You have recently bought a regular income endowment insurance policy.
You will have to “save” Rs. 3,00,000 every year for 12 years. The 13th year is a break year. From the 14th year for the next 12 years, they will pay you back Rs. 6,00,000 every year! That’s a total of Rs. 75 Lakhs over 12 years!
Wow – they are doubling your money – what a great investment! And it includes insurance as well! Ain’t that a great deal?
Well, not exactly. We’ll show you why.
Such products are typically called Unit Linked Insurance Policies (ULIPs), which combine both Insurance and market-linked Investments in the same product. While they are simple to understand and easy to buy, such products provide neither sufficient insurance risk coverage for actual disaster scenarios in your life, nor do they provide sufficiently high returns from the investments.
It is never a good idea to combine both insurance and investments in the same product. You are much better off tackling them separately as they cover two different use cases. One is a replacement of the primary breadwinner’s income in the unfortunate event of his/ her demise. The other is a source of funds to ensure your lifestyle expenses can be met for the rest of your life once your regular income stops in the case of early or forced retirement.
Let’s do an analysis of whether such policies are actually good investments and if there are better options available.
Firstly, we need to calculate the internal rate of return (XIRR) by listing the dates when the ULIP Premiums are due and the premium amount due (in negative to indicate outflow). Then we list the dates and the amount of income promised by the policy. Using the XIRR formula in Microsoft Excel, with the example mentioned at the start of this article, we get a measly return of 5.5%
In fact, for the sake of simplicity we have not added GST on the ULIP premium to this calculation, but adding it will only make the ULIP returns worse.
Yes, this is tax-free, yes this is risk-free, but so are the Public Provident Fund (PPF), and the Voluntary Provident Fund (VPF) and many other schemes which offer more than 7% – 8% presently. If there are better alternatives providing risk-free 1.5-2.5% higher returns, then why do we still find such ULIP schemes attractive?
So far we have compared only fixed income schemes for a like-to-like comparison. If we compare with a different asset class such as Equity, then the contrast is even higher. Let’s assume the same ULIP premium is instead invested as a mutual fund SIP in a fund expected to provide 12% returns. At the end of the same 25 year period you’d have a corpus of Rs. 3.5 Crores (!), instead of the 75 Lakhs promised by the ULIP scheme.
Let’s go one step further and assume that we will withdraw the Rs. 6 lakhs per year from this mutual fund corpus from the 14th to the 25th year – exactly as promised by the ULIP scheme. Even after the said withdrawal, you will still be left with a corpus of Rs. 2 Crores!
Yes, we haven’t included tax in this calculation because you’ll pay tax only at the time of withdrawal and as per current rules, that is 10% of gains. Even if you reduce 1 percentage point in returns due to tax, you’ll still be left with Rs. 1.5 Crores AFTER withdrawing the 75 Lakhs promised by the ULIP scheme.
If Mutual Funds are so much better than ULIPS, why aren’t they as popular?
The answer is “risk-tolerance.” While ULIPs provide you a guaranteed income, mutual funds are subject to market risks, which means you will not get a steady 12% returns every year, but rather your corpus could be going up and down due to market volatility and your returns could be lumpy. However, with proper risk-management, with proper asset allocation between equity mutual funds and fixed-income or debt mutual funds, and periodic rebalancing, and patience despite market corrections, over a long period, there is a pretty good probability of getting much higher returns.
While avoiding this short-term risk, people instead unknowingly take on the much bigger, and guaranteed risk of inflation, where their money is losing value every year. With an inflation of 6% – 7% a scheme that gives you 5.5% returns means you are not even getting back the same value as you invested in the first place! Don’t get swayed by the sales pitch of such schemes, even if they are sold to you by your friendly neighbourhood uncle, your bank relationship manager, your friend’s cousin, your cousin’s friend, your friend’s cousin’s uncle or someone else you trust. They just don’t know better.
Most people give up on the dreams of building huge wealth for financial independence or even early retirement, by focussing too narrowly on small tax savings in the short term or risk-avoidance due to ignorance. Don’t be that person!
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