ULIP or term insurance with mutual fund: How to choose the right option?

A ULIP is a combination of insurance and investment where the individual can choose the risk they wish to take on their investments. Before we get into the comparison, it is essential to understand the risks that it entails.

Dec 09, 2018 11:12 IST India Infoline News Service

Unit-Linked Insurance Plans, ULIPs
When the Union Budget 2018 was announced, there was a major talk about unit-linked insurance plans (ULIPs) becoming more attractive than equity funds.
 
The argument was that since long-term capital gains on equity funds would be taxed at 10% above Rs1 lakh, ULIPs, being exempt from the LTCG, will be more attractive on a relative basis.
 
While the argument may be technically correct, it is not exactly a workable alternative. Let us first focus on what a ULIP is all about.
 
Unit-Linked Insurance Plans (ULIPs)
 
What exactly is a ULIP? A ULIP is a combination of insurance and investment where the individual can choose the risk they wish to take on their investments. For example, an investor can choose whether they want a pure equity, balanced, or debt fund portfolio depending on their risk appetite.
 
In addition, ULIPs also provides a term insurance cover that is built into the instrument, and for which, there is a separate loading that is done to the fund. What investors need to really understand about ULIPs is that they are vulnerable to mis-selling. Most investors do not understand that this is a combination of insurance and investment, and hence, is not a pure investment product comparable to equity mutual funds.
 
Before we get into the comparison, it is essential to understand the risks that it entails.
 
What risks are ULIPs exposed to?
We have already seen that ULIPs are vulnerable to mis-selling. This means that investors buy ULIPs thinking it is an investment product without understanding the true attributes of the same.
 
Here are some key risks that you are exposed to when investing in ULIPs.
  • ULIPs are meant for a much longer time horizon, i.e. at least over seven years. It has been observed that most ULIPs require at least 8-10 years for covering the front-loading costs and making profits for the investors. It is not like an equity fund where you could typically make a good return after three years which would become even more likely after five years. ULIPs may take up to eight years and it could be longer if you are in the midst of a lackluster market. But you still need to provide time for that.
  • Unlike tax-saving ELSS that have a lock-in period of three years, ULIPs have a mandatory lock-in period of five years. You cannot withdraw your ULIP amount before the completion of five years. Regular equity funds, on the other hand, are redeemable from the date of allotment itself.
  • Quite often, ULIPs are sold with the promise of higher returns, which is a myth. ULIPs have also been sold as ‘assured-return’ products, which is not true at all as they entail market risk, just like equity funds. You need to check the fluctuations in the ULIP NAV on a regular basis to understand this risk.
 
But the big drawback in ULIPs is the lack of transparency with respect to loading. You get a large debit to your corpus in the first year and this loading progressively reduces. Over a five-year period, this loading is substantially higher than what you would have paid in an equity fund or even an ELSS.
 
What if I need investment and insurance as a single package?
The answer is to combine an equity fund with a term insurance plan. People make the same mistake in ULIPs as they used to make in endowment plans. You should never mix your investments and your insurance; one is to create wealth and the other is to protect your risk. Your insurance cover should be a pure risk cover without any add-on facilities. You are just hedging the risk of life with a term policy and since term policies come cheap, you can take a policy large enough to cover your family expenses in your absence.
 
A typical equity fund would have a loading of around 2.3% and a ULIP loading will be in excess of 5%. The cost that you save on your corpus will be able to pay for your term policy. If you look it that way, a combination of equity funds and term insurance will work a lot better for you.
 
Should I opt for an equity fund or an ELSS fund?
Essentially, both have a similar equity portfolio. The only difference is that an equity fund does not offer Section 80C benefits and also does not have a lock-in. If you are looking to fill up your Section 80C limit, then ELSS is a good method of creating wealth and also getting a tax break. But once your limit of Rs1.50 lakh is exhausted, then don’t bother about ELSS funds. You can get the same returns on an equity fund without locking your money for five years. Once your tax exemptions are exhausted, you can as well remain liquid in equity funds.
 
From a financial planning perspective, it is always better to keep your mutual fund investments and your risk protection separate. That helps you better evaluate the wealth creation and the protection that the insurance can provide you. Instead of going through the hassles of an opaque structure like ULIP, you would be better off by combining an equity fund with a term insurance policy.

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