if you are like the vast majority, you get taken for a major ride and in most cases, don’t even read the fine print before you sign up. Even I have done this so you’re not alone.

Consider that:
a) you pay a lot more for a financial product (ULIP or mutual fund) than for petrol or vegetables.
b) Your savings come back to help you in the later part of your life (unlike petrol or vegetables).

It seems illogical that you should pay less attention to the fine print of a financial instrument than for your vegetables!

Mutual funds and ULIPs both make you pay in the form of unintelligible fees disguised in their documents in different ways. Let me show you how.

ULIP Charges
ULIPs have an amazing array of charges that you aren’t necessarily aware of unless you read their documents carefully. Let me show you how, for a premium of around Rs. 50,000 a year, you will be made to pay fairly hefty charges.

Most ULIPs charge you a Premium Allocation Charge. This simply means a charge that you pay to have your premium allocated (kind of like your vegetable vendor telling you: You need to pay Rs. 10 for 1 kg, and Rs. 5 for the privilege of buying from me). Actually it encapsulates the commission that your friendly agent makes on the deal, and a little bit more.

But it can be huge, and the word play can get you. Allocation charge, which some ULIPs use, is the percentage of the money you PAY. Allocation rate, however, is the percentage of your money that is actually used. For instance, HDFC’s Young Star Plus plan says their premium allocation rate is 40% for the first year (for a premium less than 2 lakh a year). Meaning, you pay 60% as commissions!!! Consider that, for a policy of 20 years, you are effectively paying 3% a year, much more than a mutual fund. And you pay that upfront instead of amortizing the cost over hte whole plan, meaning you don’t even get the benefit of paying lower due to inflation.

Most ULIPs tell you that you will make money if you are loyal to them – i.e. when you stay with them for a long time. I wonder why, if they ask you to be loyal, that they ask you for all the commissions upfront? If you get benefits when you stay for the long term, why shouldn’t their benefits also be linked to the long term?

Not only is it unfair, it is also ridiculous – because the power of compounding is not being used. Investment today multiplies at a higher rate than money invested later – so the logic in taking away most of your money today and telling you that they levy very little future charges is financial stupidity.

Some ULIPs, however tell you they have a 100% allocation rate. Like Aviva’s LittleMaster ULIP, for amounts above 25,000 a year. Sounds great? Hang on a minute. Firstly, this plan limits your sum assured to 10x the premium. Meaning, for about 50,000 per year, you get a cover of Rs. 500,000. Peanuts, honestly, because if you can pay 50,000 a year you need a lot more cover than 5 lakhs. Secondly, this plan has an Initial Management Charge – which is basically taking money from your first premium. Note: Aviva’s policies tend to spread the initial management charge over the entire term – meaning, they make this money over the term of your policy – which is a very nice thing for you since more of your money is invested.

ULIPs also have mortality charges which is the amount you pay to have your life cover. ULIP mortality charges change every year (unlike a term plan) and they RAPIDLY increase after the age of 50. A 50 year old will typically pay 5 times the mortality charge for the same sum assured than for a 30 year old.

You will also have policy administration charges – typically Rs. 50-60 per month. (why do they charge this? It’s so small it is ridiculous to charge the policy holder. Like saying “I need to staple your policy document together so please pay for the staples”).

Then of course, there’s the Fund Management Charge, which is reflected in your NAV. Typically between 0.8% and 2%, this may look less than a mutual fund’s charges but when you add this and the other (non-mortality) charges together, things will look different.

Finally, there’s the surrender charge. This is what applies should you surrender your policy before the policy term. This can get complicated, because people use such terms:

Surrender Charge
– on Initial Units: * value of initial units, at the unit
price, on the date of surrender
– on Accumulation Units pertaining to regular premiums: [1-
{1/(1 + x)}^N] * value of accumulation units, at their unit price,
on the date of surrender. The variable x varies with the number
of completed years premiums paid at the date of surrender:

Sounds like Greek to you? It simply means they are finding innovative ways to take away more of your money. The above means that if you want to exit after paying 3 years premium of Rs. 50,000 each on a 10 year policy, and the X (which is given in the policy document) is 1.75%, you will be charged approximately 35,700 (assuming when you surrender, the net unit value is 150,000)

Remember: If you stop paying your premium, your policy may “lapse”, but the fund value (minus surrender charge) MUST be paid back to you after three years from inception, or a small “reinstatement period”, typically two years (whichever is later). It is legally your money. Don’t let anyone tell you otherwise, and you can go to court to claim it as well.

A major issue, which I’ve talked about earlier, is that ULIPs deduct some charges from your units, and some charges from their NAV. So at any given time you need to ask them both for the number of units you currently own, and the current NAV – and both can change anytime. In a mutual fund at least the only variable is the NAV.

