“How would you explain ULIP compared to a direct mutual fund to a layman?” Tax expert Manmohan Sethumadhavan answers.
About the author: Manmohan Sethumadhavan is a freelancer, investor, and personal finance enthusiast “in search of the absolute truth.” You can follow Manu on Twitter @ManuTsr. Also, read his articles:
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It is March – the year-end season, and the usual tax-saving madness comes with it. Walk into any office, and one of the two people you meet will be trying to sell you an insurance policy. Bank managers and financial agents are under immense pressure to meet their sales targets, and for them, pushing high-commission products like ULIPs is a priority. But remember, their targets are not your targets. Your target is to meet your goals, grow your wealth efficiently, and not to help someone else earn a fat commission. It’s important to understand what a ULIP is, how it differs from a Direct Mutual Fund, and why one erodes your wealth with high charges while the other keeps costs low and maximizes your growth potential.
You are at a store to buy a pack of biscuits. You have two choices: you can buy it directly from the store, or you can go through an agent. The store sells you the full pack for ₹20, but an agent steps in and takes his cut and gives you only half the biscuits for the same price. Would you ever buy from the agent? Of course not. This is exactly what happens when you invest in a Unit Linked Insurance Plan (ULIP) instead of a Direct Mutual Fund. A chunk of your money that you put in ULIPs, goes to commissions, premium allocation charges, mortality, management and administration charges, GST and others, leaving you with way less to invest.
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Now, imagine booking a bus ticket. Directly at the counter, you can get the ticket for ₹100. But if you go through an agent he may charge 30% commission, and you pay ₹130 for the same seat in the same bus. Would you voluntarily pay more for no extra benefit? ULIPs are like that overpriced ticket, where a large part of your money is deducted for commissions, while Direct Mutual Funds are like directly booking the ticket from the counter at the lowest cost.
Suppose you are buying vegetables. If you buy them directly from the farmer, you get fresh produce at a fair price. But if there is a middleman, he takes his margin, and you end up paying more for the same thing. A ULIP has many middlemen – insurance agents, fund managers, and administrators – each taking their share of your money. Also, ULIP is a bundled product – you pay for an insurance part, which you never need. A Direct Mutual Fund, on the other hand, works like buying directly from the farmer, where you get maximum value for your investment.
Ever recharged a prepaid mobile? If you do it directly, with ₹500 you get the full talk time and data. But imagine like you are going through a shopkeeper who takes ₹100 as commission, and you only get ₹400 recharged. ULIPs work the same way – large amounts are deducted as commissions and administrative fees before your money is actually invested.
Say, you have ₹10,000 to save. The bank offers two options. One, a regular savings account where you keep the full amount in your account and earn interest. Second option requires you to first pay ₹3,000 as various charges and then deposit the remaining ₹7,000 in your account. Which would you choose? A ULIP works like the second option, where a big chunk of your money is deducted before even it is invested.
Now, take hotel booking as an example. You can book directly with the hotel at the best price, or you can go through an agent who adds a markup, making you pay more for the same room. ULIPs are like the booking with a markup, while Direct Mutual Funds allow you to invest at the lowest cost. You get the same room in both cases.
Think of a farmer storing grains. If he keeps them in his own storehouse, he owns the entire stock. But if he gives them to a middleman, the guy takes a big portion from the grains as storage fees. With ULIPs, a large portion of your investment is taken away as charges, while Direct Mutual Funds keep most of your money invested, and working for you.
When you buy gold jewellery, if you buy from a trusted jeweller, you pay only for the gold and making charges. But if you buy from an agent, he adds his commissions, making your item costlier. ULIPs work like this – extra costs reduce the real value of your investment.
Need a cab? Booking via an app costs ₹500. If you book through an agent who charges say, ₹150 commission, you pay ₹650 for the same ride. Investing in ULIPs is like booking through an expensive middleman, whereas Direct Mutual Funds give you the same ride without unnecessary extra costs.
Buy a bottle of water. You can get it from a regular store for ₹20, or you can buy it from an airport kiosk where they charge ₹50 for the same bottle. The water is the same, but you’re paying a premium for no real reason. ULIPs are like the costly water bottle, while Direct Mutual Funds offer the same at a much lower cost.
To summarise, ULIPs significantly reduce your investible corpus, by deducting high commissions and other charges from the amount you invest. Direct Mutual Funds, on the other hand invest your entire corpus after accounting for a very small portion as expenses. While it is true that newer ULIPs have stricter regulations and reduced costs compared to the old ones, they still remain costlier than Direct Mutual Funds.
ULIPs continue to impose administration costs, mortality charges, and high premium allocation fees, (obviously they should, as it has an insurance part) which erode your investment over time. ULIP is a bundled product, in which you pay for an insurance component which you never need, as you can get a Term Insurance at a very low cost for your risk coverage requirement. There are other issues with ULIPs like termination costs, where, in some cases you may never get anything if you terminate early.
ULIP sellers may claim that they efficiently switch your corpus from equity to debt before the market falls, and then back again before the market rises. You may read Freefincal articles to understand that such market timing is never possible.
Unlike mutual funds, where expenses are transparent and uniformly applied before the allotment of units, ULIP charges vary based on age of the investor, making it difficult to compare the returns of two investors directly, and, some of these charges are deducted from your units, complicating the comparison, whereas mutual fund NAVs are net of all charges, which means WYSIWYG (an acronym used by software developers) – “What You See Is What You Get”.
Both the products invest in the same assets as if you would have invested directly – and most important – they both carry the same risk. In essence, while ULIPs may have improved, they still fall short of the cost-efficiency, transparency, and simplicity that Direct Mutual Funds offer, making the latter a far superior choice for wealth creation. Keep in mind that if a person pursues you for their business, they expect benefits – at your expense.
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