Tax free ULIPs vs taxable MFs: a reality check

Jignesh V Shah & Manthan Shah, Surat

Post Budget, there’s been a lot of noise on the tax free status of ULIPs vs taxability of equity funds and some suggestions that ULIPs will now be an easier sell compared to equity funds. Jigneshbhai, ably assisted by his son Manthan embarked on a facts and numbers based reality check on which alternative is better for investors and for distributors. Their numbers paint a very clear picture of what really is the better option – whether you consider regular investing or a lumpsum investment. Here are Jigneshbhai’s findings and his message to fellow IFAs, which we hope every IFA will read carefully, imbibe and act upon rationally.

“Let’s sell ULIPs instead of equity funds now”

The Union Budget 2018 was published on 1st February 2018. One of the most controversial and most talked-about proposals was that of re-introduction Long-Term Capital Gains Tax on Equity and Equity related instruments. After 14 years of exemption, LTCG was re-introduced on Shares/Stocks traded in secondary markets, equity Mutual Funds, etc. One of the most noticeable exemptions from this list was Unit Linked Equity Plans or ULIPs.

In light of these events, I hear many IFAs or MFDs talking about the benefit provided to ULIPs and how is this regulatory change going to affect their business. The most common conclusion I hear from this discussion is most of the participating people deciding or agreeing to sell/recommend ULIPs instead of equity related Mutual Fund schemes as they are tax-free. The most common reason I hear for preferring to sell ULIPs over mutual funds is that ULIPs are now easier to sell than MFs because they are tax free.

Do investors really benefit from ULIPs?

“Tax-free” implies a benefit for investors. My son Manthan did some number crunching to get clarity on who really benefits from selling ULIPs over mutual funds. Do investors benefit? Do distributors benefit? The answer from the numbers is very clear – neither do investors benefit, nor do distributors. So, why think of resorting to an “easy sell” when neither you nor your client benefits?

Here is a summary of Manthan’s findings:

Assumptions:

1. Since insurance illustrations don’t go beyond 8% CAGR return projections, we have considered only 8% return for both options. As returns increase, the difference between both options will also increase.
2. All Premiums are calculated to give 25 Lac Rupees Sum Assured (Guaranteed Death Benefit) in both the ULIP and the Term Plan.
3. The "person insured" (Investor) is assumed to be a 42 year old Male for premium calculations of both the ULIP and the Term Plan.
4. In case of ULIPs, the capital gains are exempt from LTCG Tax, only if the Sum Assured is at least 10 times the premium paid. Most modern ULIPs do not offer a Sum Assured 10 times the Premium paid in Single Premium Paying mode. Thus, the capital gains in Single Premium Paying mode of ULIPs are Marginally Taxed (Taxed as per the Income Tax-Slab).
5. The Income Tax-Slab is considered to be of 30% (Without Surcharge) for the calculations. LTCG taken at 10%.
6. All Mutual Fund investments are assumed to be in Equity based schemes. (Taxation-wise asset class is Equity)
7. The investor is assumed to survive the entire period of 20 years

Detailed workings done by Manthan can be downloaded here.

Beyond numbers

While the numbers make the case clearly enough on what is better for both investors and distributors, here are a few more points for distributors to think through carefully on the debate of ULIPs vs MFs:

