Thanks to the untiring efforts of many personal finance bloggers, the message "Don't mix insurance and investments" is spreading fast and creating awareness. The message is intended primarily for those who are thinking about buying a pension-plan, child-plan, ULIP, endowment plan etc. but have not yet done so. Unfortunately the message strikes fear and panic 😯 in people who already have such policies. The frantic question posed in the title is often the result.
If someone is trying to mix oil and water, it all very well to ask them to practice 'KISS' (Keep It Simple S; Where S refers to 😳 / 😮 / 😥 / 🙄 ). 'KISS' for someone who has already mixed oil and water could range from 'leave it as is', to ‘use nanotechnology to separate’! My point is, if you already have such junk policies then you must evaluate the next course of action depending on your personal situation and not blindly surrender the policies just because some 'expert' said so in his latest blog post.
Here is a step – by –step guide to evaluate such policies.
1. Stay calm. What is done is done. Nothing is going to happen by jumping up and down that you have made wrong choices (in most cases the choices may not be half-bad). Don't go around asking for everyone's opinion online. It is your life. Only you can choose what is right or wrong. Make the effort.
2. Do you have enough life insurance? Use an insurance calculator and determine the insurance amount you require and buy a pure term life insurance policy close to that amount shown in the calculator, depending on your affordability. Be sure to mention all your existing insurance policies when you apply for one.
3. List your long term financial goals and determine how much you need to save for each of them.
4. Determine how much you can save each month. Be sure to include the (effective monthly) premium of all your insurance polices except term insurance. Be sure to include term insurance premium as an expense.
5. Temporarily assign each of such junk policies to different goals. It is obvious where the child and pension plans will be assigned to (duh!).
6. Judge the suitability of each policy. Let us consider non-ULIP plans first. Say I have a child-plan with an annual premium of Rs. 50,000, an effective monthly premium of Rs. 4,167. For my child's education, the goal calculator tells me that I need to save Rs. 15,000 each month, increasing @ 10% each year until my child leaves school. Now consider the following cases:
- I can save more than Rs. 14,000 each month. The effective monthly premium is less than 30% of what I can save. This is a happy situation in which it does not matter what I do with the child-plan. I could continue the plan or choose to stop paying premiums. Either way I must intelligently invest in a well diversified portfolio. If I choose to continue the child-plan, it can be treated as a debt component which will give me tax-free returns ranging from 5-7% depending on the nature of the policy (except ULIPs. We will consider those separately)
- I can afford to save only 8000-9000 each month. In this case the effective monthly premium is 45-50% of what I can save.
(a) If my child has about 10 years of schooling left than I could consider making the policy making the policy paid-up (defined at the end) and invest the premium amount along with the remaining amount I can spare in a well diversified portfolio of equity and debt.
(b) If my child has only few years of schooling left, I can continue the policy and invest the remaining amount low-risk instruments like debt funds.
- I can afford to save only the effective monthly premium of the Child-plan.
(a) If my child has about 10 years of schooling left then I should definitely make the policy paid-up and invest in balanced mutual funds as a tax-efficient way of getting returns that beat inflation.
(b) If my child has only few years of schooling left, I continue the policy and explore education loan options.
(c) Note: (a) and (b) apply irrespective of the effective monthly premium amount (many have expensive child plans)
7. What next? If you can spare more than the effective monthly premium, first ensure you invest the difference in a well diversified portfolio of equity and debt. Then and only then consider what to do next.
If you go by the above scenarios and decide to discontinue the policy make it paid-up instead of surrendering it (see the end of the post for the difference between the two).
Making a policy paid-up has several advantages over surrendering:
- No paperwork. Just stop paying premiums.
- No tax issues if you have claimed 80C deductions with the policy
- There is still a small insurance cover available (insignificant if you have adequate term cover. However money is money).
- The paid-up value of a policy is always higher than a surrender value. Let the paid value is Rs. X and the surrender value Rs. Y. You surrender a policy which has, say, 10 years left. You get Rs. Y and invest in some instrument for 10 years. If suppose the maturity value of your investment is Rs. X, what should the rate of return be? Use this calculator to find out. Typically you would need a post-tax return of 6-7% to achieve this. My take: why bother? Just make the policy paid-up and get Rs. X when it matures. Your time is better spent focussing on how to invest the premium amount elsewhere.
Unfortunately many advocates of ‘KISS’ don’t realize this.
What about ULIPs? Imagine a mutual fund with a (very) high expense ratio and huge exit load. That is a ULIP. ULIPs like mutual funds are long-term investments. Considering the high expenses in the initial years of investment it will take a ULIP at least 5-7 years to break-even, let alone, show some profit (assuming the markets are at least a little favourable). Beyond 5 years a ULIP is like a balanced mutual fund (3-star one if you like).
If you are considering about investing in a ULIP don’t. If you have one, it would not be such a bad idea to stay invested. Learn more about the portfolio in which the ULIP has invested in and how to change it to minimize risk and hopefully increase returns.
Don’t get out of one because you read in a blog that mutual funds are better than ULIPs. If MFs are doing well, then it is very likely so will your ULIP and vice-versa.
Investors who keep looking at NAVs everyday, worry if a MF changes from 5-star to 4-star and ask everyone’s opinion whether to continue or change funds, are better off continuing the ULIP. Of course such investor should not have invested in ULIPs in the first place!
If your effective monthly ULIP premium is, say, Rs. 10,000, the same as what you can spare for a goal and if your goal is at least 10 or more years away, then and only then you should consider exiting a ULIP. Of course when you exit one, depending on when you do, it is likely you will lose money in one form or the other. So you have to be ready for that.
- Do not, repeat do not, assume that exiting your policy and investing in mutual funds is a sure-fire way of achieving your goals. Under certain circumstances (as detailed above) it can offer you a chance to get real returns (returns higher than inflation. Only a chance, never forget that. Need convincing? Read this.
- Every argument has a context. The one favouring exiting junk polices is no exception. Without the context it is bad advice.
- All very well to practice ‘Keep It Simple S#@&’. Identifying what is ‘Simple’ for a particular situation is the first task. ‘Horses for courses’.
Do you agree? Have I missed out anything important?
Postscript: Many (if not most) child-plans are designed to mature when the child turns 18. Most children finish school by 17!!
End-note: Definitions for those unfamiliar
1. To make a policy paid-up is to stop paying premiums. The insurance cover will reduce appropriately and reduced sum assured along with applicable bonuses paid thus far will be given to the policy holder after the policy term is completed. A policy can be made paid-up after a minimum number of years, usually three.
2. To surrender a policy is to severe all ties with the insurer. The policy becomes eligible for a surrender value after a minimum number of years (usually three and usually same as paid-up eligibility). If a policy is surrendered before five years all 80C deductions, if claimed, will become void and the individual will have to pay tax for total deductions made thus far in the year of surrender according to his or her tax slab. For policies issued on or after April 1st 2003, if the annual premium is more than 20% of sum assured then the surrender value is taxable regardless of when you surrender. For polices issued on or after April 1st 2012, the corresponding number is 10% and for those issued after the direct tax code kicks in it is 5%. The surrender value depends on the age of the policy and bonuses offered. It is heavily insurer dependent.