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: [1-(1/1.10^N)] * 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)
