Navigating the world of investments often leads to the choice between Unit Linked Insurance Plans (ULIPs) and Mutual Funds. This blog delves into the intricacies of both, highlighting their differences in structure, benefits, and suitability to help you make informed financial decisions.
ULIPs vs Mutual Funds- Which is Better?
Life events like buying a home, funding education, marriages, and retirement demand substantial funds. To combat inflation, identifying high-return investment avenues aligned with your risk tolerance is crucial.
While stock market investments offer potential for remarkable returns, they entail significant risk. Balancing long-term goals, mutual funds and ULIPs stand out as preferred choices. These options allow entry into equity markets with diverse risk profiles, catering to various investor preferences. Making a wise decision between the two hinges on understanding their differences, benefits, and aligning them with your financial objectives.
What is a Mutual Fund?
Mutual funds are one of the most popular investment vehicles in the market. It collects money from various investors and invests in a diversified portfolio of securities such as stocks, bonds, and money market instruments. They are offered and managed by the AMC (Asset Management Companies). It allows you to earn a market-linked return to accumulate more wealth in the future.
You can invest in mutual funds via SIP and Lumpsum mode. Under SIP mode, you invest regular amounts periodically, weekly, monthly, or quarterly. However, in the lumpsum mode, you invest a big chunk of your money in one go.
What is a Unit-Linked Insurance Plan (ULIPs)?
ULIP, or Unit-linked insurance plan, is a financial instrument that combines investment with life insurance coverage. It allows you to accumulate wealth in the long term and avail of the insurance benefits. They are offered by the life insurance companies.
When you buy a ULIP plan, you have to deposit a regular premium, or you can make a one-time payment, depending on the plan you choose. After you have made the payment, your premium payment is divided into two parts. The first part goes towards your life insurance plan, and the other part goes towards your investment plan. This way, it offers a unique method of investment plus insurance.
Difference Between ULIPS and Mutual Funds
Tax Benefits in ULIPs
There are two tax benefits that are generally offered in any financial product. One, the benefit of tax deductions under different sections of the Income Tax Act on the invested amount. Two, low or no taxes on maturity proceeds and capital gains.
ULIPs tick both the boxes. The premiums paid under ULIPs are eligible for deductions under Section 80C and all maturity proceeds are exempted from taxes under Section 10(10D).
However, as per the recently presented Budget proposals, this second tax exemption will no longer be applicable for ULIPs whose premium is above Rs. 2.5 lakh per annum. For these ULIPs, the maturity amount will be taxed likeEquity Mutual Funds. So, in these cases, the maturity from the policy shall be taxed at 10% on gains above Rs. 1 lakh. This change will be effective February 1, 2020, and will be applicable only on new ULIPs being bought.
These recently proposed changes, however, are unlikely to affect the average consumer who tends to pay an annual premium of around Rs. 1.1 lakh towards a ULIP policy. This amendment is likely to be a problem for certain distributors and banks who tend to pitch a ULIP policy as an alternative to a 5 year fixed deposit.
Tax Benefits in Mutual Funds
Except for Equity Linked Saving Schemes (ELSS), no other Mutual Fund category is eligible for deduction under Section 80C of the Income Tax Act. So, you can reduce your taxable income by Rs. 1.5 lakh if you invest only in theELSS category of Mutual Funds. The capital gains earned from ELSS, however, will be taxed like an Equity Fund.
If you need more specifics on capital gains taxation on Mutual Funds, then read:How Your Mutual Fund Investments are Taxed?
Return on Investment
ULIPs (Unit Linked Insurance Plans) combine insurance and investment, impacting ROI due to insurance costs. Mutual funds solely focus on investments, potentially yielding higher ROI. ULIPs offer insurance benefits but may have higher charges, affecting returns. Mutual funds tend to provide greater investment flexibility and transparency, potentially leading to better long-term ROI compared to ULIPs.
Life Insurance Cover
ULIPs come with a built-in life insurance cover. So, in addition to investment returns and tax benefits, ULIPs also offer life insurance coverage. This makes ULIPs a triple benefit financial product.
On the other hand, Mutual Funds are purely an investment product and have no insurance built into them. Recently, some Mutual Fund companies have come up with a free-of-cost but limited insurance plan for some of their schemes. These are offered as a group insurance cover, but these are far and few between and often come with many limiting conditions like the tenure of the SIP, a maximum sum assured, constraints like no break in the SIP, etc.
