March 18, 2009

Why unit linked plans are a bad idea ?

I recently visited icici and HDFC bank for some personal work and some of the sales folks at these branches went into a sales pitch, pushing their respective unit linked plans. These unit linked plans are a combination of an Insurance policy and mutual funds. The key highlights of these plans are

- An annual ‘premium’ payment towards the plan for around 15 years.
- An option to pick from a range of 100% equity to 100% debt plans
- If the primary holder passes away, the nominee get the insurance amount in addition to the accumulated value of the mutual fund component (varies by plan)
- A max total insurance cover of around 12.5 lacs even if the annual premium exceeds 2.5 lacs
- 40% premium charge in year 1, 30% charge in year 2 and 2% thereafter.
- A plethora of other charges some of which are not very clear unless you dig further such as mortality charge, admin charge etc
- A 1.25% fund management charge

Now these sales folks are well intentioned and all that. But frankly my initial feeling was that anything this complicated and convoluted cannot be very good. Lets look at some math

For ex : I invest 2.5 lacs per annum for 15 years in a 100% equity option. So around 1.75lacs are deducted in year 1 and 2 combined and around 5000 rs per annum thereafter. The rest would be invested in a mutual fund of choice.

The insurance component

Lets look at the insurance component first. A pure risk policy (which is what the above is) is currently priced at around 4000-6000 p.a premium for a duration of 15 years. So clearly the insurance component is overpriced.

There is a bumper component which is paid at the end of the policy term which equates 70-80% of the premium. If you look at it in another way, this equals the 70% you pay upfront at the start of the policy.

So in a nutshell, the company is taking 70-80% of the annual premium from you and holding it interest free for 15 years. At an interest rate of around 9% per annum that is 3.6 times your annual premium !!

The 2% annual deduction would get you a similar pure risk policy with all the attendant benefits including tax deductions.

Mutual fund component

Lets look at the mutual funds component – Nothing special here. The company is taking 60% of your premium in yr 1, 70% in year 2 and 90% in yr 3 and onwards and investing it on your behalf for 15 years. At the end of 15 years, you redeem based on the NAV then.

What are the negatives here ?
– For starters my money could be locked for 15 years – a big negative if the performance turns out to be poor.
– The brochures, which I have seen show very average performance for all the concerned funds (most of them, barely beating the index before charges and actually underperforming the index after the fund management fees).
– A plethora of charges I noted earlier, get deducted from the mutual fund component. There is not much clarity in the brochures on the quantum of total charges, but I don’t expect it be less than 1% of the total (maybe more).

A pretty bad investment option. The insurance component is way overpriced !!. The mutual fund component has nothing special in it and has a load of charges attached to it, which will reduce your returns substantially in the long run. I will not be surprised if the banks are getting a hefty commission or good fee from these kind of plans.

My initial feel was that anything this convuluted and complex is a nice way for the bank or AMC to make good money off the fees and leave the investor with poor returns

Buy a low cost pure risk policy for the insurance cover. These policies do not pay anything if you survive ( A happy outcome !! as I have survived) and have a very low premium. For the mutual fund component invest in a low cost index fund or ETF or a
decent mutual fund (if you can find one).
Finally, buy something nice for yourself or your spouse/friend with the money you save and send me a gift for saving you this money (just kidding !).


BRS said...

Very well written and very timely as well - thank you!
Just a couple of days back, my wife went to HDFC back for some work; she was also provided with this sales pitch. I told my wife to run away from anything which has the words "unit linked" written on it :-)

Anonymous said...

Rohit - Totally agree. I had looked at some ULIPs earlier through HDFC. Constructing a synthetic ULIP by buying a pure risk policy and an ETF investment gives you far better returns, saves you the fees and gives you complete control of your investment without locking you in.

karthik said...

Hi Rohit,
I agree..But what about pension funds?. I recently invested in HDFC pension fund. They deduct 50% in the 1st year and 1 % thereafter. I didnt invest in ETF because I was afraid that I may pull out the money well before my pension age. I wanted this 30 year lock in.

Can you give your views on pension funds and analyse couple of them? ( There are very few of them in the market)

MKD said...

This has always been the case where insurance has been bundled together with other investments.

What is irritating is that subconsciously, many have come to accept insurance as an investment.

Investors will always be better off to take pure term covers to cover the pure risk part, and invest separately in debt, equity etc based on their risk appetite.

Unless, someone is bundling them together and giving a discount (yet to come across such a case!!)

Anonymous said...

Hi Karthik,

For pension, i have been putting money into Templeton India Pension Plan. Like ELSS, they also have 3 yr. lock in. However, the exit load is high incase one wants to take money out before 58 yrs.

They put 60% of the funds into equity and the balance into debt.


Vic said...

Hi Rohit,

Good post, personal finance for a change..huh!! :-)

Your're absolutely right. Same holds true in the US where Variable annuities are pushed heavily that have high commissions, administrative and surrender charges.

It is always a good idea to not mix life insurance needs with one's investments. It is much better to have Term policy (which u have already mentioned). I see ppl making these mistakes everyday.

My wife is currently visiting India and her neighbor (she was banking on both of us) approached for the same. I told her..Sorry we can't.

Unfortunately, there's not enough education.


Anonymous said...

Simple strategy i use when i encounter these Insurance/Investment guys.

Whatever % they charge towards AMC or fund management, if they give me in writing (On 50/100 Rs bond paper) that they will give me guaranteed returns per year half of what they charge, i am ready to invest 10 Lacs on the spot.

For above example if they ready to give me in written that they will give me guaranteed returns of 10% (If they are charging me 20% for AMC) for the policy terms, i am ready to put 10 lacs.

No one will stand by you..


Rohit Chauhan said...

Hi brs
it was good to avoid these unit linked schemes. they are not attractive.

hi karthik
i have not looked at pension schemes, but the lockin is not a good thing for me. also i would look at past returns to evaluate a pension scheme. performance is more important than the name of the scheme


Rohit Chauhan said...

Hi mkd
banks and sales professional can find enough people who do not understand these things well to palm off this garbage.

i think all this bundling is to complicate stuff and make money off investors


Rohit Chauhan said...

hi venkat
why do find this fund attractive ? i checked the performance is fine but not great. In addition the time commitment is too high and the exit loads are high too.
finally the expense ratio is 2.1 % which means net of expenses the fund is underperforming the index


Rohit Chauhan said...

Hi vikas
my reason for not writing personal finance stuff is it is not too complicated to understand. once you have spent 1-2 years learning about investing, it is a matter of 1 hr of figuring out whether an investment is good or not.

i will write a post on how to do it. once you have the variables in mind, it is quick to do it.

this is a bit selfish, but frankly i write only stuff which interests and challenges me can find good personal finance stuff elsewhere and i would really not be adding much value by writing on it


Rohit Chauhan said...

Hi ani
this may sound cheeky, but i have better approach - the words 'NO , i am not interested'. saves everyone time :)


Vic said...

Correct Rohit. I expect (guess others too) more of Value Investing stuff which u publish for the most part.

This was a little change/surprise..not that I expect such stuff at this site. I'm already passed that..:-)
I agree it is much easier and available elsewhere.