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Opinion

At Yahoo: ULIPs or Mutual Funds?

A small story at Yahoo on the choice: Ulips or Mutual Funds.

(Posted in entirety)

It was the day they’d talked about 9 years ago. The first day of 2011.

“I’m on my way.”

Ganesh Raghupathi sighed. He had known Arnold would be late. But then, Arnold had two kids, and you always give that species a little more respect, and a little more time.

Arnold D’Souza was looking forward to the meeting. He walked in to the coffee shop, while Ganesh was clumsily switching on his laptop.

“Over here”, said Ganesh, raising his hand.

“Hi Guns!”, said Arnold. “Happy New Year! Let’s get started. To recap – it’s the 1st of January, 2011 and we are here to compare our retirement choices. I chose a Unit Linked Insurance Plan (ULIP) and you bought something else. Let’s see where we are today.”

“Thanks for the wishes, Arnie, and the same to you.”, said Ganesh. “Let’s see the chart:”

 

Arnold

Ganesh

Plan

Invest 50,000 per year for retirement

Option

ULIP

Mutual Fund + Term plan for insurance cover

Insurance

5 lakhs

10 lakhs

Premium

Part of the money paid

Ceases when fund>5lakhs.

Separately, Rs. 3,000 per year.

47,000 left for investment

Investment choice

ICICI Pru LifeTime

Zurich India Equity Fund

(Now HDFC Equity Fund)

“Let us now compare. Now only with current values of our investment, like we had discussed; let’s dissect and see how each investment has done in different areas..”

“First, let’s look at costs. For the ULIP, the commissions were fairly hefty – 18% in the first year, 7.5% in the second, and 4% every year after that. For the mutual fund, the entry loads were 2.25% till 2009, and after that, zero.”

Arnold

Ganesh

Upfront commissions

26,750

8,460

Arnold gasped. “Whoa. I paid more in the initial years? That means less of my money compounded itself, and thus would have destroyed my return. Okay, my fund had better have given stellar performance!”

“Look at the NAV comparison in this chart I plotted, mapping both funds together. “

clip_image002

“Purely from an NAV perspective, the mutual fund has done better, with a 35% annualized return, versus 22% for the ULIP”.

“What does that mean, Guns?”

“Well, remember our conversation at that time? That insurance advisor told us that even though the ULIP was a high-cost product, it would do so much better in terms of performance because it was a new fund. The mutual fund I chose was one of the best at that time; it is no longer among the top 10, but it still has beaten the ULIP comprehensively. In the performance area, the fund has returned 15x, while the ULIP, only 6x.”

Arnold whistled. “Wow. Okay, that’s another piece for you. What about insurance?”

“We both decided to take insurance for 5 lakhs. For you, it was part of the ULIP. For the first year, you would pay a risk charge – called a mortality charge – for 5 lakhs minus whatever your fund value was. The minute your fund value reached 5 lakhs, there was no more mortality charge.

“For me, as an investor in a mutual fund, I could not replicate that structure at all, with a reducing cover. And no one would sell me a term plan for 5 lakhs – the premium was too little. The best I got was an offer of Rs. 3,000 for a 10 lakh insurance. It was higher insurance, but it was constant – that means if I died my family would get 10 lakhs PLUS the value of the fund, but in your case it would be only the higher of 5 lakhs or the fund value. Even then, what it means now is that I paid about 27,000 as insurance; you probably paid less than 4,000”.

Arnold

Ganesh

Insurance costs

3,600

27,000

Arnold half-smiled. “Okay, but the two aren’t necessarily comparable. You had a higher cover, but I admit that the insurance cover was hardly useful to either of us. I mean, if we could put in 50,000 per year, a cover of 5 lakhs was woefully inadequate. Let’s leave those alone. What about taxes, Guns?”

Ganesh replied, “Yeah, that’s where the ULIP scores. My tax saving, at about 30% a year, purely on this product was Rs. 1,000 per year for the term insurance. For you with the ULIP it was Rs. 15,000 per year. The difference, if invested back into the ULIP, would have bumped your returns to much higher levels. But again, we have a problem with reality.”

“Darn. Just when I was showing signs of winning. What reality?”

“The fact that our tax saving potential has been capped under a collective investment limit. See, we both started to get bigger salaries, Arnie. Today about Rs. 8,000 per month for each of us goes to our provident fund account, which takes up most of our tax-saving limits. If you ignore that, your housing loan principal repayment will take it. Or, your children’s school fees. Or the principal repayment on my housing loan. Or, like we mentioned, our insurance was inadequate, so we took on much larger term policies – even that premium may be used under the same tax saving limit, currently of Rs. 1 lakh per year. Effectively, the ULIP didn’t help with saving taxes – reality bites.”

“Guns, you’re right. My accountant laughed when I asked him for tax-saving schemes. I already had too much in them, and the new Direct Tax Code might make the tax angle redundant, he said. There may be no tax saving for insurance schemes like mine, and worse, the maturity proceeds may be taxable!”

“You have till 2012 to withdraw, though. So what’s the verdict, Arnie?”

Arnold let the information sink in. “Look, Guns, it’s not about rupee amounts – in those terms, the Equity mutual fund approach has done far better. In fact, just a rough comparison of the two using their real NAVs shows that one approach has been vastly superior.”

image

“It’s the Term Plan + Mutual Fund, without doubt. Not only did it have far lower costs – it has provided a far better return. In terms of saving tax, the ULIP might have done me some good initially, but other avenues took over my tax-saving limits, and there was no real tax-saving eventually. Both our approaches were inadequate for insurance. You win – here’s your one rupee.”

