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Wealthy Wednesdays: What should you choose—Unit Linked Insurance Plan (ULIPs) or Mutual Funds?

Nirmal Rewaria, Business Head, Edelweiss Financial Planning states the pros and cons

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In terms of structure and functioning, ULIPs as an investment avenue compares well with mutual funds. Just like mutual funds, the insurance company allots units to its ULIP investors and a net asset value (NAV) is declared on a regular basis. Along with that, ULIPs have the liberty to invest across assets just like mutual funds.

Of course, to say that the two are similar except for the insurance is simplistic. Despite all the similarities, there are several factors that set them apart. We evaluate the two avenues on the most critical parameters to see how they measure up.

Ease of investment
Investors have greater flexibility while investing in a mutual fund. In most cases they can start small with as little as ₹ 500 a month for as short a horizon as 12 months. This feature known as SIP i.e. Systematic Investment Plan, proves to be affordable for just about anyone—even college students and is a great way to start saving for a goal. An investor once he commits to an SIP can discontinue midway without any penalty or financial implications and his investment remains intact.

ULIPs on the other hand are more structured in that sense. The insurance advisor will assess your income, your financial responsibilities and will draw up an investment plan, which will entail paying a fixed premium for a minimum of 5 years. If the individual wants to exit the ULIP before the minimum investment tenure, there is a financial implication and he stands to lose part of his premium.
Needless to say, investing in mutual funds is easier and embraces a larger segment of the investor community.

Expenses
As determined by the Securities and Exchange Board of India (SEBI), expenses charged by mutual funds to investors for a range of activities like fund management, sales and marketing, administration are subject to certain limits. For example, equity-oriented funds can charge investors a maximum of 2.25% per annum for all expenses; if it exceeds the limit, the expenses will be borne by the fund house instead of investors.
The Insurance Regulatory and Development Authority (IRDA), the regulator for insurance companies, also prescribes limits on certain but not all ULIP expenses. The most expensive part about ULIPs is the high-premium allocation charge usually not exceeding 10% of premium. This was even higher before IRDA clamped down to eschew mis-selling in ULIPs.

Then there are mortality charges, fund management charges and policy administration charges among others. Most of these charges are without limits and at the discretion of the life insurer.
Since higher expenses translate into lower return, expenses have far-reaching consequences and must not be taken lightly. A big advantage mutual funds enjoy is that the investor knows upfront what he is getting into from an expenses perspective, because the structure is very simple. ULIPs on the other hand have complex expense structure, which to comprehend might not be easy for everyone. From a purely expense perspective, mutual funds are more cost-effective, which will reflect in their performance vis-à-vis ULIPs, everything else being the same.

Portfolio disclosure
Based on SEBI guidelines, mutual funds are expected to disclose their portfolios on a quarterly basis, although most disclose them monthly as best practices. This gives investors a chance to study their portfolio and figure out where and how their money is working for them.
ULIPs are also required to disclose their portfolios on a quarterly basis and like mutual funds many choose to do so monthly for greater transparency.

Flexibility in altering asset allocation
Mutual funds are not as flexible or friendly as ULIPs in giving investors the opportunity to migrate across plans. The facility to switch across plans is particularly useful for informed investors, who want to migrate from equity to debt at peak market levels or from debt to equity at the bottom.

When an investor in a diversified equity fund wants to switch to another mutual fund within the same fund house, there is usually a cost implication in terms of entry or exit loads. Also, in most cases he is required to invest particularly in long-term equity and debt-oriented firms for a minimum investment tenure, violating which entails an exit load.
ULIPs offer more freedom to investors in terms of migrating across various asset allocation plans. Most insurers offer certain free switches a year, exceeding which investors may be charged a nominal fee per switch.

Tax benefits
Under Section 80C of the Income Tax Act, premium on ULIP investments are allowed as deduction from income upto a limit of ₹100,000. Likewise ULIP proceeds are tax-free in the hands of investors under Section 10 (10D). There are detailed guidelines on the percentage of the ULIP premium eligible for tax benefit.

As far as Section 80C is concerned, only Equity Linked Savings Schemes (ELSS) qualify for tax benefit. So investments upto a maximum of ₹100,000 in ELSS are allowed as deduction from income. ELSS proceeds are not tax-free in the sense that they attract Securities Transaction Tax (STT) on redemption.
Non-ELSS mutual funds have varying tax implications on redemption depending on the nature of the mutual fund viz. equity-oriented, debt-oriented, money-market/liquid fund.

There isn't a clear winner. Both ULIPs and mutual funds have their benefits and investors should ideally consult their investment advisors before making an investment.

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