When a potential investor wants to invest for long-term, the two options that pop-up in his/her head is the Unit Linked Insurance Plan (ULIP) and Mutual Fund Pension Plan. It is debatable which one is the best but one thing that is sure is that both are suitable for particular individual needs. Being long-term investment plans, both ULIP and mutual funds are prone to market risks and fall under the moderate to high-risk category. Diversification is a common feature of both. So what exactly differentiates one plan from another?
Mutual Fund is an investment instrument that purely invests either in equity or in hybrid investments. Equity investments are made in different companies in different sectors. Hybrid investments are made in equity and other available debt market instruments such as securities issued by NBFCs, Corporate Debt, ABS, Financial Institutions and Banking Sector Bonds & Treasury Bills, PSU Bonds, Govt. Of India Securities, State Government Bonds, money market securities, Government Guaranteed Bonds, Call Money, Certificate of Deposit & Discounted trade Bills, Commercial Paper.
ULIPs, on the other hand, are insurance plans that invest in the share market with the benefit of insurance coverage. It is the lump sum amount of money that the insurance company promises to pay to the investor’s nominees in case of untimely death of the investor. This is the added benefit that mutual funds don’t offer. The investors in ULIP are exposed to market risk because it is entirely a market-linked portfolio.
The aspects that investors take into consideration to narrow down the instrument they want to invest in have various dimensions which are:
Investment has everything to do with risk. People of various ages have variable risk appetite. It could depend on the quality of instruments one invests in, the volatility of the market, the potential performance of one’s investment instrument and the amount to be invested. Being an insurance product, ULIP is less risky than mutual funds. However, investment in ULIP also needs to be done carefully because it is not immune to risks only.
As compared to ULIPs, mutual funds have higher risk quotient. There are two types of mutual funds - equity-linked mutual funds and hybrid mutual funds. Equity-linked mutual funds are the investments done in a basket of shares of different companies. Being solely the share market investments, it is prone to higher risks as the stock value fluctuates every day depending on the market sentiment and the performance of the company. Hybrid stocks, as the name tells, are a combination of investment done in both the stocks and other investment instruments such as securities issued by NBFCs, Corporate Debt, ABS, Financial Institutions and Banking Sector Bonds & Treasury Bills, State Government Bonds, Govt. Of India Securities, Government Guaranteed Bonds, money market securities, PSU Bonds, Commercial Paper, Call Money, Certificate of Deposit & Discounted trade Bills.
These are less risky because of the diversification. Equity mutual funds are riskier than hybrid mutual funds, and hybrid mutual funds are riskier than debt mutual funds (ULIPs).
Well this one is a potential influencer here. People would always choose a tax saving option even if it comes at the cost of slightly lesser return on investment. And why not. Tax wedges bring out a substantial portion of your return. So “tax-free” is frantically searched for in the scheme/s when looking for investment options. There was a preference of investment in mutual funds over ULIPs sometimes back; equity-linked saving schemes (ELSS) are completely tax-free.
In the budget of 2018, reintroduction of 10% of long-term capital gains tax (LTCGT) % on equity investments has sparked a debate again. The long-term capital gains tax is a levy realized on the withdrawing of investment of funds. This gives ULIPs an edge over mutual fund investments, especially equity-oriented investments.
ULIPs don’t attract long-term capital gains tax or short-term capital gains tax, instead, it gets tax benefit under section 80C and the benefit extends beyond equity funds to the fixed income space. ULIPs offer both equity funds and other debt instruments to invest in. Gains made from ULIPs are tax-free- the final amount upon maturity is tax-free under section 10(10D).
Fund Management Cost
Calculating the fund management cost is another decisive factor. So which option from amongst ULIPs and mutual funds has higher fund management cost? Short answer- ULIPs have higher management cost than mutual funds. Long answer- there is competition in the market that grabs a higher share of customers, companies leave no stone unturned. ULIPs have higher fund management cost than mutual funds- on average it is 2.5% for ULIPs and 1.35% for mutual funds. But it has come down substantially over the years to become more lucrative to the investors. Some of the basic, no-frills schemes have operating costs equivalent to those of low-cost direct plans of mutual funds. With other benefits such as tax benefits and insurance benefit, ULIPs has neutralized its image as a costly investment scheme.
The minimum period required to remain invested in an instrument is its lock-in period. For ULIPs, there is a lock-in period of three to five years after which the exit option is available. It may vary from product to product. However, there is no such constraint in mutual funds. In the case of ULIPs, the investor needs to stay invested for the entire term of the policy. She does not have an exit option before that. Also, in case one gets stuck in a not so good performing ULIP scheme, there is no turning back at least till the lock-in period remains. The only flexibility provided in ULIPs is intra-switching, i.e. equity to debt and vice versa (no tax liability) and additional top-ups are also available to the investor.
Mutual funds provide a greater degree of flexibility to the investors. If the scheme one has invested in is not yielding desired benefits, one can easily pull out of the scheme and switch to some other better-performing option. Also, there is an option available to take some amounts of money, i.e. to make partial withdrawals from the existing scheme and invest elsewhere
Return on Investment
Well there is not an ounce of doubt about this factor. Investment in low-risk instrument yields a lower return than an investment in a high-risk instrument. Here low-risk instrument being ULIPs and high-risk instrument being mutual funds. If patience is also taken in the picture, it would be clear that mutual funds score higher in this. Since the investment is predominantly in equity in mutual funds, the market can deliver more than it promises to depend on various factors. It can provide more than you expect and there could also be a slump period which can test your patience. You need to hang on to gauge the consequences of your action. If exiting seems to be the better option, mutual funds give you the flexibility to do that. Also, equity mutual funds give higher returns than hybrid mutual funds.
The market and one’s financial conditions can change anytime. If the chosen option offers higher liquidity, then exiting becomes easier in case the condition is not in your favor. In the case of ULIPs, because of the lock-in period of three to five years, the investor can feel stuck in a bad performing scheme. Although for a limited initial period of investment after which the situation might change which eliminates the need for exiting, it can make one feel stuck.
Investment in mutual funds, on the other hand, is more liberating than ULIPs because of no compulsion of the lock-in period. This makes mutual funds more liquid than ULIPs. It is argued that investors, when given freedom to leave at any time they wish even at the cost of mild damage in the form of exit load, hamper their saving habits. It affects their commitment and exposes the insecurity at times of slump. So this is where the lock-in period can be helpful especially if the aim is a long-term benefit. This is one of the reasons why investors, on average, exit from mutual fund schemes after three years.
Mutual fund investments are more open and transparent for the investor especially when we see where the money is being invested. ULIPs, on the other hand, are a little shrouded in mystery and opaqueness.
Summing It Up:
ULIP essentially is an insurance plan which gives the benefit of returns on the premium paid. Both mutual funds and ULIPs have their takers who argument on the pros of their choice. Where mutual funds give higher returns, the risk involved is also higher in them- something that ULIP takers get the point for. Mutual funds have lower operating/ fund management cost than ULIPs, but again the latter have greater tax benefits than the former. To invest in ULIPs, one needs to be more patient as the lock-in period in ULIPs is five years whereas there is exit option available for mutual funds which can be done within a year but with a levy of 1% exit load.