Why you should ditch the ULIP for a Term Insurance plus equity mutual fund

Unit Linked Insurance Plans (ULIPs) are investment products in India that combine insurance and investment components. Such plans also come with various charges and fees, including premium allocation charges, policy administration charges, fund management charges, mortality charges, and surrender charges, which eat into your returns and reduce the value of your investment.

How ULIP plans work: 

 ULIPs invest your money in equity, debt, or a combination of both, providing market-linked returns. They also provide life insurance coverage in addition to investment benefits. A portion of your premiums goes toward the insurance coverage, and the remaining amount is invested. ULIPs have a minimum lock-in period of five years, during which you cannot withdraw your money. 

The biggest drawback is the premium allocation charges, policy administration charges, fund management charges, mortality charges, and surrender charges. These charges can vary from policy to policy.

Are endowment plans similar? 

Similar to ULIP where the scheme invests in equity or debt-oriented schemes,  endowment plans offer a guaranteed benefit called the sum assured.  Neither of them is recommended by financial experts as they offer a sub-optimal combination of insurance and investment.

Why are they so popular? 

"Most ULIPs show very high returns, which is the selling point. But they don't share that these returns are calculated without any charges. This means the absolute returns would be much less. For example- The Max Life Online Saving Plan is a 20-year ULIP which shows approximately 8% tax-free returns. But on calculation, the XIRR came up to~6.56%. EPF, PPF, and ELSS offer a much better proposition for tax savings. There is no need to buy a ULIP for the same. Even if the maturity amount is tax-free, tax is a one-time cost, but these charges are recurring for your lifetime," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.

Value Research explores the point by looking at the two purposes of such plans separately:

 Insurance 

Most often, people fail to fathom what kind of insurance coverage they need. For instance, in a family of four where you are the only earning member, a life insurance coverage of Rs 5 lakh (see example below) is simply not enough in the event of your untimely death. The effect is more pronounced if you haven’t left them much inheritance and/or if you had loans running. And, then there’s inflation, which will eat away your wealth. 

 To put things in perspective, if a term plan cover of Rs 50 lakh costs you Rs 7000 per annum, it will cost you Rs 5 lakh per annum in case of an ULIP.

Investment

The biggest factor that goes against them are the exorbitant charges. A significant percentage of the premium you pay, particularly in the initial years, are deducted in the form of various fees and charges, the biggest component being distributor commissions. This reduces the amount of your premium that is actually invested to generate returns. Over a long period, that makes a huge impact on the total wealth you are able to accumulate. 

The actual invested amount is after deducting the following charges which make up almost 7% of the total invested amount. For instance, if your annual premium is Rs 50,000, after all charges, the actual premium invested comes down to Rs 45, 510. So, even though in ten years you have paid Rs 5 lakh, the actual invested amount, after deducting all the aforementioned charges, will be around Rs 4.68 lakh.

Why ULIPs and Savings Plan charge higher premiums

"ULIPs and Savings Plans have higher premiums because they include both insurance and investment components. Since a portion of the premium in ULIPs and Savings Plans is invested, the death benefit is typically lower than what you would get with a term insurance policy. Consumers must be aware of the higher costs and market risks associated with these plans. If your primary goal is financial protection, the term insurance could be the best option due to higher death benefits," said Adhil Shetty, CEO of BankBazaar.

Endowment Plans don't yield higher returns once adjusted for inflation

Endowment plans may offer you fixed returns, but they are linked to the market and may not yield higher returns when you adjust them with inflation and tax liabilities. For example, if you invest Rs 100 with negative returns of 1.7 per cent per annum, you are left with only Rs 84.3. But, if you invest and get 8 per cent growth over the same period, you will have Rs 216. That’s why you may avoid mixing insurance and investment, explained Shetty.

"Savings plans are in a sense worse than ULIP’s, because they are structurally incapable of providing inflation-beating returns. A large part of the first-year premiums of these plans is used to pay agent commissions. What is left over needs to be invested largely into government securities that only earn the risk-free rate of return, which is comparable to bank FD returns. As a result, these plans could not deliver more than 4-6% returns if they wanted to! To make matters worse, these plans are extremely opaque and their features are built to confuse investors. Their returns are disguised in the form of bonuses and only an IRR calculation on a spreadsheet would actually reveal what rate your money is growing at. They are also extremely illiquid, with few to no viable exit options. Even if exit options exist, they levy heavy penalties in the form of surrender charges," said Mayank Bhatnagar, Chief Operating Officer, FinEdge.