So, overall, as a Mutual Fund investor, you will need to buy life insurance separately. You can consider a term insurance plan as they offer very high coverage at reasonably low premiums.
ULIPs have a lock-in period of 5 years. This is similar to the other tax-saving options under Section 80C such as theNational Savings Certificatesor tax-saving 5-year fixed deposits. However, when compared to Mutual Funds, 5 years seems a long period.
Most Mutual Funds come with no lock-in window which means you can redeem your units as and when you please. There are only two exceptions to this. One, in the case of ELSS or tax saving Mutual Funds, the lock-in period is 3 years. Two, there are some solution-oriented Mutual Funds like a Children’s fund or a Retirement fund where the lock-in is 5 years. But the bulk of the Mutual Fund schemes have no lock-in period while all ULIP policies have a 5-year lock-in.
So, if you have a short-term goal of 1-2 years, then definitely a ULIPs will never make sense. ULIPs can be considered, only if your goal is at least 5 years away. On the contrary, Mutual Funds can fit into multiple tenures running from as low as 1 day to goals that run into several years and even decades.
In the period between 2004 and 2010, ULIPs used to levy various charges to policyholders. These charges came in many different forms and included premium allocation charges, policy administration charges, switching charges, partial withdrawal charges, discontinuance fees, surrender charges, and so on.
Such were the levels of these charges that only 50-60% of the premium paid by investors was actually being invested in the stock and bond markets on behalf of the policyholder. However, much has changed in the last 10 years, thanks to the regulators and growing competition from Mutual Funds.
Most modern-day ULIPs have stripped off all predatory charges and are much simpler in their construction. Yes, there are some peripheral charges in some plans but the most popular and cheapest ones are the online ULIPs which generally have just two charges – the mortality charges and the fund management charges.
Compared to ULIPs, Mutual Funds don’t have any mortality charges. This is because Mutual Funds don’t offer an insurance cover that ULIPs provide. Mutual Funds only charge an expense ratio, which is similar to fund management charges in ULIPs. These fees are used by Mutual Funds and insurance companies to pay for fund managers, recruit good research analysts, trade-in securities, audits, regulatory compliances, and implement other administrative tasks.
A ULIP policy’s fund management charges are capped at 1.35% as per the IRDAI rules. This 1.35% is generally what most insurers charge for Equity Funds while Bond Funds are a bit lower at around 0.9%.
In the case of Mutual Funds, expense ratios are a bit more spread out with different asset management companies charging a different percentage for different asset classes. To compare these charges with ULIPs, the direct plans of most equity Mutual Fund schemes are generally lower than the 1.35% mark while the regular plans are higher than 1.35%.
Apart from the expense ratio, Mutual Funds have one additional charge called the exit load. The exit load is a sort of a penalty that Mutual Funds charge when a unitholder redeems some part of his or her investment too soon. So, if you are someone who invests in Mutual Funds for very short durations, then the impact of exit loads should be kept in mind.
To sum this up, always remember that high charges will eat into your returns and one should be cautious of the charges, especially when considering ULIPs. Be certain that you have understood each and every charge and don’t forget to carefully read the benefit illustration before enrolling in any ULIP policy.
Fund Options and Asset Classes
There are a lot of Mutual Fund schemes across various categories. So, Mutual Fund companies outscore ULIPs when it comes to availability and range of investment options. Mutual Funds offer consumers a wide range of asset classes such as equities, bonds, gold, commodities, international equities, and even specific sectors or themes.
On the contrary, ULIPs don’t have many fund options and often come with the standard equity and debt variants. So your choice of asset classes is quite restricted with ULIPs. This in turn might impede the build-up of agood asset allocation strategyif you only invest in ULIPs.
Additionally, there are no passive funds in the ULIPs portfolio of funds. The passive funds have become quite popular globally and are attracting investor interest in India as well. To put in numbers, the total AUM of index and ETF funds stood at Rs. 1 lakh crore in December 2018. Then by December 2019, this number had jumped to Rs. 1.7 lakh crore. And most recently in December 2020, this AUM is at Rs. 2.7 lakh crore.
Index-linked insurance products (ILIPs) were rolled back in 2013. Given the popularity of index funds in recent times and availability of multiple benchmark indices such as the 10-year Sovereign Bond Index, NIFTY 50, NIFTY Midcap, SENSEX, etc, the insurance regulator IRDAI or the Insurance Regulatory and Development Authority of India in February set up a panel for the re-introduction of these products.
