ULIPs - Know your charges in advance

Let us assess and compare the charges in ULIPs:

1) Allocation charges
This charge is in percentage of premium paid. Charge is very high in initial years mostly in first year and then it comes down to 2% or even nil, depend upon plan to plan. For e.g. you are buying a ULIP plan with an annual premium of Rs.30,000 and the allocation in the first year is 80% and from 2nd to 5th year is 94% and thereafter 99% till policy years. Than your charges for 1st year shall be Rs.6,000/-, 2nd to 5th year Rs.1800 and Rs.300 thereafter till you pay the premium. If you stop paying premium afterwards than this charges are not applicable. Now in equity schemes of mutual funds, there is no entry load. So there are no charges like this. But before coming to conclusion you should also see other charges also.

2) PAC - Policy Administrative Charges
This charge is either fix or is in percentage of either premium or insurance cover. The insurers very smartly design these charges. These charges also increase in some plans by certain % every year. Allocation charges are very easy to identify but this charges are very complex and difficult to understand. Many products came with 100% allocation and with no allocation charges and did very well in the market. All this plans had these hidden charges, which nobody noticed. Even today these types of plans are available in the market. This charge continues till your plan is alive even though you stop paying the premium. For e.g. we have to compare two different products in which one has PAC of Rs. 600 in first year and is inflating by 5% every year and other has 1.25% on the first opted life cover throughout term. Your PAC, in 1st case, will be Rs. 600 first year, Rs.630 2nd year and Rs. 660 in third year and so on. It will increase by 5% every year. In 2nd case, suppose you are paying premium of Rs. 30,000 and have opted for 3 lacs sum assured. Than this charge will be 1.25% on sum assured i.e. Rs. 3,750 every year till your policy is alive.

3) Surrender Charges
Liquidity is the major factor in deciding any investment avenue. Therefore, you should also know SC, before you buy an insurance plan. If you have not paid minimum 3 yearly premiums, the surrender charge will be 100%. It means all money, which you have paid, is forfeited as surrender charge. As per new guidelines of IRDA, there should not be any surrender charges after completion of 5 years. Still we have to be very cautious before finalizing ULIP. Before buying an insurance product, you must be sure at the beginning that you will be continuing the plan till end. Even though there is no surrender charge after 5 years, you will loose the money if the policy is surrendered, as it is difficult to cover the initial higher allocation charges in short term.

4) Mortality Charges
This charge is nothing but the cost of insurance cover you have opted for. The major difference between term plan and ULIP is, in term plan level term premium is levied and in ULIPs it is levied as per the current age of the insured and increases every year as age increases. The cost of insurance is very low in initial years in ULIPs compared to term plan. For e.g. In ULIPS for person aged 30 years, the cost of insurance is approx Rs.130 per lakh whereas in term plan it is Rs. 250 to 300 per lakh. ULIPs also charges mortality rates on the balance sum assured i.e. actual sum assured minus present fund value. Mortality Charges are deducted monthly in ULIPs whereas in term plan you have to pay yearly premium in advance or if you opt for any other mode than your premium goes up by way of interest.

There are lots of arguments and discussion both in favor of and also against ULIP plans offered by life insurance cos. mutual fund advisors will suggest their client to buy term insurance and put the balance amount in mutual fund schemes. They will always advice to keep insurance and investment separately. Insurance agents, on the other hand, push ULIP plans as a combination of insurance and investment option with tax benefit. This tussle on the ground is likely to continue, but after this amendment insurance agent will have an upper hand.

The fact is insurance is a long-term product compared to mutual fund. The time horizon for buying an insurance product should not be less than 10 years. If your time horizon is lesser, than you should put your money in Mutual Fund Schemes and buy a term insurance plan. ULIPS are mostly missold to customer, either for lower premium term say 3 to 5 years or for lower insurance cover i.e. 5 to 10 times of premiums paid. If you buy a life cover for a term more than 10 or up to your retirement and also you opt for maximum multiplier offered by the plan than it can be a good combination against term insurance and mutual fund, even though higher charges in initial years in ULIPs. Both have advantages and disadvantages, which depend upon time horizon, insurance cover opted for, premium payment term and goal for which you are buying the particular product.

5) Fund Management Charges
This charge is levied in percentage on the total fund value. This charge makes a lot of difference compared to mutual fund schemes. As per new guidelines by the IRDA, the FMC cannot be more than 1.35% in ULIPS where as this charge is approx 2% in equity schemes of mutual fund. This half a % difference can make a huge difference in fund value if the time horizon is longer and also your investment is in lacs. For e.g. you are paying premium of 1 lakh every year and after ten years your fund value after deducting all expense is ULIP is approx. 20 lacs. The ULIP will charges you Rs. 27,000/- for that year. On the other hand, if you have the same corpus in mutual fund than Mutual fund will charge you Rs. 40,000/-. This difference of Rs. 13,000 is not only for one year but it continues and increases every year till you hold the fund. This set offs the allocation charges levied in the initial years.

Whether an ULIP is a better option compared to term and mutual fund combination is largely depend on these charges. Buying a ULIP can only be good if you continue to pay the full premium till the end of the term and also opt for maximum cover available in the plan. The reality is, there are good ULIPs available in the market, which can be competitive compared to term and MF combination, but in the hundreds of plans available in the market, it is very difficult to identify the right one. Secondly agents also do not promote this because of lower commission.

I am not advocating ULIPs, but you should be aware of all facts before criticizing. Most of the experts compare ULIPs with mutual fund, but I will first compare ULIPs with traditional plans of insurance. ULIPs are 100 times better than traditional plans, which neither offer flexibility nor will give good returns in the longer run. Today also sale of traditional plan is about 40 to 50% and the hard earned money of the people is just depreciating every year and even fail to beat the inflation. Surprisingly, nobody comment on this.