1. Transparency in performance: AMCs are much more transparent about their day-to-day operations like stocks entry/exit or daily NAV calculation or pretty much everything else. If the distributor is any good, the investor can also get a consolidated statement of all Mutual Fund schemes of all family members; which seems like an unrealistic idea for ULIPs. In addition to that, the easy availability of NAVs of all Mutual Fund schemes practically guarantees an accurate calculation of returns; whereas in case of ULIPs, the investor has to stay dependent on the Insurance Company.
2. Transparency in charges: Another area in which I believe AMCs to be a lot more transparent than Insurance companies is Charges. All AMCs are required to publish the Total Expense Ratio or TER for all Mutual Fund schemes. Whereas ULIPs have a few distinct charges like; Premium Allocation Charge/Rate, Fund Management Charges, Policy Administration Charges, Mortality Charges, Miscellaneous Charges, Partial Withdrawal Charges, Switching Charges, Discontinuance Charges, etc. Such charges are also usually hidden behind a thin veil of continuing misrepresentation.
3. Suitability: Product suitability is an investor-centric and question-driven process. What I mean to say is that as far as Mutual Fund schemes are concerned, you can’t say that any one of the Mutual Fund schemes is suitable for all. In the same manner; ULIPs raise bigger concerns on suitability front. ULIPs are a combination of two very different financial concepts; namely Investment and Insurance. The stark difference is; Investment is a choice. You can choose whether to invest or not. Insurance is a necessity. Once taken up, you are liable to pay at least a few premiums, if not all. I believe that both these concepts should be thought of and executed independently of each other. Mutual Fund schemes are an instrument of Investment only. And, as investment avenues, mutual funds don’t differentiate between one investor and another. In contrast, different ULIPs have different age criteria on minimum and maximum entry age as well as maximum covered age. ULIPs are suitable only to some investors, not all.
4. Not all ULIPs are tax free: Not all investments made in ULIPs are tax-free. The investments which are also incorporated with an Insurance cover of sum assured/insured at least 10 times the investment value; are exempt from LTCG Tax. If not incorporated with said Insurance cover, all gains are taxable as per the tax slab of the proposer.
5. Cash flow planning: Few of the more important features of Mutual Fund schemes are Dividend Pay-Out option and Systematic Withdrawal Plans or SWPs. Such features allow investors to generate a regular income from their Mutual Fund investments. Such features can be used to start a regular income stream from the very month of investment. ULIPs cannot generate such regular income in such fashion. Thus, ULIPs would be unsuitable all investors who require a regular income out of them.
6. Flexibility: Mutual Fund is an unparalleled investment instrument when it comes to operational flexibility. Growth/Dividend Pay-Out/Dividend Re-Investment Options, Partial Withdrawals, Systematic Investment Plans (SIPs), Systematic Withdrawal Plans (SWPs), Dividend Transfer Plans (DTPs), Intra-AMC switches, etc are various basic features which enable all Mutual Fund schemes to be operationally flexible. Most of the features listed above cannot be availed with a ULIP. Some of them may be available, but usually, they come with one charge or another.
7. Performance: Due to an inherent nature of the concept of maturity and other terms and conditions associated with them, most ULIPs are not open-ended. Most ULIPs can be invested in at any point of time, but the exit is determined by the policy term. Thus they do not have a requirement to perform well regularly. All open to investing at any time Mutual Fund schemes are truly open-ended. Such schemes can be invested into or redeemed at any point of time (Subject to Exit-Load of each Mutual Fund scheme). Thus Mutual Fund schemes have an implicit requirement to perform well regularly to be successful. I believe that this lack of discipline is what leads most ULIPs to under-perform as compared to the respective category of Mutual Fund schemes. Plus, if I look at the industry average, no category of ULIPs has out-performed a Mutual Fund category in a long period of time. After the Union Budget 2018, I hear many people saying that the LTCG tax on Equity Mutual Funds will dampen the performance and thus ULIPs may be better performers. I would like to remind them of a real-life scenario that took place in the recent past. In 2011, Equity Mutual Fund schemes were exempt from LTCGT and Debt Mutual Fund schemes were not. Still, owing to the negative returns in the Equity Mutual Fund schemes, most of the money coming in was being invested in Debt Mutual Fund schemes. This proves that the investors’ money flows into schemes with steady performance and consistency, irrespective of the taxation.

What’s in your best interests?

We are all motivated by the twin factors of investor interest and business interest and one of the important aspects of our profession is to maintain the right balance between both. When it comes to business interest, trail-based commissions on mutual funds over the life time of the investment get you substantially higher income than ULIPs over the same time horizon. While the summary numbers presented above give the conclusions, for those of you who are interested in the details, Manthan’s detailed excel sheet can be downloaded here. Check out for yourself which product makes better business sense for you in all three investment modes: single premium/lumpsum, regular premium/SIP and limited term premium/STP.

Think rationally and make your choice

I will urge all my IFA friends who are getting swayed by the notion of ULIP now becoming an easier product to sell, to consider the numbers as well as these points, think rationally and come to your own conclusions on which product is really better for your investors and for yourself.

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