The new financial budget announced by the central government announced a new long term capital gains/LTCG tax on investments. Since then a lot of insurance firms have been promoting the tax-free or LTCG tax free aspect of ULIPs/unit-linked insurance plans. It is however important for investors to understand the fact that taxability is not the sole parameter on which to base your judgment of any instrument of investment. There are several other factors that play a key role in defining the ideal investment option for any investor as their needs and goals.
Presented below is a comparison between mutual funds and ULIPs, in a post LTCG tax world.
ULIPs were always better than mutual funds when it came to taxability of the investment instrument. The new LTCG tax now gives the former even more added advantage!
Even during the times before the imposition of LTCG tax on mutual funds and stocks, ULIPs were slightly better than equity MFs with regards to taxability. When equity or balanced mutual funds were held by investors for less than 1 year, then it invited taxation of 15 percent as short term capital gains. ULIPs are defined as insurance instruments; hence it did not have any short term gains tax as the product was tax free as per Sec 10 (10d).
After the new long term capital gains tax comes into effect from April 1, 2018, the tax advantage held by ULIPs over stock/MF investments will become even bigger. The new tax is like manna sent from the heavens for insurance firms. Insurance companies have quickly made use of this opportunity and started emphasizing the fact that a new tax of 10 percent will be levied on equity and balanced funds on gains made, while there will be no tax on income accrued from investments in ULIPs.
This advantage of ULIPs as being a tax free investment instrument does not cover just equity MFs, but also other sources of fixed income. ULIPS provide not just equity funds, but also different options of liquid and debt funds for investors. Debt funds will invite LTCG tax of 20 percent on gains after indexation, while fixed deposit incomes will invite taxation at the marginal tax rate. However, income from ULIPs will remain free from taxation, irrespective of whether the gains are long-term or short-term from any kind of fund.
- The Overall Returns
Mutual fund investments have provided better yields on a consistent basis, year on year. This has a significant impact on the overall returns on investment in the long term.
It has been argued over the years by insurance firms that mortality fees should not be taken into account as such charges are meant for provision of life coverage to the holder of the policy. Even when the mortality fees are set aside and just the NAV-linked yields are examined, then it will be evident that the returns of mutual funds are higher as compared to returns provided by ULIPs. Data analysis of the past years has shown that the returns of ULIPs as compared to the returns offered by mutual funds are lower by 100 to 300 basis points. Over the last one year, the growth in average ULIP large cap fund was 15.51 percent while it was 18.83 percent in case of average mutual large cap funds.
Such a difference in performance levels can result in a significant impact over the long-term period of 15 to 25 years. Over the last 5 years, an investment of INR 1 lakh in an average mutual large-cap fund would have become a corpus of INR more than 2.02 lakhs with an annualized return of 15.24 percent. Comparatively, investment of same amount in an average ULIP large cap for the same time period would have yielded annualized return of 14.41 percent and grown to more than INR 1.95 lakhs. When this data is used as an example for a period of 20 or more years, then even such a minor difference in returns can enhance the corpus of the mutual fund to over INR 29,500.
It is important to note that insurance firms are more skilled at protection and risk management, while mutual fund houses are more adept at managing investments. The effect of the new LTCG tax on equity fund returns however remains to be seen.
- The Involved Costs
Investments in mutual fund products are really affordable. The costs of a few ULIPs available online are also quite low.
All the products competing with ULIPs for investors have used the high charges associated with ULIP plans as an advantage point to promote their own investment instruments. However, pricey ULIP plans ended several years ago in 2010. The charges associated with some of the newer ULIP plans are so low that they are nearly in direct competition with low-priced mutual fund direct plans. A lot of ULIP plans do not feature fund allocation fees or policy administration charges. If the mortality fees are not added, then the yearly charges of certain ULIPs come to be less than 1.7 percent.
It may however be noted that the mortality fees that are charged by ULIPs result in decrease of the policy holder’s net investment. There have been continued efforts by insurers to decrease the overall effect of the mortality fees. For example, a few ULIPs make extra contributions to the corpus of the fund to offset the effect of mortality charge. This additional corpus contribution can be nearly 1 percent of yearly premium over a period of five years. Thus, if the annual investment in a ULIP by an investor is INR 2 lakhs, then an extra amount of INR 2,000 is put in by the insurance company each year.