Having an index fund option within ULIPs can actually help insurance companies market their offerings better. And there are a couple of strong reasons for that. One,.quite a high number of investors are moving towards passive investing as more fund managers find it difficult to beat the index. Two, the combination of index funds, rebalancing through unlimited switches along with zero tax implications can lead to higher returns for investors and can be a serious challenge for Mutual Funds.
The 5-year average performance of ULIPs and Mutual Funds across some popular fund categories shows that the category performance of ULIPs was only marginally lower than the category returns of Mutual Funds.
|5 YEAR PERFORMANCE OF ULIPs AND MUTUAL FUNDS
|Number of Funds
|Number of Funds
|Dynamic Asset Allocation
However, ULIPs do have some construct issues which is where the real problem lies. Because of the charges, the amount of money that goes into investments is lower in a ULIP policy as compared to Mutual Funds. For example, if you invest Rs. 100 in both Mutual Funds and ULIPs, nearly Rs. 99 (after theexpense ratio) is invested in a Mutual Fund while maybe only Rs. 95 rupees get invested in a ULIP policy. That remaining Rs. 5 goes towards mortality, premium allocation, and other charges.
So, when a ULIP policy delivers 10% returns, it means that it has delivered 10% on the Rs. 95 invested in the market and not on the Rs. 100 invested by the policyholder.
Another concern with ULIPs is that they don’t have a porting feature. This means if you are not happy with the investment performance of your insurance company’s ULIP policy, you cannot move your portfolio to another insurance company that might have a better investment team. Moreover, with a high lock-in period of 5 years, there is a chance that you might be stuck with a poor or average performing fund for a prolonged period of time
Mutual Funds offer no loyalty benefits to their unitholders. On the other hand, new-age low-cost ULIPs have come out with loyalty benefits for their policyholders. These are in the form of additional units that are allotted to policyholders if they stay with the fund for longer durations like 5 years, 10 years, or more.
This is done to ensure that policyholders remain invested for a longer duration. So effectively the loyalty bonus becomes a retention tool. How much loyalty bonus will be given and when it will be given would be available in the benefit illustration given to you by the insurance company or your insurance agent. Please ensure you read through that completely and don’t forget to ask questions whenever there are any doubts.
Switching and Rebalancing
One of the best advantages of ULIPs is the switching and rebalancing facility. ULIPs allow policyholders to move units – fully or partially from one fund to another without attracting an exit load or any form of taxes.
For investors who tend to time the market and change asset allocation often, this is certainly a big plus when compared to Mutual Funds. Such facilities are not available with Mutual Funds
In Mutual Funds, when one wants to rebalance his or her portfolio from one asset class to another (for example equity to debt), one has to sell some units of equity and purchase corresponding units of debt. So, when you sell units of an equity fund, they will be liable for capital gain tax and some exit load might also be charged.
Both Mutual Funds and ULIPs have improved their levels of transparency on many fronts over the years. For instance, both Mutual Fund companies and insurance companies offer daily NAVs which can be accessed from their respective website. Both publish a fact sheet every month which includes the fund’s performance, portfolio of holdings, benchmark returns, volatility score, fund manager details, etc.
In terms of charges, the Mutual Fund scheme’s TER or total expense ratio is communicated to the unitholder from time to time. And likewise, in ULIPs, every policyholder is offered a benefit illustration that features a projected cash flow statement and a break-up of each and every charge so that the prospective investor understands what they are buying into.
Comparison between Mutual Funds and ULIPS
|To create wealth as well as life insurance cover
|To create long-term wealth.
|IRDAI (Insurance Regulatory and Development Authority of India)
|SEBI (Securities and Exchange Board of India )
|Available for all horizons (Short, Medium and Long Term)
|There is no lock-in except for ELSS funds and solution-oriented funds
|Eligible for deduction upto Rs 1.5 lakh under Section 80C
|Only ELSS funds are eligible to claim a deduction upto Rs 1.5 lakh under Section 80C
|You have to pay a regular premium on specific intervals or lumpsum investments.
|You can invest via SIP or Lumpsum
|Low to high-risk
|Risk levels vary based on the fund’s investment portfolio
ULIPs or Mutual Funds: Which one Should You Choose?