Ganesh took the coin and nodded. “But, what happens, going forward”, he asked. “If you had to decide on a retirement strategy today, what kind of product would you invest in?”

Arnie said, “Here’s my four lessons:

1) I won’t bother about tax saving. So much has changed since I bought a product 9 years ago, and so much more will change going forward, all towards taxing of potential gains. The only thing I care about is that I mustn’t be taxed while “accumulating” my growth – only when I exit. In that regard, fixed deposits are out.

2) Costs matter. The more you pay for a product, the more it hurts you later. In fact, a product that costs higher in the initial days seems to destroy your compounding potential.

3) Performance matters. While I might have chosen a badly performing fund and you a great one, in the end the fund that does better will win. But fund performance cannot be taken for granted or assumed, the only thing you must have is the ability to shift out of a badly performing product. With a ULIP you really don’t have that freedom – you can’t just shift to another ULIP without paying huge upfront costs.

4) Don’t mix insurance and investment. The advantage of “insurance” was cursory – it was terribly inadequate with the ULIP in any case.

In that context, I wouldn’t go with any of the ULIPs they have to offer today either – even though some of them offer lower upfront costs, they are not low enough. I might choose a long term strategy of allocating money to different kinds of assets – debt, gold, real estate and stocks, and to get there, I am likely to choose either a mutual fund or go direct. There’s also the New Pension Scheme (NPS) which has even lower costs, though I don’t like the fact that they force you to buy an annuity at the end. There are Exchange Traded Funds that have even lower costs. For insurance, a term plan works best, and it seems like the insurers are reducing costs every month!”

Ganesh was impressed. “You’ve come prepared, Arnie!”

It was now Arnold’s turn to sigh. “I had put aside the one rupee coin a few years ago, Guns. And the strangest thing is – I made a substantially higher return from stock options in a startup that was just acquired. That takes care of my retirement, but wouldn’t it be crazy to discuss that as a retirement strategy?”

More Yahoo Columns:

  • ravi says:

    >Your spreadsheets and your write up seem to suggest that ULIPS have done worse because of commissions charged.
    Kindly have a look at my calculations at https://spreadsheets.google.com/ccc?key=0AhSGiLhFDbcidGhzMXctT3JqSXpzY3BRWmpvT190aUE&hl=en_GB&authkey=COWZm6UJ wherein I have calculated the value of the ULIP by taking zero commission charges.
    Even with zero commission charges the total fund value in the case of ULIPS is lower than that of the Mututal Fund.
    This just shows that one fund was able to outperform another, not that Mutual Fund investment will always be better than a ULIP.

    regards

  • kbmu says:

    >Dear Deepak,

    Now the scenario is changed :

    1, No insurance company can charge more than 2 % of the annual premium as premium charges (agents' commissions have come down drastically)

    2. Admin charges are negligible

    3. Mortality charges are "non-Level-premiums", which means the charges are for the current age, and as your fund grows , you are charged ONLY for the balance. eg: you take 5 lakh cover and your fund is at 2 lakhs, you are charged mortality for cover of only 3 lakhs.

    4. All open ended mutual funds have NO restrictions to redeem, hence whether market goes UP or DOWN, the redeem pressure will mount on the fund Manager of mutual fund, whereas, the ULIP fund manager can plan proper investment strategy and execute as per plan as NO withdrawal permitted for the first 5 years.

    5. IF you are saving for a purpose, and ready to wait for 5 years, in the current scenario, ULIP is better option.

    With Love & Regards,
    Vetrivel

  • Santosh Sharma says:

    >very well written and explained..
    we tend to forget small things..

    also happen to see this so thought of sharing with you all..

    Customer going for a Ride!
    Story of a loyal customer of Kotak Bank, who was duped for crores

    In a shocking incident, a high net-worth client of Kotak Mahindra Bank was hustled into buying a dud product for a whopping sum of Rs2.27 crore, with the bank pocketing a cool profit of Rs1 crore in the process. The wealth management arm of the bank allegedly misled the investor into putting the money in its India Growth Fund, based on bogus claims regarding its worth and taking undue advantage of the brand name to influence the buyer. The investor’s repeated pleas to rectify the damage have fallen on deaf ears as Kotak officials refuse to budge.

    For full story click on this link http://moneylife.in/article/4/12944.html

  • Anonymous says:

    >Great Post. ULIPs even if made commission free will not be a substitute for doing the same yourselves.

    Advantages of doing it yourselves.

    1. You can choose the best term insurance plan.

    2. You can choose the best Mutual Funds for your investments. (not limited to Funds offered by ULIP)

    3. In all probability ULIPs claim ratio will not be as good as LIC Term plans. We have so far not heard horror stories of claim being rejected. But I am sure the fine prints will tumble out of the closet when claims are processed and legally challenged by Claimants.
    ULIPs are Scams.

    MK

  • Sandeep says:

    Excellent post. I did similar calculation and found out that MFs are surely better options for flexibility.As in MF, you can choose to exit whenever you want. Moreover MFs portfolio is more transparent than ULIPs. There is more wider choice of MFs available if one is ready to invest some time to understand it.

  • Hemant says:

    >Hi Deepak,

    My friend wrote exact same story but totally different outcome.

    His views "I think ULIP has an edge over the combo, at least on the psychological and practical grounds."

  • Baskar says:

    Hi everyone,
    the topic was real good,
    But i couldn’t understand how the Returns after 10/15/20 years will be.
    How much Tax i have to pay for the returns i get.
    Just Thinking of It