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Personal Finance

ULIP Underperformance: Stunted By Guarantees

Unit Linked Insurance Policies tend to be very complex and highly loaded with costs. But some policies have looked good in theory, but they turn out to be dud performers anyhow.

In an email conversation I was referred to an excellent analysis of ULIP costs by RRK which talked about how ULIP costs could actually be low. He used the analysis of an IDBI Federal Dreambuilder Plan, which offers just a first year allocation cost of 3%, and fund management charges of just 1.35%.

Over a 15 year period, the return on the policy beats the return on the mutual fund+Term plan method, according to RRK; the return on the ULIP comes to 30 lakhs while the MF+Term approach gives you just 28.5 lakhs.

(35 yr old, 10 lakh sum assured, 1 lakh per year premium, 15 year policy, 10% returns assumed).

In theory, awesome policy. With low allocation charges which apply only in year 1, the difference is that mutual funds charge an average of 2% as charges every year, and the ULIP In question had only a 1.35% charge. Over the long term, the difference works out to be a gerat

Sadly, the devil is in the details. The fund outperforms because of two “guaranteed” loyalty additions of 3.15% – one at the end of the first 10 years, and the other after 15 years. Without these guaranteed additions, the ULIP would underperform, giving just 28 lakhs after 10 years.

How does the guarantee work? Does IDBI Federal give money out of the goodness of their hearts?

This guarantee is available across most of their ULIPs. Which means that they must bake in the cost somewhere. The answer is: Fund Performance.

Let’s look at the IDBI Federal Equity Fund performance since inception, compared to HDFC Taxsaver and HDFC Top 200, two funds that aren’t the best today but are something that I have used as benchmarks over the last five years. (The IDBI Fund Starts 17-Mar-2008)

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In the last four years:

HDFC Top 200: 53% (Annualized: 10.60%)

HDFC TaxSaver: 45% (Annualized: 9.25%)

IDBI ULIP’s Equity Growth Fund: 26% (Annualized: 5.7%)

The IDBI fund has underperformed by over 3% per year.

We assume that a ULIP fund and a mutual fund will perform at the same level – both after all invest in the same assets. But mutual funds have no such “guarantee”; does the guarantee hurt the performance of the fund?

The cost of this guarantee seems to be hidden inside the fund management strategy. If you assume that the ULIP will do about 2% lesser every year, then the net return, after 15 years is:

Term Plan Plus MF: Rs. 28.5 lakhs.

ULIP: Rs. 23.5 lakhs. About 5 lakhs lesser.

What’s the Point?

That ULIPs are terrible investment vehicles. But you know that.

That there are two kinds of costs: a) stated and b) hidden. Hidden costs are not just shrouded in complexity, they are invisible unless you do the kind of analysis I did above. And who has the time for that?

Needless Complexity

If you’re still here, I consider myself lucky. It’s very boring, complex and unnecessary. Why bother with “guaranteed” loyalty additions? How does an investor know that this gives you a small guarantee but takes away hugely from your return? Why should anyone bother investing in such a policy unless they are excel wizards with too much time on their hands?

If you don’t have the time, invest where the proposition is simple.

  • Manish says:

    The other thing which RRK did not look at is “Policy administration charges” , that would be minimum of Rs 60 per year . So with 10k premium policy , its Rs 720 per year.. or 7.2% per year .. what would I do with 3% premium allocation charges 🙂
    Over a 20 yrs period , ULIP would give terrible return , other point is surrender charges if I want to withdraw earliar !

    • Ritz says:

      Manish
      But now the surrender charges in ULIPS are anyways capped. 15% or Rs. 3000/6000 depending on premium whichever is lower. And sometime it helps also, as most of us do not surrender the policy when we are in need, otherwise the same is with MF too.

  • Sarang says:

    Also, one more point is flexibility!
    As you rightly pointed out, HDFC Top 200 and HDFC TaxSaver are not the best performing funds today. In such a scenario, one can move out to a better fund which is normally not the case with any Insurance product.. again owing to complexity of withdrawal.

  • H S says:

    I dont think this is a fair argument…The point in the data that you have made seems to be that the IDBI ULIP’s managers were worse at managing money than the HDFC managers.
    This is not a ‘cost’ (if you insist on calling it that) associated just with ULIPs…this is a potential ‘cost’ associated with ANY investment into any discretionary pool (whether its a mutual fund or a PMS service or a ULIP).
    Case in point: For HDFC Top 200’s 10.69% returns (over the last 5 years), there are 42 Equity (Large & Mid-cap) funds that returned less than that…some going as low as -5.29%. Would much rather have invested in the IDBI ULIP then right?
    source: valueresearchonline.com
    Agree completely on the points made in the comments on Policy Admin Charges & Flexibility.

    • Hardik,
      the cost is not of the fund manager. It’s simply that even the best fund manager can’t give a good return, because they are supposed to work in the guarantee as well.
      Secondly HDFC Top 200 was not one of the best funds in 2008, it is not one of the best funds now. I wanted to make sure there was no survivor bias, I have taken only these funds as benchmarks consistently.
      The cost is that fund managers have to struggle to meet the guarantee. The guarantee comes from the fund management itself, they have to account for it and thus give lower returns, there is no cost for it in any other place.

      • H S says:

        Theres still a disconnect in my mind…Correct me if Im wrong here but heres how I think it would work:
        On the 9th year and 364th day, say your NAV is 20L. On 10 years and 1 day, your NAV becomes 20L (adjusted for mkt movement) + 3.15% of average fund value over year 8, 9 and 10. Same concept for loyalty addition in Year 15.
        If my understanding of the loyalty allocation is correct, such a step increase in NAV cannot be generated by the fund assets, it would have to be from money tipped in from the fund management company. It is pretty much like the fund management company giving up most of their fees from year 8, year 9 and year 10 (and then year 13, 14 and 15).
        Dont see how this affects the fund management strategy. If they were targetting/guaranteeing a minimum return over a period of time, that would definitely affect fund management strategy, but cant see how a step increase in NAV can be generated by the fund management strategy.

        • Hardik: Here’s the thing – there is no such thing as the “management company giving up most of their fees”. Just does not happen, sir, not in the financial services world. Why would they give up their fees? Remember there is no such thing as “the kindness of their hearts”. They’ll make you pay for that guarantee in some way or the other. What they do, is to take a part of your premium paid in years 1-10 (and then 11-15) and sequester it away so that it generates that 3.15% to pay you. So in each year, they may put say a certain % of your portfolio into fixed income to generate that guaranteed return; this amount will not be invested in equities, so the underdeployment also causes an underperformance. Meanwhile if the market falls, the company has to move more cash into fixed income to generate that return, and they do so upto a limit. This causes underperformance and it is a known side-effect of a guarantee (I think the method is called CPPI – constant proportion portfolio insurance, though in this case because the guarantee is a % of a fund value, it is more like variable PPI, but just a math formula nevertheless).
          The step increase in NAV can be achieved by investing in an asset that generates the step return. The fund house creates such an asset where the asset is priced at zero until the “trigger” date (it is an option of sorts, a derivative). The option therefore is zero if the user exits the fund (and all the money goes to the fund house instead) If he stays, the option pays out that much.
          The fudn management strategy then has that much lesser to deploy, because some money has gone into the guarantee, so the NAV growth comes down relatively.