we had discussed that Unit Linked Insurance Plans, popularly known as ULIPs, are now much better products than what they were before 2010. The IRDA regulations with respect to ULIPs in 2010 made significant changes with respect to the life cover of ULIPs as ratio of annual premium, policy surrender procedures (including charges) and most importantly with respect to the rationalization of costs of ULIP policies.The minimum life cover or sum assured in ULIP as per IRDA regulations is 10 times the annual premium for investors below the age of 45. But is a life cover of 10 times your annual premium adequate? Life insurance thumb rules suggest a minimum life cover of 10 to 12 times your gross annual income. Your annual ULIP premium is only a fraction of your gross annual income. Therefore, it is clear that your ULIP policy will not be able to meet your life insurance needs. You have to buy additional life insurance to get adequate financial protection in the event of an unfortunate death.
We should understand the mechanics of how the costs work. The various expenses of a mutual fund scheme are charged proportionately against the assets under management of the scheme. Some of these expenses are variable, while others are fixed. Therefore, when the assets under management grow the expense ratio comes down over time. If you look at the expense ratios of some large sized mutual fund schemes, you will observe that they are much lower than average expense ratios. Over a period of time as the assets under management of a mutual fund scheme grows one can expect the expense ratio to come down. The mechanics of ULIP expenses are different. If you go through the product brochure of different ULIPs, you will see that premium allocation and policy administration specified, usually as a percentage of your premium. In fact, in many ULIPs the total expenses are closer to the IRDA cap unlike large sized mutual fund schemes where the expense ratios are much lower than the SEBI cap. However, in the recent years, several low cost ULIPs have been launched where over a long investment horizon the costs might be comparable or even slightly lower than mutual funds.
We will simply focus on the impact of these costs on yield of ULIPs. As per IRDA regulations, the maximum reduction in yield, excluding mortality charges, due to ULIP costs are capped as follows:-
- In the first 5 years, maximum reduction in yield is capped at 4%.
- From years 5 to 10, the maximum reduction in yield is capped at 3%
- From year 10 onwards, the maximum reduction in yield is capped at 2.25%
By maximum reduction in yield, we mean the maximum amount your gross returns can go down due to the costs. It is important to reiterate here that, the maximum reduction in yields exclude mortality charges (the cost of life insurance cover). Therefore when we compare the costs of ULIPs without mortality charges and mutual funds, we are making a like to like comparison.
What is the cost in mutual fund?
Expenses in mutual funds are regulated by the market regulator SEBI. Expense ratios vary from one mutual fund scheme to another, based on the expenses of the scheme and the assets under management. Expense ratios in equity funds can range from 1.5 to 3%. In debt funds it is usually much lower. For the purpose of comparison of ULIP and mutual fund expenses, let us assume that the expense ratio is 2.5%. You can see that compared to the maximum expense cap specified by IRDA, a mutual fund with 2.5% expense ratio is significantly less expensive than ULIPs in the first 5 years. It continues to be less expensive than ULIPs from years 5 to 10 too.
We should understand the mechanics of how the costs work. The various expenses of a mutual fund scheme are charged proportionately against the assets under management of the scheme. Some of these expenses are variable, while others are fixed. Therefore, when the assets under management grow the expense ratio comes down over time. If you look at the expense ratios of some large sized mutual fund schemes, you will observe that they are much lower than average expense ratios. Over a period of time as the assets under management of a mutual fund scheme grows one can expect the expense ratio to come down. The mechanics of ULIP expenses are different. If you go through the product brochure of different ULIPs, you will see that premium allocation and policy administration specified, usually as a percentage of your premium. In fact, in many ULIPs the total expenses are closer to the IRDA cap unlike large sized mutual fund schemes where the expense ratios are much lower than the SEBI cap. However, in the recent years, several low cost ULIPs have been launched where over a long investment horizon the costs might be comparable or even slightly lower than mutual funds.
Source (Business Standard)
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