Equity Mutual Funds or ULIPs - Which Gives Better Returns?

In Budget 2018, a single announcement brought back the whole debate about mutual funds and ULIPs (unit linked insurance plans) back to life. This announcement was obviously the re-introduction of long term capital gains on equities. Subsequent to the announcement, the finer points of the new taxation rule seemed to matter little as more and more individuals started exiting mutual funds believing that all their equity returns were taxable if they redeemed after 31^st March. Coincidentally during the exact same time the internet got flooded with insurance companies focusing on the tax free returns that ULIP investors could get. In fact, though complete data regarding this is still unavailable, it might turn out that a large chunk of the equity mutual fund redemptions during the post budget period might easily have flowed into ULIPs of leading insurance companies. But, there is actually no simple answer to which is the better option to invest in unless you specify what exactly you are seeking. In the following sections, we will compare mutual funds and ULIPs from an investor’s point of view.

Returns

ULIPs are not pure investment products unlike mutual funds. If you consider returns and only returns, especially in the long term, equity mutual funds on average have managed to outperform even the best ULIPs. The reason for this is simple – ULIPs only invest a portion of your premiums into capital markets, a major portion of the rest goes towards providing the life cover feature of the ULIPs. This in effect reduces your overall investment and lower amounts invested over time equal lower returns as the amount being compounded is also smaller. So in terms of pure return on investment, equity mutual funds are way ahead of ULIPs. Of course the playing field does get a bit more level in case you compare returns of a potentially lower risk hybrid or debt fund with that of a ULIP. This is obviously because hybrid schemes and debt schemes invest a minor and major portion of their assets respectively in fixed income instruments just like ULIPs hence their returns tend to be comparable.

Taxation

The re-introduction of long term capital gains (LTCG) in case of equities has the obvious impact of reducing your overall mutual fund returns. However, there are a few caveats to the new rule. The 10% LTCG rate is applicable only if your gains from redemption of equity scheme units and equities exceed Rs. 1 lakh during the fiscal. Any less and your equity returns are completely tax free and the 10% tax is applicable only to the amount that exceeds the Rs. 1 lakh limit. Additionally, there is the grandfathering clause that allows you tax exemption on all your long term equity investment gains made till the 31^st of January, 2018. Thus only gains accrued by your investment after that date will be taxed subject to the Rs. 1 lakh annual limit rule. In fact, this LTCG tax will probably have little impact on most small investors and they will continue to earn tax fee returns on their mutual fund investments. Additionally STCG (short term capital gains) tax at 15% on gains is also applicable for equity mutual funds units held for less than 1 year from the date of allocation. In case of ULIPs, there are no short term capital gains considerations as they have a lock in period of 5 years from the date of subscription. Any capital gains you may receive from surrendering your ULIP after the 5 year lock-in period is tax free as per existing rules. So in terms of taxation, ULIPs score over mutual funds, but considering the potentially higher returns offered by equity schemes over ULIPs, this taxation benefit might not account from much in the long term.

Flexibility

Mutual funds including equity schemes offer reasonable amounts of flexibility and allow you to switch from an underperforming scheme to a better performing scheme with relative ease. This type of switch is allowed within the same fund house and also from fund house to another. With the advent of Aadhaar-based eKYC for mutual funds and centralized KYC, switching from one mutual fund to another has become very easy and no paper documents need to be signed any more. This level of flexibility is at least at present not available in case of ULIPs and you have to surrender your existing ULIP and then subscribe to a new one with submission of relevant documents, medical examinations etc. What’s more, the older you are, the more you have to invest in ULIPs to get the same benefit – that’s because of the life insurance component that is integral to a unit linked insurance plan. So in the flexibility of investment department, those who invest in mutual fund schemes are way ahead of ULIP investors.

Transparency

When you make mutual fund investments, one of the key assurances that you have is that of transparency. At the end of every quarter you can get a complete list of all investments that your fund manager has made, changes if any in management structure, investment strategy and so on. This level of transparency especially across the entire industry is credited to SEBI (Securities and Exchange Board of India). ULIPs on the other hand being an insurance product are under the jurisdiction of IRDAI (Insurance Regulatory and Development Authority of India) so different rules are applicable. As per existing rules, ULIPs lack a uniform reporting structure with respect to their investments. Hence ULIPs in India are currently relatively less transparent when compared to mutual fund schemes operating in India.

Charges

Experts often slammed the previous generation of ULIPs due to their high charges. In the past few years, ULIPs have undergone a makeover and their charges have not only decreased, but also grown more transparent. At present, IRDAI has mandated that fund management charges in case of ULIPs cannot exceed 1.35% per annum however there are additional charges to consider here. Some of the lesser known charges that you pay as a ULIP investor include premium allocation charges, policy administration charges, mortality charges and surrender/discontinuation charges. In total these charges can easily add to up around 4% of your gains over a 5 year period and eat into your overall returns. On the other hand, actively managed regular plans of equity mutual funds have a total expense ratio of around 3%. Additionally, this expense ratio is around 0.25% lower in case of direct variants of the same funds’ regular schemes. So in terms of ROI for investors, mutual fund investments have an edge over ULIPs even if both investments gave equal returns.

Mutual Funds as an Investment

It should be evident from the above sections that as an investment option, mutual funds still outscore ULIPs, even after the LTCG for equities was introduced. The reason is of course rooted in using the “right tool for the job” concept. Unlike ULIPs that split your investment into two almost completely contrasting directions of insurance and investment, mutual funds focus on a single goal – making your investments grow. And as we have been told time and again as kids – if you focus and work towards a single goal diligently, the chances of achieving desired results from your investments are much higher. So instead of trying to mix insurance with investment through ULIPs, try a combination of mutual funds for investment with a separate term plan for insurance to get the biggest bang for your buck.