Best to stay away from guaranteed NAV plans

The flavour of the season for insurance companies seems to be the guaranteed net asset value plans, or guaranteed NAV plans, as they are known as in popular parlance.
This is not surprising as the last date for this financial year (March 31, 2010) comes closer, and people get ready to make tax-saving investments. Also, with last year’s stock market crash still fresh in the minds of investors, any sort of guarantee on investment makes for a good marketing proposition.

So here is a lowdown on what these plans are all about and why it makes sense for you to avoid them:

What is a guaranteed NAV plan?
It is essentially a 10-year unit linked insurance plan (Ulip) which guarantees the highest NAV for a period of the first seven years of the plan. Ulips are investment plans which come with some amount of insurance cover. The majority of the insurance premium paid for investing in an Ulip is invested in an investment fund. For the insurance cover, the insurance company charges a mortality premium every month.

How does the guarantee work?
Let us say you invest in a guaranteed investment plan now at a price of Rs 10 per unit. Five years down the line, the NAV is Rs 30, after that the NAV starts to fall and at the time of maturity 10 years on, the NAV is at Rs 15. These plans guarantee the highest NAV achieved during the period of the first seven years of the policy. So, in this case, you will get paid Rs 30 per unit at maturity even though the NAV of a single unit at that point of time is quoting at Rs 15.

In a more optimistic scenario, if the NAV at maturity is Rs 45, you will be paid Rs 45 per unit. Essentially, the insurance company will pay you the highest of the following three things — the highest NAV achieved during the first seven years of the policy,  the NAV at maturity and Rs 10 per unit. So far so good. Read on to figure the problems.

What does the plan invest in?
These plans have a flexibility of investing up to 100% in equity as well as debt. Insurance companies which have launched such plans are of the view that they will decide on the allocation between debt and equity depending on the state of the market. So, if equity markets fall, investments will be moved from equity to debt and vice versa. This is where things get interesting. As any serious market observer will tell you, guaranteeing investments being made into the stock market is not the best way to operate. If such funds plan to invest 100% in equity, how can they guarantee the highest

NAV, given the fact that the highest NAV will be obvious only in retrospect?
So let’s dig a little deeper into the example we had taken at the beginning. Let us say an insurance company is able to raise Rs 1,000 crore for such a plan by selling units at Rs 10 per unit. Now, during the course of operation, the NAV hits Rs 30, five years down the line. This means the Rs 1,000 crore collected initially is now worth Rs 3,000 crore. As assumed above, Rs 30 is the highest NAV achieved.

At the time of maturity, one unit is worth Rs 15, and the total investments are hence worth Rs 1,500 crore. But as per the guarantee given, the investors need to be compensated the rate of Rs 30 NAV, and hence Rs 3,000 crore is needed. Rs 1,500 crore can be raised by selling the investments at the time of maturity. 

This still leaves Rs 1,500 crore (Rs 3,000 crore guarantee - Rs 1,500 crore value of present investments) to be got. So the question is, where is the Rs 1,500 crore going to come from?

The insurance company will compensate the investors from its own pockets. But Rs 1,500 crore is a lot of money.

What are such plans betting on?
To an extent, the above example was a rather extreme one — no company would be willing to take on such huge losses. From the look of it, these companies will have a higher exposure to equity initially and will gradually move the investments into debt as the date of maturity nears. So towards maturity, these funds are likely to have significantly more investments in debt than in equity. Also, the funds are likely to keep booking equity gains and moving them into debt over the period of the plan. This, in a way, will ensure that the equity gains are cashed in, the NAV does not go to very high levels, and the loss on account of the guarantee, if any, is minimal.

Reasons to stay away
The first and foremost is that equity markets and guarantees are a very risky idea, as explained above. The Securities & Exchange Board of India, the stock market and mutual fund regulator, does not allow mutual funds to guarantee returns. But insurance companies come under the ambit of Insurance Regulatory and Development Authority of India, which has been clearing such plans from insurance companies.

For those who do not remember how risky stock markets and guarantees can be, let us go back a few years in history, and talk about the Unit Trust of India (UTI). UTI had around Rs 17,000 crore invested in its assured return schemes and all these schemes had to be shut down in 2002 when things started to go haywire. 

The insurance companies running these plans haven’t elaborated on how exactly they plan to manage the guarantee. Investors should also keep in mind that in the world of finance there are no holy cows, as the recent financial crisis clearly shows. Some of the best names in finance have gone bust and 10 years is a long time.  

It is next to impossible to figure out which is the best insurance company when it comes to investment performance, given the different charges that different insurance companies have. 

During the course of the plan, you may realise that the returns haven’t been up to the mark in comparison to the broader market and may want to exit. Or you may want to exit simply because you need the money. Exiting a Ulip can be a costly affair. This is primarily because most Ulips have upfront charges which they recover from the investor in order to pay high commissions to insurance agents. Also, the guarantee that comes with these plans is applicable only if the investor stays the entire duration of the plan.

The solution
If you want to invest in the stock market and save on taxes, invest in tax-saving mutual funds. These funds have very low upfront charges and come with a lock in of three years. If three years down the line, you figure out that the performance is not up to the mark, you can simply encash the money and switch to investing in some other mutual fund. If you are looking for an insurance cover as well, buy a term insurance policy. Also, if you are the kind who is looking for guaranteed return, invest in the public provident fund, national savings certificate and tax-saving fixed deposits. And remember that stock markets and guarantees are an extremely risky proposition and don’t go together.