Mutual funds
Mutual funds have not quite as many charges but they’re quite relevant all the same. Firstly the “entry load” is charged to you on buying units in a fund. This is the same charge even if you buy the first time or later, and typically vanishes when you invest more than 5 crores, in which case you are probably not the kind of person I mentioned earlier in this article.

Entry load is actually commission given to the agent. Anyone can become an agent by becoming an AMFI test and getting certified. But even if you are an agent, you do not get commission on mutual funds taken in your own name! And they don’t excuse you from the entry load either. It’s illogical.

For those funds without entry loads, there may be an exit load, meaning you pay if you get out of the fund within a certain time. Some funds have exit loads to protect themselves from redemptions but in passive funds like index funds, the concept of an exit load astounds me.

Closed ended funds charge you amortised issue expenses if you exit before three years. Such funds basically take away 6% of your money upfront and charge it to you in bits and pieces daily, over a three year period. You can’t attempt to exit early because they will charge you the unamortised expenses on a redemption.

The fund management charge of course varies by fund. Typical expenses are of the range of 1.5-2% for equity funds. Index funds are the cheapest here; since they require very little decision making, they should charge less. I say “should” because many charge a lot – upto 1.5%. Benchmark’s NiftyBEES, an exchange traded fund, charges you very little – only 0.8% as far as I know. Fund management charge is reflected in the NAV of the fund, and is not something you pay. But it’s good to be aware.

I hope this opens your eyes to the various ways you pay for your own financial products. You may not be able to negotiate away these charges, but you should choose a product that does not try to take as much as it can and hide things in small print. Don’t trust anyone, including your advisor. Our legal system ensures that all such products MUST document all charges on the brochures and offer documents, all of which are available online. So if you’re reading this (and not yet asleep) you can read those documents as well.

Happy investing. Caveat Emptor. (means buyer beware)

  • Jain says:

    >Hello Deepak,
    Thanks you so much for the in-depth note on ULIPS charges. I need an advice from you.
    I have ICICI LifeTime plan and paying yearly premium of 18K. The charges you mentioned for this policy is as follows. ( Charges for 3rd year on wards)
    1) Premium Allocations – 96%
    2) Annual Admin & Fund Management
    charges: – 2.25
    3) Mortality charges – No idea how much they charge. But I took the sum assured as 1Lac.

    So my question to you is, is it worth to continue the policy after 3 years, considering the charges are relatively less. I feel anyother policy will have almost same or higher charges.

    Thanks
    Jain

  • Deepak Shenoy says:

    >Jain, thanks for the comments. You pay 18K for a one lakh cover so I am assuming the cover isn’t immportant. Then all you are doing is going for an investment.

    If you’re doing the “growth fund”, then I guess you want to do equity. For that you pay 4% a year. Instead, why don’t you go for an ELSS fund which will give you the same deal for 2.25%. So I would say withdraw your money and use hte money for a ELSS mutual fund instead.

  • Siva says:

    >Deepak,
    Great. You write the article at the time I am looking for the same.For the past 1 week, I have been trying to get a Investment policy from ICICI.The company person suggested one LifeTime polciy(similar to Jain’s).When I started digging at that policy, I come across all these chgs you have mentioned.

    I bought a LifeTime Pension policy 4 yrs back. IT gives handsome return and I do switches regularly according market.I do top-up whenver I have money.However, after vesting period, I can take out only one-third as commutation and remaining two-third I have to pay either income-tax or buy a pension.

    Is this top-up allowed only in PENSION plans? not in Lifetime policies?

    My aim is to withdraw money after vesting period w/o any Tax.

    Mutual FUnds doesnt allow switches w/o charges.

    Please suggest a good one .

  • Deepak Shenoy says:

    >Siva: Top up should be allowed, but it’s policy specific. You can withdraw anytime you like BEFORE the vesting period (since three years are up). My suggestion is that you don’t let it vest, but take the money out just before it vests.

  • Anonymous says:

    >Index funds could be a way for investors to keep charges down, but I am unaware of any good fund that has consistently performed as good as other equity diversified schemes.

    Do you know of any good Index funds we can invest in?

    blogginginvestor

  • Jackson David says:

    >Hi Deepak,
    A small rejoinder on the ULIP initial management fees. Unlike you commented this charge is not actually spread over the entire tenure. What they do is that this charge is deducted by cancellation of certain percentage of units allotted in the first year. This means that you loose whatever growth that accrues on them – which IMHO is the biggest cheating now going on. The greatest example is the hugely successful Bajaj Allianz Capital unit gain, which charges 100% of first year allotted units over 20 years of the scheme !! what else is daylight robber if this is not? Also, the investor seldom knows about this as he cannot easily see his units being eroded over years.

