Sunday, September 24, 2006

Why one should avoid traditional endowment plans

Just wanted to illustrate with this example why Term + PPF is better than LIC guaranteed return endowment policies (or) any traditional endowment policy from any company.

In the below example, I am comparing the returns from Komal Jeevan(which guarantees 7.5% per annum bonus) against term insurance plan(for insurance) and PPF(for investments). The plans are for a 30 year old male for a sum assured of Rs.5,00,000.

Komal Jeevan Plan
Sum Assured: Rs.500,000/-
Yearly Premium: Rs.37,177/-
Total Premium Paid in 18 years: Rs.6.69 Lakhs.
Returns by the end of 26 years: Rs.14.75 Lakhs.

Term + PPF:
Sum Assured: Rs.500,000/-
HDFC SL Term Insurance Yearly Premium: Rs.1,600/-
PPF Investment Yearly: Rs.35,577/-
Total Investment(PPF + Term Insurance): Rs.37,177/-
Total Premium Paid in 18 years: Rs.6.69 Lakhs.
Returns by the end of 26 years (8% PPF returns): Rs.26.63 Lakhs.
Percentage of investment that is used to pay term insurance: 4.3% per year.

Returns from Komal Jeevan which gives Rs.37,500 bonus per year is lot less than what you get back from PPF.The reason for this is quiet simple. Endowment Plans gives bonus based on the sum assured. Your returns each year is the same irrespective of your investment. In an endowment plan there is no compounding effect on your investment, interest. Hence the returns are very low. On the other hand, investments in PPF which is guaranteed by Government of India gives 8% returns compounded annualy. The power of compounding is immense, hence your returns are almost double than what you get from an endowment plan. Even if you invest in avenues which offer compund interest of 5%(like bank FDs, RDs), you will get back Rs.15.5 Lakhs at the end of 26 years.

Lesson 1 for an Investor: Power of Compounding
Compound Interest of 5% per annum will give higher returns than bonus of Rs.75 per thousand. Please donot be tricked by LIC agents who say 7.5% bonus has been declared for that year. Bonus is purely on sum assured and not on your investment. Only invest in avenues where your returns are compounded. Stay away from traditional endowment plans. These plans are the most beneficial to the insurance agent(in terms of commision received) but are not the best plans for the investor.

Lesson 2 for an Investor: Understand your charges properly
Insurance agents use the terms 80% charges on endowment plans is better than 100% charges on term insurance. But are you really paying 100% charges on term insurance. From the above example
100 % Charges for Term Insurance = Rs.1,600/-
80% charges on Endowment Plan = Rs.29,741/-
One is paying Rs.1600 charges in term insurance while paying Rs.29,741 as charges in endowment plan the first year. But how come insurance agents say paying Rs.1600(100% charges) is worse than paying Rs.29,741(80% charges). In reality, the actual percantages are different. The total percentage of your investment that you pay for term insurance charges is just 4.3%(Rs.1600 out of total investment of Rs.37,177). The insurance agents hide the overall picture. It is your duty,the duty of the investor to understand the overall picture of charges.

Lesson 3 for an Investor: It is your Money!
What ever you invest is your money so understand where you are putting your money. Donot rush into something because someone else said so. Donot buy LIC plan just because your father said it is the oldest insurance company, most profitable and hence will offer the best returns. Do your home work. Explore all possible avenues of investment. Understand the product where you want to invest. Understand the charges, returns and also RISKS. This is no Rocket Science. All you need is pure common sense to understand most of the products. It is your hard earned money. A rupee saved is a rupee earned.

Friday, September 22, 2006

Comparision of ULIPS vs MFS (India)

Below is a brief comparision of ULIP (Unit Linked Insurance Product) vs MF (Mutual Funds) specific to the Indian market.

Primary Objective
MFs : Investments
ULIPs: Protection + Investments

Investment Duration
MFs: Works out for Medium term, Long Term Investors. Risky for Short Term investors.
ULIPs: Works out for Long Term Investors only.

MFs: Very flexible. Plenty of scope to correct your mistakes if you made any wrong investment decisions. You can easily shuffle your portfolio in MFs.
ULIPs: Flexibility is limited to moving across the different funds offered with your policy. Correcting mistakes can turn out to be expensive. Moving funds from one ULIP to an other ULIP of a different fund house can be expensive.

MFs: Very liquid. You can sell your MF units any time(except ELSS). Some MF's like those from Reliance have introduced redemptions at ATMs.
ULIPs: Limited liquidity. Need to stay invested for the minimum number of years specified before you can redeem.

Investment Objective
MFs: MF's can be used as your vechile for investments to achive different objectives.(Eg: Buying a car three years from now. Downpayment for a home five years from now. Childrens education 10 years from now. Childrens marriage 15 years from now. Retirement planning 25 years from now. Medical expenses after retirement 25 years from now)
ULIPs: ULIPs can be used for achieving only long term objectives (Chidrens education, Childrens marriage, Retirement planning)

Tax Implications
MFs: All investments in MF's don't qualify for section 80C. Only investments in ELSS qualify for 80C.
ULIPs: Provide Tax Benefits under section 80C.
MFs: Returns on equity MF's are exempt from long term capital gains tax. (Unless tax laws change in the future).
ULIPs: We are moving from EEE to EET. No clarity if ULIPs will be taxed under EET.
MFs: Tax liabilities when moving across from debt to equity funds.(Returns from debt MF's are taxed.)
ULIPs: Very flexible in moving between equity and debt funds(not tax implications until maturity of the policy).

Strings Attached(fine print)
MFs: None so ever. At most you pay a small exit load if any.
ULIPs: Some strings attached for your policy to be in effect. Minimum number of premiums need to be paid. Minimum fund balance need to be always maintained. (I personally donot like policies which say pay three years premium and get insurance cover for the next 25 years since there are a lot of ifs and butts involved. A lot of assumptions made and nothing is in your hand, it could turn out your fund balance might be exhausted after just 12 years of insurance cover).

  1. Can easily rebalance your risk between equity and debt without any tax implications.
  2. Best suited for medium risk taking individuals who wish to invest in equity and debt funds(atleast 40% or higher exposure to debt).
  3. No additional tax burden for those investing mainly in debt unlike in MFs.
  1. Better returns than ULIPs.
  2. Lower charges than ULIPs.
  3. Very flexible and enables you to switch your investments from non performing MF's to better performing MFs
  4. Very Liquid can be redeemed at anytime.
  5. Best suited for medium to high risk taking individuals who wish to invest a significant portion in equity funds(atleast 65% exposure in equities).