There are additional benefits as well. From the 6th year onwards to the 10th year, the contribution of the companies rise to 3 percent; from the eleventh year to the 15th year, it rises to 5 percent; and from 16th to the 20th year, it increases to 7 percent. The mortality fee that is levied does eventually get compensated by the contributions made by the companies to the corpus of the fund each year. There are some ULIPs which comes with the option of repayment of the entire mortality fees levies after the term is finished.
Investors still however need to remember the fact that the premium associated with ULIPs is higher as compared to a normal policy. This subsequently cancels out the benefit of the contributions made by the insurers.
- Simplicity and Transparency
The structure of portfolios of mutual funds is simple and can be easily accessed. ULIPs are not so transparent and are inundated with complicated fees and charges.
A number of agencies and analytic companies track the progress and structures of mutual funds. Investors can check out the portfolio makeup of the funds they have invested in, see the sector allocations, individual shares, and market segments, etc. The same data is also provided by ULIPs; whoever, they are not tracked by agencies on a large scale and not many would have knowledge about the performance of different ULIP funds.
The way ULIP fees and charges are structured makes them really hard to understand. A few charges that are levied are not a part of the NAV but are incurred due to cancellation of ULIP units. There may have been a rise of 11 percent in the NAV of a ULIP, but due to cancellation of some units, the total value of the corpus may have increased only by 9 percent.
As opposed to the above, charges associated with mutual funds are quite transparent and fairly simple to understand. The charges levied by AMCs are a part of the NAV. If the fund is redeemed by the investor before the minimum holding period is over, then a stipulated exit load is levied.
- Adaptability or Flexibility
Investments in mutual funds can be stopped or switched over to other kinds of investments. However, investors in ULIPs cannot do either and have to keep them for the term of the plan.
Investment in ULIPs is a commitment for several years. Premium has to be paid by the policy holder, year on year, till the full tenure of the plan. Investment in ULIPs can be compared to purchase of a closed-ended mutual fund which will attain maturity in 15 or more years. The worse part about ULIP investments is the fact that policy holders have to remain with the specific insurance company and the policy for the entire policy term. As opposed to this, mutual fund investments do not come with such restrictions. The investors can easily move to a better mutual fund if the current fund is not performing up to expectations.
Investors in mutual funds can exit whenever they want or stay invested for a long time. They can make extra contributions to the fund or withdraw some money from the fund without any problems. Extra top-up contributions are also allowed in ULIPs; whoever such additional payments are considered as single premium contributions and mortality fees are levied on such payments.
The option of switching offers some level of flexibility to ULIPs. It is possible for investors to move from debt to equity and vice versa without being burdened with a tax liability. It is argued by insuring companies that this aspect allows ULIPs to be a good tool of rebalancing.
- Choice and Convenience
People who already have investments in mutual fund and have already completed the relevant KYC formalities can proceed with online investments in MFs without the need to fill out additional forms or other paperwork. Investors in ULIP policies do not have this option. Even after the online form for ULIP has been filled up and payment has been made, investors also have to complete some offline paperwork. Such additional offline work may include income tax returns papers in case a huge insurance cover has been sought, medical tests, etc.
A wider array of choices is also available for mutual fund investors as compared to ULIP investors. People who desire stable and steady growth can invest in large cap mutual funds, while those who are less averse to risk and want increased returns over a short period can opt for investments in small cap and mid cap funds. Flexi cap funds offer a combination of both large caps and small/mid caps. Some insurance companies offer different kinds of ULIP funds; however most of these policies offer selections between debt and equity liquid funds.
It is possible for investors to stop their investments in mutual funds whenever they want. ULIPs however come with a lock-in period of 5 years.
ULIPs as well as mutual funds are instruments of long-term investments. The latter are however really liquid. It is possible for investors to make partial fund withdrawals whenever he/she needs to do so. Also, he/she can exit from the fund whenever they want. ULIPs however come with a lock-in period of 5 years after which investors get the option of making partial fund withdrawals. ULIPs before 2010 came with surrender fees; the new ULIP plans however do not feature any surrender charges after completion of the lock-in period.