ULIPs versus ELSS: And the winner is…

Talk of life insurance nowadays and unit-linked insurance policies (ULIPs) immediately spring to mind. ULIPs' popularity, for some life insurance companies has surged to such an extent that they have become the talk of the town.

But have individuals also evaluated the option of investing in tax-saving funds/equity linked saving schemes (ELSS), which offer similar tax benefits? We don't think so.

ULIPs basically work like a mutual fund with a life cover thrown in. They invest the premium in market-linked instruments like stocks, corporate bonds and government securities. Investments in ULIPs attract tax benefits under Section 80C.

A tax-saving fund is a diversified equity fund. It works like an open-ended diversified equity fund that invests predominantly in the stock market to generate growth by way of capital appreciation for investors.

The only difference between an equity fund and a tax-saving fund is that the latter has a 3-year lock-in and tax benefits under Section 80C. To that end there is a common ground between tax-saving funds and ULIPs in the shape of Section 80C tax benefits.

So how does one go about comparing ULIPs vis-à-vis tax-saving funds? An illustration will help in putting things in perspective.

ULIP from ABC Company Ltd.

As can be seen from the table, an individual decides to invest in a ULIP having a sum assured of Rs 1,000,000 and tenure of 10 years. The premium for the same would be approximately Rs 100,000.

The assumed rate of return is 10 per cent (compounded annualised). The individual has selected the growth option, i.e. the entire investible amount can be invested in equities.

The maturity amount in the above example at the end of the tenure would be Rs 15,20,375. That is presuming that the investments grow at the rate of 10 per cent. But company illustrations can often be misleading.

That is because the returns calculated by life insurance companies are often on that portion of premium, which is net of expenses. In other words, the 10 per cent return shown in the above illustration has not been calculated on the premium of Rs 100,000 but on a figure, which is less than that, after deducting expenses from the premium.

Therefore, the net return on Rs 100,000 works out to approximately 7.50 per cent in our illustration. Also, for some life insurance companies, the fund management charges are not factored into the returns shown in their illustration, which means that the net return will take a further beating to the extent of the fund management charges.

But individuals might argue that a ULIP offers life insurance as well whereas a tax-saving fund does not. To counter this argument, let us take an example of an individual buying a term plan plus investing in a tax-saving fund.

Term plan from XYZ Company Ltd.

As the table indicates, an individual, instead of investing the entire amount of Rs 100,000 in a ULIP, opts for a term plan from XYZ Company Ltd for a sum assured of Rs 1,500,000. The premium amounts to Rs 3,600 per annum.

Systematic investment plan

In the table, we have assumed that the individual makes an investment of Rs 96,400 per annum (Rs 100,000 - Rs 3,600) in tax-saving funds. This amount is further divided into 12 parts for 12 months as we have also assumed that the individual will make regular monthly investments every year.

Assuming a 10 per cent rate of return, he will get approximately Rs 16,18,308 at the end of the tenure. But since mutual fund NAVs are usually net of expenses, we have also assumed returns at the rate of 9 per cent and 8 per cent.

The best part about keeping one's investment needs and insurance needs apart is that both work towards their respective goals separately. Therefore, in case of an eventuality, the individual's nominees would stand to get not only the sum assured from the term plan (i.e. Rs 15,00,000) but also the amount that has been invested in a tax-saving fund.

Of course, since the tax-saving fund has a lock-in period of 3 years, the maturity amount would differ to that extent. In our example, we have calculated the maturity value after 10 years.

The nominees would stand to gain only that part of the maturity amount, which has been unlocked, i.e. become free from the said lock-in period and can be redeemed.

One reason why ULIP returns are on the lower side compared to tax-saving funds is due to the higher expenses charged by them. The expenses take their toll on the 'investible surplus', which reduces to the extent of the expenses.

For example, mortality charges as well as the commission paid to agents are factored into the ULIP expenses. While mortality charges are unique to ULIPs as compared to tax-saving funds, commissions form a part of tax-saving funds as well.

But while life insurance agents can earn up to 25 per cent to 30 per cent commission by selling a ULIP upfront in the first year, their tax-saving fund counterparts earn a measly 1.50 per cent to 2.00 per cent. Also, the trail commission earned can go up to 5 per cent for a ULIP while it is in the region of around 0.50 per cent to 0.75 per cent in case of tax-saving funds.

Another advantage tax-saving funds offer is the option of staying invested in the scheme during maturity. In case individuals feel that the markets are not conducive to a sale, they can stay invested till the markets turn in their favour.

This is unlike in ULIPs where individuals do not have the option of staying invested post-maturity. If at the time of maturity, equity markets are down and your ULIP returns have taken a hit, you do not have the option of staying invested. You have to necessarily collect the maturity proceeds.

A point to be considered before individuals take the plunge in tax-saving funds is that they invest 100 per cent of their corpus in equities. Balanced or debt schemes are not available for availing the tax benefits under Section 80C. Therefore, individuals who do not have the risk appetite for equities could opt for a balanced ULIP, as tax-saving funds would be too risky for them.

Also, a ULIP offers an individual the choice to 'protect' his portfolio if need be by way of a restructure. He can shift his money from high-risk equities to debt or go for a balanced portfolio, unlike investments in tax saving funds where he either could holds on to your investments or sell them.

Besides, many insurance companies have introduced ULIPs with a capital guarantee. This product protects individuals from a potential market slide. In case of a market slide, the insurance company purports to at least return the premia paid by the individual.

This is unlike investments in a mutual fund scheme where you are partner to both profits as well as losses incurred by the scheme.

So where does all this talk lead to? Individuals who have the stomach for taking risk can separate their investment and insurance needs. They can consider the option of buying a term plan separately and investing in tax-saving funds.

Whilst investors who do not have an appetite for risks, but who would still like to add a dash of equity to their portfolio, could look at investing in a balanced ULIP.

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