The objective of every investor is to create long-term wealth. Obviously this means money cannot be left idle. While Fixed Deposit yields have been falling, for other investment avenues like real estate, the initial entry cost is too high for an ordinary investor. As a result, Unit-Linked Insurance Plans (“ULIP”) and Mutual Funds “MF”) have become popular options for investors.
Which of these should be preferred? To get the answer to this, let us first understand each of these products in a little more details:
ULIP is a product offered by Life Insurance companies. It is an investment product with an included Life Insurance element. The premium you pay is allocated between ‘mortality charge’ and ‘insurance portfolio’. There is a certain degree of flexibility between choosing an aggressive and conservative portfolio.
Mutual Fund is offered by Asset Management Companies (“AMC”) which are often group companies of Banks or Insurance Co’s. These are a pure investment product. The amount you invest goes towards buying shares / debt / other products in the portfolio managed by the AMC. There are various types of MF which are categorized depending on their investment profile (something we have covered in more details elsewhere on these pages).
Having understood this, which of the two products is preferable for long-term wealth creation? The opinion of most experts, which is shared by this writer, is that MF’s are a superior tool for investment. The main reasons for this are as below:
a. Insurance factor: A ULIP typically offers cover of 10 times the annual premium, and rarely does one offer more than 20 times the same. However, the ideal insurance for an earning member of a family is ideally five times the net annual income at least. Considering that the amount you would invest in ULIP or MF would be a fraction of your annual income, the insurance cover is unlikely to be anywhere near adequate. This means you will end up having to by term cover to make up the difference anyway, as you would when investing in a Mutual Fund.
b. Ease of investment : Investment in MF is discretionary and can be done at any time using surplus funds. Even an SIP can be stopped and re-started at any time. In case of ULIP however, while ‘top-up’ premiums can be paid at any time, the regular premium payment needs to be met to keep the policy in force.
c. Expense ratio : Both ULIPs and MFs deduct a part of the yield from your portfolio to cover various costs. For a ULIP these include various costs like premium allocation, portfolio management, mortality charge, surrender charge, and so on. Due to excessive deductions for these charges in the past, the IRDA regulations now cap expenses by ULIPs as below:
- First 5 years: Maximum reduction in yield is capped at 4%
- Years 5-10: Maximum reduction in yield is capped at 3%
- Year 10 onwards: Maximum reduction in yield is capped at 2.25%
(This excludes the mortality charge which is the amount allocated towards paying insurance premium for the life cover that is a part of the ULIP)
By contrast, Mutual Funds expenses are all covered under “Total Expense Ratio” which is capped at 3% for the life of your investment, and in reality can be as low as 1.5%
d. Exit options: Mutual Funds are quite easy to exit unless it is an ELSS with tax benefits in which case there is a lock-in of 3 years. ULIPs on the other hand tend to lock-in for 5 years with exit before that time likely to have significant value penalties.
For all of the above reasons, MF’s are generally considered a more reliable tool for long-term wealth creation than ULIPs. It should be pointed out however that ULIPs do offer tax benefit under Section 80 (C) of the Income Tax Act, while Mutual Fund investments (other than ELSS) do not. However, there are other avenues for availing tax benefit under Section 80 (C) which are more suited to the purpose.
Finally, both MFs and ULIPs are inherently risky; they invest in equity or debt instruments that are subject to market forces. One needs to have a certain amount of risk appetite and choose the scheme, whether MF or ULIP, very carefully before committing money to it.