Monthly income plans
In a quarter that saw the mutual fund industry AUM decline by around 12% (excluding domestic fund of funds), investment in the MIP schemes registered a 16% increase. We explain this mutual fund category and look at its recent performance.

Recent industry figures indicate a rising interest in monthly income plans (MIPs). Data shows that in the last quarter (April to June 2010) investment in MIPs showed an increase of 16%. This is at a time when the industry`s assets under management (AUM) reduced by around 12%.

Table 1: Percentage Change in MIP AUM over first quarter of Financial Year FY2010-11

Investing in MIPs
What are the options available to investors with a sizeable sum to invest for the medium term? Or funds from which investors can receive regular income? In both cases it is important to ensure capital preservation and appreciation, while in the second case they need regular payments as well.

The traditional option would be bank fixed deposits, or post office monthly income scheme with zero risk and options allowing the investor to receive monthly/quarterly interest as income. For investors with low risk appetite, we agree, this is the best option. However, for investors whose life stage and profile allows them to take slightly higher risk, mutual funds offer the monthly income plan scheme. Monthly income plans (MIPs) are hybrid mutual fund schemes, with major allocation to debt and between 15 to 30% allocation to equity. Investors can opt to receive monthly or quarterly dividends, or go in for the growth option.

Often, described as a deposit with a `kicker` because of equity allocation. MIPs aim at capital conservation through the debt component and growth and higher returns through the equity component. The difference between an MIP and a balanced fund is that MIPs have a higher asset allocation to debt, whereas balanced funds invest a larger share in equity. It follows therefore, that MIPs are aimed primarily at moderately conservative investors who seek regular income and have capital gains as the secondary objective.

Other benefits of MIPs over traditional deposits are:
- Investors can redeem MIP units whenever they need just like any other mutual fund - investment is therefore liquid
- Dividends are tax free
- Capital gains taxation is as per debt funds:
- if held for less than a year, capital gains will be taxed as Short Term Capital Gains at rate based on investor`s income slab
- if held for more than a year, capital gains will be taxed as Long Term Capital Gains @ 10% without indexation benefit, or at 20% with indexation

From a taxation point of view, investors on the highest income slab would find it beneficial to go in for the dividend option if investing for less than a year and growth option for the long term.

Options
All MIP schemes offer growth, monthly dividend and quarterly dividend options. The dividend options further have dividend payout and reinvestment sub-options. Of these, the monthly dividend option requires higher initial investment. For example, in most MIP schemes, the minimum investment amount for growth and quarterly dividend option is Rs 5000, whereas for monthly dividend option the minimum investment amount is Rs 25000. Systematic investment plans (SIPs) are also available for MIPs.

Risk
Unlike bank deposits or postal monthly income schemes, MIPs carry some risk of capital depletion. This risk is lower than pure equity schemes, but higher than pure debt schemes. On Fundsupermart, the MIPs are rated 4, which indicates moderately low risk. While the schemes` potential downside is restricted because of the large debt component, volatility is higher than pure debt schemes due to the equity investments, as well as short-term volatility due to the debt instrument calls that the fund manager may make.

Another risk factor is the regularity of receiving dividends. Although the schemes are named `monthly income plans` and offer regular dividend payments, these payments are not mandatory or assured. After a regulation passed by SEBI in March this year, MIPs can declare dividends only from distributable surplus. The fund has to generate enough surpluses to declare regular dividends, but in case distributable surplus is not available, dividends may not be declared.

Tenure
MIPs are ideally held for 18 to 36 months. A shorter time frame than this exposes investors to greater volatility.

Expense Ratio
Expense ratios affect the overall returns on the amount invested and are therefore important to look at. Although MIPs fall within the debt category, their average expense ratio tends to be higher than debt-oriented funds; this is because of the equity component which requires more intensive management than pure debt assets.

Performance-wise
The average annualized return for this class of mutual funds is historically pegged between 7.5 and 8%. The recent preference for MIPs can perhaps be explained by the double-digit returns given by the leading schemes in the class.

Following are the annualized returns on the leading MIP schemes over the last 5 years. The common benchmark for MIP schemes is the CRISIL MIP Blended Index.

Table 2: Returns for Leading MIP Schemes

Source: iFAST Compilations | Returns are calculated considering Growth options of the schemes | Returns as at July 20, 2010 | ^ Fundsupermart Recommended Funds

Dividends Declared
For investors interested in receiving monthly income, the track record of a fund in declaring dividends is also important. However, it is important to remember that a good past record of declaring dividends is no guarantee that the fund will continue to do so.

Our study reveals that the leading MIP schemes have had greater than 90% consistency in declaring dividends. The following table lists the dividends declared by the leading MIPs over the last year (monthly dividend option).

Conclusion
A great equity market run and favorable calling of interest rate movements in the debt markets have helped MIPs deliver strong performance and reasonably consistent returns. High returns combined with the features of capital protection and income generation are helping bring the MIP into investor focus.

While this makes the product worth evaluating, investors must bear in mind that this level of past performance may be difficult to sustain or replicate. There are strong expectations of RBI raising rates in the month of Sept 2010, which will lead to fall in prices in the debt market. Similarly, the equity market is already considered to be trading at very high valuations, making chances of any further steep rises negligible.

It is also important to take your risk profile into consideration. For purely conservative investors, bank deposits or Post Office monthly income schemes still suit the purpose. For investors with low to moderate risk appetites though the case for investing in a product like the MIP, over the medium to long term, is still sound. Happy investing!

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