ULIP’s De-Mystified

When you walk into your nearest bank or financial advisor to plan for your tax or to plan for your retirement, in all probabilities the first option they suggest is an ULIP. A ULIP stands for Unit Linked Insurance Plan. A ULIP is nothing but a mixture of Mutual Funds and Insurance bound together and sold to investors like us. You may be wondering, how do all these people suggest you to go for a ULIP. The answer is plain and simple. MONEY. Yes, you read it right. It is because of Money. Most ULIPs offer hefty commissions to the agents who sell those products and hence all of them suggest these products to their prospective customers invariably.

ULIPs are very good investment options provided we understand them properly and buy only what we want and not what our agent wants us to buy. Before getting into those details let us first understand what a ULIP is and how it works.

What are ULIP’s?

In terms of functioning, ULIPs are very similar to Mutual funds. To know what Mutual funds are Click Here. A ULIP can be considered as a type of mutual fund that provides you insurance benefits and that too, to the extent you want. The money you invest would be converted into units just like in MFs and invested in the stock market and also you would be charged an amount out of your premium to provide you the insurance coverage you want. For a layman we can assume that

ULIP = Mutual fund + Insurance

How do ULIPs work?

Let us say you invest Rs. 10,000/- in a ULIP plan with NAV at Rs. 20/- per unit. There would be a number of charges associated with the ULIPs. Let us say they constitute 15% of your investment hence Rs. 8500/- Ideally speaking you should be getting 425 units but you may not get it fully. As there is insurance provided to you, the ULIP house would deduct a portion of your money for that. Lets say it is 2.5% then that would leave Rs. 8250/- for buying units. Which means you would get 412.5 units during your first year. Every year when you invest, after deducting all the charges units would be allocated to your account. The policy duration typically is around 10 years or more. You would be provided insurance coverage only during the policy tenure.

Assuming you had paid your premiums every year properly and at the end of 8 years you have 4000 units. Now let us say due to some unforeseen circumstances, the policy holder dies the ULIP company would pay the nominees (Our parents or spouse) the insurance amount plus the market value of the 4000 units that we hold. Lets say the unit price at that time is Rs. 45/- and your insurance was Rs. 2 lacs then your family would get Rs. 1,80,000/- (Fund value) + Rs. 2,00,000/- (Insurance Amount) which works out to a total of Rs. 3,80,000/-
Assuming we outlived our policy duration of 10 years and at the end of it we hold 5500 units and the unit price at that time is Rs. 55/- then we would get Rs. 3,02,500/-

Either ways we are getting a good yield on our investment. (Provided the equity markets fare well and the fund house does not suffer huge losses like what has happened now)

What makes these ULIP plans attractive for us, as an Investor?

1. Insurance benefits
2. Tax exemptions under sec 80c
3. Various investment options (These days ULIPs offer us the convenience of choosing the type of fund in which we want our money to be invested. We can opt for higher equity allocation during initial stages and then switch over to balanced or conservative funds which invest in debt market for capital preservation during the end of the tenure)
4. Disciplined investment approach (ULIP investments expect us to stay invested for a long term, a minimum of 3 years or more and up to 10 – 15 years. This makes regular savings a habit and we can save a lumpsum for our future usage)

With so many benefits all of us would be tempted to invest in these products. But these ULIPs do not come without any flipside. They too have their own drawbacks. There are few things we must consider before investing in these products. Let us check them out one by one.

1. Understand what ULIPs are

Many people invest in ULIPs without knowing that their money would be invested in the stock markets and it comes with its risks. Remember that our money would be invested in the stock market and the returns on our investment would depend on the performance of the stock markets. They function more or less like mutual funds and do not believe any false promises given by your agent. They may give you guaranteed return predictions, but they are only predictions and there is nothing like guaranteed returns when it comes to investing in the stock markets.

2. Decide on your RISK profile and fund type

Decide on how much RISK you can afford to take and decide on the type of fund you would want to invest. If you are in your 20’s and are a high risk investor opt for higher equity allocation funds. If you are a family man then you can opt for a balanced allocation to equities and debt market. If you are near your retirement you can opt for higher debt allocation. Most ULIPs offer facilities to switch fund types during the policy tenure. Decide and choose the fund that would suit your risk profile.

3. Compare the expenses charged on you

Most ULIPs have a number of charges associated with them. If you see the initial parts of this article you would have seen that out of a premium of Rs. 10,000/- only Rs. 8,250/- was converted to units. The remaining money was used to pay the charges/expenses associated with the fund. Some of those charges are:

a. Premium allocation charges

This is a front end charge that is deducting from your premium. The money that is left after its deduction is invested into the funds that we choose. The insurer uses this to meet most of its expenses. In some ULIPs it is as high as 60% in the first year and in some it is as low as 0%. This charge would keep going down every year.

b. Mortality charges

This is the actual cost of the life insurance coverage provided to us. This may be deducted from our fund on a monthly/quarterly/yearly basis. This depends on a number of factors like age of the investor, his health condition and the amount of coverage sought. The charges for this are almost similar in all ULIPs

c. Fund management charges

This is deducted as a fixed percentage of the fund value and is used to manage the investment of the funds. It is one of the most important charges because; every year as your fund value goes up this charge would go up.

d. Policy administration charges

This charge is usually deducted from the fund value every month. It can be a fixed amount throughout the policy term or vary at a pre-determined rate.
The costs associated with ULIPs vary with products, the age and health of the investor, the tenure of investment, insurance amount sought etc. Experts suggest that the internal rate of return (IRR) is the best parameter to judge the total impact of these costs for an investor.

Let us assume you invested Rs. 1 lakh a year in a ULIP for 15 years. At an annual rate of return of 10% you would get Rs. 26.8 lakhs after the 15 years. With zero charges you would have got back Rs. 35 lakhs. This means that the costs associated with your investment have eaten nearly 8 lakhs of your money. The greater the gap between the IRR and the assumed rate of return, the higher are the costs associated with the policy.

You can ask your insurance company for the IRR of the policies you have or for the policies you are planning to take.

4. Set your Insurance target

A general thumb rule is that your insurance requirement is around 7-10 times of your annual income. Do not ask for huge amounts of insurance through such ULIPs. They eat a fat portion of your investment. Instead opt for pure term insurance products and choose only the amount of insurance you want from the ULIP.

5. Keep a track of your fund performance

Once you have bought the policy, do not forget it. Keep a track of how it is performing and if required decide upon changing to a different fund type. After all it is our hard earned money and we have all the rights to decide what we want to do with it.

6. Other Parameters

Certain parameters like the number of free switches you can make from one investment plan to another, ease of premium payment options, pre-closure charges etc also need to be considered before finalizing our investment.

Important Note:

ULIPs are long term investment instruments. The charges associated with the funds during the first 2 or 3 years is usually high in almost all funds and it is important to stay invested at least for 7-10 years in the ULIP to reap the benefits of the equity markets and also to recover the costs that were deducted from our investments. Most agents sell them as short term products but in most cases the market value of our investment is not even as much as the amount we paid them. So it is advisable to stay invested throughout the policy duration to achieve maximum benefits out of our investments.