The primary purpose of insurance is protection

"The primary purpose of insurance should be protection, and term insurance provides comprehensive coverage at a low cost, allowing you to allocate more of your funds towards investments. Moreover, separating your insurance and investments offers greater flexibility and control, enabling you to choose investment instruments that align with your financial goals and risk tolerance," said Amit Goel Co-Founder & Chief Global Strategist, Pace 360.

The insurance coverage associated with ULIPS is typically insignificant from a risk-protection standpoint.  In addition, ULIP funds typically underperform comparable mutual funds that invest in the same space

Taxation

Previously, returns from ULIPs were not taxed if your annual investment did not exceed 10% of the life cover in the plan. However, under the revised regulations, if the premium you pay towards ULIPs exceeds Rs 2.5 lakh, the returns you receive will be subject to taxation. "This change makes ULIPs less tax-efficient as an investment option, particularly for the HNIs and UHNIs.  By investing in a diversified portfolio that includes assets like stocks, bonds, and real estate, you can potentially achieve higher returns over the long term compared to the more conservative strategies typically associated with ULIPs and saving plans," said Goel. 

The verdict: 

"Certain investment instruments are often presented as golden opportunities, and ULIPs fall into this category. However, the true picture emerges once the actual returns materialise. While ULIPs have a longstanding presence, their major drawback remains the substantial charges that ultimately erode long-term returns," said Vishal Goel of Value Research. 

What should investors do instead? 

The best thing to do would be to separate these unique problems (insurance and investment). 

Term insurance is the most affordable type of life insurance, as it provides pure protection without any investment features. It is a simple and affordable product that provides high death benefits and guarantees financial protection to your loved ones in case of untimely death.  

For instance, for a cover of Rs 1 crore, you may have to pay Rs 8,500 annually (may be higher and lower depending on the plan) for 30 years under a term plan. But you may have to invest about Rs 1 lakh or more annually for 30 years under an endowment plan to get the same amount as it has both insurance and investment offerings. Therefore, if you are looking at just the insurance coverage to protect your family, a term plan is more affordable than an endowment plan. You must remember that term plans will not give you any amount annually or on maturity which endowment plans offer you once you complete the payment of premium for the tenure you have selected.

"Get a simple term plan to cover your risks, and invest the remaining money in mutual funds, based on your financial goals. Doing this may require a mindset shift for you as well because terms plans (like health insurance) are pure risk plans that do not “give back anything” at the end. However, if you believe that mortality risk is one worth transferring to an insurance company (a personal choice), term plans are the only way to go," said Bhatnagar.

Once you have bought a vanilla term insurance, the policyholder can invest in an index fund. "Compared to a ULIP, you can expect a comfortable 9-10% annualized return over the long term from a Nifty 50 index fund. A simple term plan and an index fund are far better than any ULIP," said Kulkarni. 

How can you reinvest the proceeds of the ULIP upon maturity?

Bankbazaaar's Shetty explains this with an example:

Imagine you are investing Rs 5,000 every month for a period of 5 years in a ULIP plan, with a fixed interest rate of 10 per cent. After five years, your total investment would amount to Rs 3 lakh. With returns factored in, this sum would grow to slightly over Rs 3.87 lakh. However, it's crucial to note that for ULIP plans purchased after February 2021, the total premiums paid should not exceed Rs 2.5 lakh in order to qualify for tax exemptions upon maturity.

Once your ULIP matures and you receive the payout, you have several options for utilizing the money. You could choose to allocate it across various fixed deposits (FDs) with different tenures, taking advantage of any increases in interest rates when renewing each FD.

Alternatively, a wise decision might involve using these funds to settle high-interest debts, such as home loans, personal loans, or credit card balances.

Another option is to initiate a Systematic Investment Plan (SIP) if you have a good understanding of and are willing to accept moderate to higher market risks.