why mutual fund schemes score over insurance ULIPs

Five key reasons why mutual fund schemes score over insurance ULIPs
ECONOMIC TIMES-10th July 2007

Muthukumar K ET INTELLIGENCE GROUP

MR RAJSHEKHAR is an insurance agent who is just back from a foreign trip after attending strategy meetings there. His insurance company had taken its top insurance agents abroad. On his new laptop, he is seen making plans for selling more ULIPs (Unit Linked Insurance Plans) the next year. There are thousands of Rajshekhar clones. Some probably residing in your neighbourhood. They have hardsold ULIPs and are making fresh plans for this year. Caution is the word for retail investors this season. Five things ought to be understood about ULIPs. While insurance ULIPs might be transparent in its workings than its traditional counterparts, it also suffers from drawbacks, which makes it not so investor-friendly. Carefully analyse its pros and cons before putting your hard-earned money. 1. Higher agent commissions: Insurance agents are often given front–loaded commissions. Frontloading, as the name suggests, are policies for which its agents are paid higher commissions in the initial years itself instead of staggering it over the years. It could be as high as 40% of premium paid in one year. For instance, on selling a 15-year ULIP policy, an insurer might pay its agent 30% in first year, 20% in second as well as third year and 5% thereafter. Such structure of commission paying — which is widely prevalent in the industry — ultimately reduces the investor returns. Say, you opt for an insurance policy with annual premium of Rs 10,000 and the first-year agent commission of 30%. In that case, only Rs 7,000 is invested into the fund in the first year. If the net asset value (NAV) of the fund appreciates by 20%, your portfolio would be worth Rs 8,400. This is still lesser than your original investment. Remember Rs 3,000 has gone as commission to your insurance agent. In contrast, the commission structures in case of mutual funds are far lower. It ranges from 2-5% of investment in the first year. The subsequent years have commissions, which is not more than 1% every year. In addition, Sebi, the mutual fund watchdog, has put an overall cap of 2.5% per annum for expenses of equity funds. 2. Costlier exit options:It is costlier to prematurely exit an insurance ULIP than a mutual fund. While both are open-ended products, surrender value for an insurance ULIP is very low in the initial years. Surrender value refers to the actual amount that investors get net of all exit charges on redeeming investments. In contrast, mutual funds are open-ended in the true sense. If you find that the fund is not performing well, investors could exit the fund at no cost. For an equity fund, if the exit is within six months, one might have to pay around 2%, but nothing beyond six months. In case of a ULIP policy, exit charges reduce only over the years. But then, the higher commission and exit charges just make it unviable for an investor to exit prematurely. 3. No track record: Many of the ULIP funds don’t have a performance track record of more than three years. While handfuls of funds have a three-year history, it is actually advisable to check fund performance over market cycles. In the last four years, the equity market has only moved up. While over the shorter term, it did see bearish phases, it might be interesting to see how the fund performs over longer bearish periods like that of 2000-03. Mutual funds, in contrast, have longer track record of performance across market cycles. Some of the private fund houses are operating for more than a decade. In addition, handful of independent rating agencies give fund ratings, helping investors take investment decisions. At this juncture, there aren’t any ratings available for ULIPs. 4. Larger commitments: Investing in equity funds of a mutual fund house might be a one-off thing, but not ULIPs. Once you opt for ULIPs, investor has to commit to pay annual premiums over the entire period (say 15 years or so). As you might have known by now, the penalty for premature withdrawal is far higher. 5. Insurance v/s Investment: Insurance ULIPs have been a hit among retail investors and its collections have matched that of mutual fund schemes. But the larger question is whether we should separate insurance and investment needs? Insurance is primarily a product for protection. Investment-lacing is just an additional feature. But since the insurers make more money from asset management fees, they push ULIPs over traditional products like term policies, which provides only life cover. A savvy investor is probably better off investing in a mutual fund, while taking term policies from an insurer. Say this to an insurance company and there are bound to be controversies.