The tax advantage in Unit Linked Insurance Plans (ULIPs) is luring many of us. The tax-free status of ULIPs at maturity is a clear advantage for long term investors when compared with mutual funds which are taxable at redemption.
However, there are other factors which make ULIPs inflexible and demanding. Here is what you need to watch out for.
Once you invest in the ULIP offered by a life insurer, you have the option to switch between various funds. However, you cannot switch out of the insurer. If you are unhappy with the way your money is being managed, the charges, or the service you cannot simply redeem and switch over to another ULIP.
There is a lock in period of five years. If you want to redeem funds before this period is up there are specified surrender charges which will be levied. Once you redeem, you will have to apply for another ULIP from a different insurer and undergo the entire process including medical clearance again. Unlike this, in a mutual fund redeeming from a scheme you are unsatisfied with and reinvesting in another is a matter a few clicks online (there may be an exit load applicable as well as capital gains tax).
While fund management costs in both products are highly comparable, there are other charges in ULIPs which you should be aware of. Firstly, there is a premium allocation charge in the first year, which is deducted before your premium amount is invested. There is a mortality charge each year that gets deducted from your premium, again before it is invested.
There are ULIPs now which return the mortality charge paid at maturity, however, this amount would have served you better had it been invested from the start, the gains could have compounded over the years. Plus, there are monthly policy administration charges too which get deducted from your fund value.
You may not see all these charges upfront, but a clear impact is that a lower amount gets invested than the premium you are paying.
This is also relevant when you are looking at previous year returns in ULIPs before you decide to buy. The returns shown do not include mortality charges and this can make all the difference in the return you get in hand. Moreover, mortality charges will differ for each individual and in case of ULIPs are higher than what you will pay for the same insurance cover as in a term life policy.
Once invested in a ULIP there is practically no flexibility; no SIPs, SWPs and so on. You have to remain invested through the term of the policy.
Once invested in a ULIP there is practically no flexibility; no SIPs, SWPs and so on. You have to remain invested through the term of the policy. If you land into monetary distress and want to stop your premium payment, your policy itself will lapse. You can withdraw the amount in your fund but this will be a disadvantage to you. In open ended mutual funds, you can pause your monthly contributions in times of distress, rather than having to withdraw.
These are some of the conditions that make ULIPs a lot less desirable than mutual funds. You must not simply chase the 10% tax benefit; there is no transparent performance, and transparency on costs also needs to improve along with flexibility built into the product.