The charges associated with a Unit linked Insurance Plan (ULIP) can significantly impact the returns from the policy. A two-part discussion on ULIPS: first how charges reduce returns and then a category-wise study of ULIP returns and how to compare them with mutual funds.
This post is entirely due to an interesting thread started by Guru Rudagi at Facebook group Asan Ideas for Wealth with key comments from Ramesh Mangal (one of my personal finance influencers) and Butan Mohapatra who took the trouble of sending me his ULIP statement with a detailed explanation.
A ULIP which is active has four key charges:
- Premium allocation charge
- Policy administration charge
- Fund Management Charge
- Mortality Charge
Premium allocation charge will be deducted from the premium before investing.
Policy administration charge will be levied by deducting units accumulated at the start of each month.
The fund management charge will be removed from the NAV like good old mutual funds.
The mortality charge will be removed from units accumulated once a month. Thanks to Ramesh for pointing this out. This charge will change depending on the age and insurance cover opted for.
This charge will change depending on the age and insurance cover opted for.
All these charges will vary from insurer to insurer, and are subject to service tax and applicable cess!
Here is an example from HDFC Life
Premium allocation charge:
Year 1: 2.5%
Year 2: 2%
Year 3+: 0%
Butuan showed me charges of a Canara HSBC 'smart future plan' which was much higher and zero only after 10 years!
Policy administration charge:
Year 1 to 5: 0.42%
Year 6 to 10: 0.83%
Year 11 to 15: Nil
Year 16 onwards: 0.83%
These will be deducted monthly and is subject to a maximum charge of Rs 500 per month.
Fund management charge (expense ratio) 1.35% a year.
Mortality charge is the cost of the life cover.
HDFC Life uses the following formula
Annual mortality charge =
(Mortality rate x Sum insured) /1000
The mortality rate changes with age as shown below
Notice how the insurer perceives higher risk (of paying out the sum insured) for children and naturally to senior citizens.
How ULIP Charges Reduce Returns!
For the sake of argument, we will assume Rs. 1000 as the one-time premium of a ULIP.
Step 1 If the return from change in NAV is 10%, the impact of the mortality charges alone is shown below
The NAV return is assumed to be always 10% for simplicity. This data is for a person who started to invest in the ULIP at age 24.
For a person who started to invest at age 34, the impact due to mortality charges alone would be greater.
The NAV return of 10% is after taking into account the fund management charge.
Step 2 Now if we take into account Policy administration charges for the ULIP started at age 24, the return drops further.
For ULIP return calculation, premium allocation charges should not be factored in as they are deducted before investment. However if we wish to compare returns to a mutual fund, then it becomes like an entry load.
Step 3 For the policy started at age 24, after taking into account the premium allocation charges (only for the first year, since it is a one-time premium).
Step 4 Factor in service tax for steps 1,2 and 3!! Too tired to do this. Just we reduce another 0.5%?
The purpose of this post is two-fold
1 To illustrate how ULIP charges reduce returns (done)
2 To determine a reasonable number by which we should reduce the ULIP NAV returns reported if we have to compare them with mutual funds.
If the mutual fund return (after taking into account the much higher expense ratio ~ 2.5%) is 10%, the corresponding ULIP return (after expenses)
for a 10 year policy started at age 24 would be _____ (only an estimate)
for a 10 year policy started at age 34 would be _____ (only an estimate)
Can you please fill in the blanks by looking at the tables above? Thank you.