A Unit Linked Insurance Plan (ULIP) may appear akin to a mutual fund (MF) in many ways. It appreciates over time, has an equity component and allots units. So, ULIPs appear to be largely similar to mutual fund units. However, from a personal financial planning perspective, there are some key differences between a ULIP and a mutual fund that you need to understand. This is crucial to your choice.
ULIPs are hybrid products; mutual funds are not
ULIPs, as the name suggests, offer a combination of investment and insurance. In fact, ULIPs offer a choice. If you are conservative, you can opt for debt; else you can opt for equity. You can also opt for a go-between wherein you get the growth of equity and the stability of debt. In addition, ULIPs also offer a life insurance component. It offers a term insurance that is in-built into the ULIP product apart from the growth that investment offers.
Mutual funds, on the other hand, do not have an insurance component at all. They are pure investment products. Of course, you have a complete choice of mutual funds ranging from liquid fund at the lowest end of the risk ladder to equity funds and sectoral funds at the highest end of the risk ladder.
ULIPS have a higher loading compared to a mutual fund
Loading is one factor where mutual funds score over ULIPs. When you invest in a ULIP, there are steep upfront costs that get debited to your fund NAV (Net Asset Value) in the initial years. ULIPs typically take away 15-20% of your contribution in the initial years, although it reduces in the later years. Mutual funds have a more reasonable cost structure, as measured by the Total Expense Ratio (TER). For example, equity funds may have a TER of around 2.00-2.25% while debt funds will have an expense ratio of less than 1.5%. Liquid funds have TER of even below 1%. Compared to the loading that ULIPs impose on your NAV, mutual funds are substantially better off.
ULIPs take much longer to break-even compared to mutual funds
This follows as a logical corollary from the previous point. Since the loading is much higher in ULIPs, it takes longer to break even and make profits. A typical ULIP, even in moderately bullish market conditions, is able to break even only after 6-7 years. In fact, it takes a ULIP nearly 8-10 years on an average before it can really generate positive returns. If you want to buy a ULIP, you need to be prepared to wait at least long enough before you can actually be in the money. Hence ULIP is only suitable if you are willing to stay put in the long term. Mutual funds on an average turn profitable after 3 years in case of equity funds. In fact, according to studies, well managed equity funds are profitable in over 99% of the cases if you take a time frame of 5-6 years.
ULIPs are less transparent compared to mutual funds
Despite being a regulated product, ULIPs continue to be opaque. It is hard to understand how the costs are allocated and what portion goes towards your life cover and what portion goes towards growth investments. This is exactly opposite to what mutual funds are required to do. As per SEBI guidelines, mutual funds are required to provide monthly fact sheets with portfolio mix, NAV returns, analytics etc. You do not get such insights if you are holding on to a ULIP. The level of transparency in terms of portfolio disclosure, costs etc is much lower.
Are ULIPs more tax efficient after Union Budget 2018?
This is a new debate that has come out in favour of ULIPs after the Union Budget 2018 imposed a 10% flat tax on Long Term Capital Gains on equity funds. ULIPs have been exempted from paying capital gains. Will that really make a difference? The truth is that in case of equity funds, the LTCG tax makes a difference of less than 1% to the CAGR returns. That is not really significant. Even though ULIPs are exempt from LTCG tax, they entail a longer lock-in period to avail the benefits of Section 80C of the Income Tax Act. While both the ULIP and the ELSS funds are eligible for Section 80C benefits up to Rs.150,000 per annum, the ELSS Fund has a lock in period of just 3 years while ULIP entails a lock in period of 5 years.
In practice, it is best to keep insurance and investment separate
The biggest argument in favour of mutual funds is that it is best to keep insurance and investments separate. That was the problem with insurance endowment plans too. They mix insurance and investment and the final product becomes too opaque. ULIP has the same problem. A better way to go about it would be to buy mutual funds for your investment needs, create SIPs to meet your long term goals and then take term insurance policies to meet your risk coverage needs. This gives you better leverage and also a transparent structure for your financial plan.
While ULIPs as a product have certain advantages, the big challenge in the past has been that it has been mis-sold. The demand for the product has come down sharply after IRDA clamped down on mis-selling. As a matter of investing principle, it is always better to keep your investment and insurance separate. That is where a combination of mutual funds and term insurance scores over ULIPs.
(By Vaibhav Agrawal, Head of Research and ARQ, Angel Broking)