A person needs higher returns by doing both investment and purchasing insurance. This is where a Unit Linked Insurance Plan (ULIP) comes to their assistance. When a policyholder pays the premium, a part of it goes toward their life cover and the rest is invested in debt, equity, or hybrid funds. However, not many people recommend a ULIP plan and consider term insurance or mutual funds as better options. The primary reason behind this might be the low life cover associated with the plan and a few other restrictions that we will discuss in this guide.
How Do ULIPs Work?
When a person pays a premium for a ULIP, the insurance company does not invest the entire amount. First, they deduct multiple charges associated with the plan. What remains after these deductions is invested in a fund chosen by the policyholder.
This invested amount buys them units at the current net asset value (NAV). In short, the number of units a person holds is their total fund value, multiplied by the current NAV.
Meanwhile, further deductions are made on mortality, fund management charges, and policy administration charges. This is usually done monthly by canceling units from the policyholder’s account.
ULIPs also come with a mandatory 5-year lock-in period during which a person cannot withdraw funds.
So, the best ULIP plan with high returns gives them the flexibility to switch between fund options during the policy term.
What Are the ULIP Charges to Know Before Buying?
ULIP charges are the biggest reason most people look for alternative options for investment and insurance. These generally include:
Premium Allocation Charge
A premium charge is always deducted upfront from the premium before any investment. The IRDAI has capped it at 12.5% of the annualized premium in a policy year. If a policyholder pays ₹1 lakh and the charge is 5%, only ₹95,000 is invested. This charge is the highest in the first few years but may also reduce over time.
Policy Administration Charge (PAC)
The policy administration charge is a monthly fee for maintaining the ULIP for a policyholder. However, it cannot exceed ₹500 per month (₹6,000 per year) as per the latest IRDAI regulations. The PAC is also deducted by canceling units every month.
Fund Management Charge (FMC)
The FMC is always embedded in the NAV and capped at 1.35% of fund value per year by IRDAI. It generally reduces a policyholder’s returns and is quite similar to a mutual fund’s expense ratio.
Does That Mean Term Insurance and Mutual Funds Are Better?
The best way to understand this is to clear up the differences between ULIPs, term insurance, and mutual funds. This involves two different perspectives: investment and insurance.
Investment Perspective
A person thinks of investing an amount of ₹1,00,000 every year. The entire amount is invested from the first day if it’s a mutual fund. However, there is also an expense ratio, but it is deducted from the fund’s value gradually.
The case is completely different in a ULIP, where the entire amount may not be invested immediately. The insurer may deduct the charges initially, depending on the plan.
Moreover, it has a premium allocation charge of 5%, so only ₹95,000 is invested in the beginning.
Even after that, the insurer has a choice to cancel a small number of units every month to recover the policy administration and mortality charges.
The bottom line here is that the money is directed toward investment in a mutual fund. However, the same premium is split between investment, insurance, and charges in a ULIP.
Insurance Perspective
If a person’s only goal is to protect their family, term insurance is the best option. A healthy, salaried individual can buy a term plan worth ₹2 crore until the age of 65. The best part is that the premium will be quite affordable for them and is usually between ₹17,000 and ₹20,000.
However, the final premiums will always depend on the person’s age, sum assured, health conditions, lifestyle choices, and the underwriting decision of the insurer.
Coming back to ULIP, the life cover is always linked to the annual premium. If a person invests ₹1,00,000 in a year, the sum assured may be 7 or 10 times the premium, depending on their age and plan. That means their cover will be somewhere around ₹7 to ₹10 lakh. Unfortunately, that cover may not be enough for most families.
What Are the ULIP Fund Options?
A policyholder gets to choose how their money is invested when they proceed with a ULIP. Most of these plans offer three broad categories:
Equity Funds
These funds involve investing predominantly in stocks. Although there is a higher potential return, the associated risks are quite high too. Equity funds are those who have a long horizon (10+ years) and can deal with short-term volatility.
Debt Funds
These funds are associated with investments related to bonds, government securities, and fixed-income instruments. They are steadier but moderate returns and have lower risks.
Balanced or Hybrid Funds
Hybrid funds are a mix of equity and debt. They always provide some growth potential while protecting the person against sharp market swings.
The Ultimate Verdict on ULIPs
Although term insurance or mutual funds may seem like a better option than ULIPs, the latter has its benefits too. A ULIP generally makes sense for a person if they already have a pure term plan that covers their family members and other liabilities. This also applies to those who want to make the most of the tax-free debt-equity switching feature inside a ULIP.
However, that requires the annual investment to be below ₹2,50,000, so that it is tax-free.
Some newer ULIPs available in the market also offer return of mortality charges, loyalty additions, and fund options to improve net returns over a long hold period. Hence, individuals must always check the policy wordings or seek assistance from advisors before proceeding with their investments and insurance decisions.