ULIPs are a good investment option that comes with built-in insurance cover, tax benefits, loyalty benefits, and seamless switching options. Incidentally, Mutual Funds also have a good appeal in them with better performance, lower expenses, more fund choices, and no lock-in period.
So the choice between ULIPs or Mutual Funds comes down to the understanding of how either product fits into your investment plan.
For example, you have a short-term goal like you want to pay off your car loan in 2 years. In such a scenario, the suitable investment option is the one that would offer safety of capital and the ability to withdraw money in 2 years. So, low-riskDebt Mutual Fundswill be suitable rather than a ULIP policy.
If it is a longer duration goal like retirement, then some different questions need to be asked. These questions include:
- What is your performance expectation over the years?
- Which assets do you need to invest your money in?
- How often would you rebalance your portfolio?
- Do you need liquidity?
- What will be the total tax implication?
- What will be the mortality charges at your age?
The work that one puts towards getting the answer to such questions distinguishes a good investor from a lazy one. So take up this question on Mutual Fund returns versus tax saving on ULIPs yourself and let us know what you found in the comments below.
As an expert in financial matters with extensive knowledge of investment products, I can confidently guide you through the intricacies of Unit Linked Insurance Plans (ULIPs) and Mutual Funds. My expertise is grounded in practical experience and a comprehensive understanding of the concepts discussed in the provided article.
Firstly, let's delve into the concepts mentioned in the article:
- Definition: Mutual funds are investment vehicles that pool money from various investors to invest in a diversified portfolio of securities such as stocks, bonds, and money market instruments. These funds are managed by Asset Management Companies (AMCs).
- Investment Modes: Investors can choose to invest in mutual funds through Systematic Investment Plans (SIP) or Lumpsum mode.
- Tax Benefits: Except for Equity Linked Saving Schemes (ELSS), mutual funds do not offer tax benefits under Section 80C of the Income Tax Act.
Unit-Linked Insurance Plans (ULIPs):
- Definition: ULIPs are financial instruments that combine investment with life insurance coverage. They are offered by life insurance companies and involve the payment of a regular premium, which is divided into parts for life insurance and investment.
- Tax Benefits: ULIPs offer tax deductions under Section 80C, and maturity proceeds are exempted from taxes under Section 10(10D). However, recent changes in the budget may affect tax exemptions for ULIPs with premiums above Rs. 2.5 lakh per annum.
Differences Between ULIPs and Mutual Funds:
- Tax Benefits: ULIPs offer tax benefits on premiums paid and tax-free maturity proceeds. Mutual funds, except for ELSS, do not provide tax benefits under Section 80C.
- Return on Investment (ROI): ULIPs combine insurance and investment, impacting ROI due to insurance costs. Mutual funds focus solely on investments, potentially yielding higher ROI.
- Life Insurance Cover: ULIPs come with a built-in life insurance cover, providing a triple benefit. Mutual funds do not include insurance, and investors need to purchase life insurance separately.
- Lock-in Period: ULIPs have a lock-in period of 5 years, while most mutual funds have no lock-in period, except for ELSS and some solution-oriented funds.
- Charges: ULIPs historically had various charges, but modern ULIPs are simpler with mortality and fund management charges. Mutual funds have expense ratios and exit loads.
Fund Options and Asset Classes:
- Variety: Mutual funds offer a wide range of asset classes, including equities, bonds, gold, commodities, international equities, and specific sectors/themes. ULIPs have limited fund options, usually standard equity and debt variants.
- ULIPs vs. Mutual Funds: The 5-year average performance comparison suggests that ULIPs' category performance is marginally lower than that of mutual funds, primarily due to charges impacting the amount invested.
Loyalty Benefits, Switching, and Rebalancing:
- ULIP Advantages: ULIPs may offer loyalty benefits to policyholders who stay invested for longer durations. ULIPs allow switching and rebalancing without exit loads or taxes, providing flexibility for market timing.
- Improved Transparency: Both mutual funds and ULIPs have improved transparency with daily NAVs, monthly fact sheets, and clear communication of charges.
In conclusion, the choice between ULIPs and Mutual Funds depends on individual financial goals, risk tolerance, and investment preferences. ULIPs offer a combination of insurance and investment benefits, while mutual funds provide more flexibility, variety, and potentially lower costs. Understanding your specific needs and conducting a thorough analysis will help in making informed financial decisions.