The recent decision by the insurance regulator to cap the charges on insurance products may level the playing field, in terms of effective returns, between mutual funds and ULIPs.
We attempted a comparison of the two products, based on certain return assumptions once the new regime takes effect. The calculation shows that, assuming similar portfolio returns, ULIPs may manage a marginally higher effective return than mutual funds if the investment horizon is 10 years and above. If the investment is for a shorter term of less than five years, mutual funds emerge as a superior option to ULIPs due to the latter’s high initial charges.
While deciding between the two, however, investors should weigh in the much better liquidity offered by mutual funds and the safety of the sum assured offered by insurance products, and make the choice based on need.
SEBI (Securities and Exchange Board of India) and IRDA (Insurance Regulatory and Development Authority) have been trying to make the respective products more cost effective. While the former has cut back on the front-end charge, the latter has capped the back-end charges.
With these changes in recent times, it may be necessary to understand the cost advantage while investing in these financial products.
To begin with, comparing a regular insurance product with mutual fund product is not an apple to apple comparison. However, with ULIPs, which account for 70-80 per cent of sales of insurance companies, having an investment strategy similar to mutual funds a comparison might help understand the characteristics of both investment options after the recent changes.
A quick check on the numbers to capture the return on investments suggests that insurance products’ returns are close to that of mutual funds if the tenor of the investment is 10 years and above. The internal rate of returns (IRR) of insurance products are marginally (20-30 basis points) lesser than those of mutual funds. We have made an assumption that investors apply directly for mutual funds, thus avoiding entry load charges (assuming no fee paid for the distributors). However, the risk cover provided by the insurer provides some cushion for ULIPs as the sum assured is protected from day one of investment.
Over a longer period of 15-20 years, ULIPs may offer returns that are 15-20 basis points higher than mutual funds. In 20-year plans too, there will be slight differences in yields based on the option selected by the policyholders.
There are two types of ULIPs that are currently available. Under type-I the sum insured or fund value whichever is higher is paid to the beneficiary in the event of death of policyholder, whereas type II has dual benefits; in the event of the death of policyholder the beneficiary will receive the fund value and the sum insured.
The type I policy will give higher yield compared with type II as life cover charge deducted on monthly basis will stop once the fund value is equal to sum insured. The premium that was directed towards risk charge will add up as an investment.
In type II, as the cover is provided till the policy term, yield on such products will be lower than type I as a result of continuing life charge.
To illustrate, assume an investor aged 30 years plans to invest Rs 1 lakh per annum in ULIP products for 20 years with sum insured of Rs 5 lakh. A similar sum is invested in mutual fund as well. Assuming both earn a 10 per cent return, the maturity value of the ULIP will be Rs 47.6 lakh with a yield of 7.7 per cent. The maturity value for the mutual fund will be Rs 46. 4 lakh with an IRR of 7.48 per cent. But if the investor opts for type-II ULIP, with a sum insured of Rs 25 lakh for the same premium and tenor, IRR works out to 6.87 per cent – 0.57 percentage points less than the mutual fund. But the positive aspect is that in the event of the policyholder’s death before policy maturity, Rs 25 lakh is paid along with the maturity value of Rs 43.2 lakh, making the plan more beneficial. The lower fund management charge of ULIP is likely to offset the initial charges.
Interestingly, the new guideline of 225 basis points cap on ULIP charges will not be of much benefit to policies with a tenor of 20 years and above. But it can save at least 50 basis points in policies that have maturity tenor of less than 15 years. However, the recent changes will be applicable only for non- guaranteed products (such as ULIPs). ULIPs also come with a guaranteed plan option.
The general perception is that mutual funds and a simple term insurance is a more cost effective option. Assume an investor aged 30 plans to invest directly a sum of Rs 1 lakh per annum in mutual fund for 20 years and if the scheme generates a return of 10 per cent post-charges, the maturity value will be Rs 46.40 lakh. If he prefers to buy a separate term cover for Rs 25 lakh, the entire premium outgo will be Rs 1.56 lakh for entire term where as if he buys type II ULIP from an insurer the outgo will be Rs 1.50 lakh. With the new regulation even type II policies may be attractive.
Methodology
For calculation, we assumed the total charges applied on asset under management at 2.17 per cent (Management charge, marketing and selling, among others) for a scheme with total asset under management (AUM) of less than Rs 700 crore. The reduction on yield based on charges on AUM and service tax is approximately 2.54 per cent (Rs 8.40 lakh and Rs 50,000 for AUM charges and service tax respectively).
If advisory fee is paid to distributors for utilising his service, it will further reduces the yield. Assume if you investor pays fees as one per cent of investment value maturity value likely to fall by Rs 63,000.
For example, if the fund earns 15 per cent, the net effective yield for the investors will be 12.4 per cent. If the scheme manages more than Rs 700 crore, yield is likely to go up by a few basis points due to reduced charge on a larger asset base. ULIP investors are likely to get yield of 12.75 per cent (net reduction yield inclusive of premium allocation charge, policy administration and mortality among others) inclusive of life cover.
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