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Journalism of Courage
Unit linked insurance or mutual fund?
Which should you get, when both potentially do very similar things. A mutual fund is a simple asset management company that pools investors’ money and invests it with a view to maximising returns. A unit linked plan is an insurance product that can be used as a mutual fund vehicle and give market linked returns with almost nil protection or it can build in protection along with market linked returns.
Assuming that we are comparing mutual funds with unit linked insurance plans with minimal protection, which is better? The answer to this lies in costs that the two charge and the tax breaks available. And here lies the problem. Mutual fund costs are simple, transparent and standardised and insurance costs are like a noodle soup.
What are these costs?
Ever tried to pick a noodle out of soup with a fork? Working out costs of insurance is a similar exercise, just when you think you have it, it slips away. Costs vary across companies, across products in the same company and within the product, across premium cut-offs, categories, tenures and riders.
Mutual fund costs, on the other hand, are simple, transparent and common across product categories. Front end or entry loads (the upfront deduction to take care of the distribution costs of a mutual fund) and exit loads have a total common limit of 7 per cent of the the net asset value (NAV), though the industry norm in equity is 2 per cent entry load today. Annual fees that a fund can charge is restricted to a maximum of 2.5 per cent per year (this rate is according to slabs and reduces as the fund size increases). There are no other charges. However, there is no tax rebate on a fund and though capital gains are exempt from tax for a year, its future is uncertain.
Insurance costs and benefits
Because of the complexity of the insurance product and the cost differentiation we cannot tell you which product is the least cost. It depends on what you buy. However, we will give a handle with which to open the door to understanding unit linked costs. You will know what to ask the agent and how to compare costs.
A unit linked product will have costs across five sub-heads:
• Upfront costs. This is a percentage of your first premium that is deducted before the money is deployed. These costs can continue over the life of the product or terminate in a few years.
• Regular charges. These include the annual asset management charges for managing your money and could include a per month charge towards the insurance part of the policy.
• Switching costs. To switch, from one scheme within a plan to another, may carry a charge.
• Exit costs. If you exit before a certain time period you may pay a heavy charge for that.
• Other administration costs. Some periodic costs can be loaded under this head as well.
On the plus side insurance gets tax breaks. Insurance premium gives you a tax rebate and the insurance lump sums are tax free.
How do the two products compare?
It all depends on what the costs are. How costs can impact returns is obvious when we look at what a 10 per cent per annum return in the regular premium Life Time policy of ICICI Prudential Life Insurance becomes after costs are taken into consideration. If the annual premium is Rs 50,000 a year, then the cost is: 18 per cent of the first premium as an upfront cost in the first year, in the second year, it is 7.5 per cent of the premium and 4 per cent per annum from year three onwards. In addition is an annual management fee of 2.25 per cent for their equity plan. If we build these costs in, we find that the actual rate of return drops from the assumed 10 per cent per annum to 7.86 per cent over a holding period of 10 years and to 7.72 per cent over 20 years. In comparison, a mutual fund returning 10 per cent over the same period that takes 2 per cent load each year and 2.5 per cent asset management charges, returns 8.29 per cent over 10 years and 7.7 per cent over 20 years. Build in the tax breaks on insurance and you get a product that can be cheaper than a mutual fund. The market buzz is that the ICICI Pru product is the cheapest and therefore compares well. Do a cost comparison of the company and product you choose. Insist on costs being disclosed to you.
So, what should I do?
Unless you can get the agent to disclose these costs and are able to work out the numbers, stick to a mutual fund that is more transparent, has better liquidity and is an uncomplicated investment product. If you have the ability to work these numbers yourself, or can get an insurance broker to help, compare across companies, product categories and within products. Build into your calculations the fact that asset management may be better in an insurance company since they have the funds for the longer term and are not faced by heavy redemption pressures like the mutual funds.
Insurance is a long term contract, with low liquidity and potentially higher costs. Consider these costs in an insurance plan before you buy them for investment.