  • Amit says:

    >Hi Deepak,
    I agree that MF charges are high close to 5% (Entry load + FMC) but they are the best way for a person who doesn’t have the time or skill to buy direct stocks. Index funds have lower charges but their returns have been less than atleast 20 top-performing diversified schemes.
    So what shall be done?
    could you suggest

  • Abhinav says:

    >This article is great and an eye-opener.
    I had planned to invest 15000 premiums annualy in ULIP HDFC Unit Liked Endowment Plan.
    I have already given 1 premium and the date for the second premium is approaching soon.
    I am worried if ULIP is the right thing for me. This is because it takes away most of my money upfront. I have an insurance plan of 20000 annualy too.

    Should I quit from this ULIP and go to MFs?

  • varun says:

    >Hi Deepak,

    Grt8 work man.
    You really cleared many of my doubts.
    Thanks a ton.
    I shall be highly thankful to you if you can further clear my doubts regarding these pension plans coming in the market.
    I am thinking to invest in LIC pension plan where I I have to pay around 25k premium and a coverage of 10lakhs in the starting which will grow to 30lakhs at 56 years.
    At 57 I will start getting the pension starting at around 13k growing to 25k till I become 74 years.
    Could you please tel me is it fine enough to invest in such plans?
    Also are there any plans where I get better and more returns keeping in mind the current market situation.
    Also please let me know what is this equity and debt actually means?
    Thanks a ton again.

  • Anonymous says:

    >What a concidence, I had very similar feel about these blade investment options which will guarantee only the revenues/profits/retirements for the insurance companies, their employess and agents and not necessarily benefit of their clients. If any of these companies are sincere atleast their charges (if not principle) need to be rationalized to the retuns.

    All these financial institutions sell ULIPs simply because they can charge more, guarantee their revenue for long and hide behind general safety comments like “you need to take long term perspective”

    I did lot of research and decided to put some lump sum money in retirement plan since charges are much lower for such bulk/one time investment. ICICI prudential has LifeLink super and Wealth Advantage which will charge 2% or less the assett allocation which seem to be lowest. It is not quite easy to compare the returns of these retirement plans as most of them have been released in the last 4-5 years and their mutual fund component performances are not quite easy to find.

    I would strongly urge separating insurance fron investments. LIC has cheated India for too long selling expensive traditional endowment and ULIPs which will give really low cover. Get a term insurance which will give good cover at really low premiums. For 25 lakhs, I am paying 8300 per annum for 20 years and i am 36. If you want to buy similar coverage in traditional or ULIPs your premiums are going to be ridiculous and may become unsustainable after sometime.

    After long research, here are my sincere advice –

    Separate Insurance from Investments – simply buy a term insurance. You will get good coverage at low rates (still we pay 10 times more than Americans!). Atleast aim for 20-25 lakh coverage. Don’t rely on employer provided insurances, you have the coverage as long as you are with the employer. Also starting insurance late will result in higher premiums for shorter terms.

    Try to invest in retirement/child plans which don’t charge too much upfront. Use really small percentage of your income/savings in these plans so that they are sustainable for atleast 5 years.

    Don’t get carried-away with brain washing about child education, marriage, retirement with current level expenses, they are emotional gimmics.

    Invest in good mutual funds as they are more liquid and flexible. If you want you can walk away anytime in the worst case 4-5% of the investment unline ULIPs where you are locked for 5-6 years without significant charges.

  • abhi says:

    >Hi deepak,

    I appreciate the way you explain things and intricacies of funds in layman's language. God bless you!
    Can you help me out son? I am a govt employee and going to retire the next month i.e. April,2010. One of my accquaintainces have asked to invest in Kotak super advantage fund. They have assured me guarranted returns for the investment. I need to invest Rs. 1,00,000 per year for three years and from fourth year i will get a fixed return of 8,000 per month. This looks nice but is it a intelligent decission to put my money in the fund. Post retirement any wrong financial decission will push me to grave before time. So, i need to be very cautious.
    Please son, advice me the best course of action.

  • Deepak Shenoy says:

    >Abhi: Don't do it. There is no such guarantee. Please mail me (deepakshenoy at gmail) and I hope I can help you not get suckered.

    There is no guarantee, what they will do is just rob you of your money. Please put retirement money in better avenues. Mail me, I can help.

  • Anonymous says:

    >i took an ICICI prudencial ULIP (ICICI Pru SmartKid Maxima). the allocatin charge is 15% for the first year. ie if you invest 1lh, allocation charges will be 15k. Second year its 10 % and 3rd year its 8%.