Sunday, June 12, 2005

Mutual Funds - Make Your Own Unit-Linked Insurance

Much is written and said nowadays about unit-linked insurance, which is touted as one of the best savings schemes for the retail investor, especially one with some appetite for risk.

Unit-linked insurance plans are essentially bundled savings offerings that combine the risk cover of insurance with stock market-linked returns of a mutual fund. These schemes are likely to generate superior long-term returns to the traditional endowment policy while allowing the individual to retain the tax benefits available on insurance – a win-win situation. As with any market-linked instrument there is a modicum of risk attached but over the long term that insurance policies are (or should be) held, the chances of loss are negligible.

There is a catch, however. Unit-linked insurance plans are always offered against funds managed by the insurance provider, which might not be among the better-performing options available in the market. Therefore, while you would be better off than if you invested in an endowment policy, the returns could have been higher. And the power of compounding is such that over the twenty-year period of the average insurance policy, a difference of even one percent could mark quite a significant increase in the size of your nest egg.

Do-It Yourself

Ideally, we’d like to have our insurance linked to the returns of the market-leading mutual fund and there is a way to achieve this. The solution lies in term assurance.

Term assurance is a no-frills insurance that covers risk, full stop. There are no returns – even your principal will not come back. However, the premium payments are really low, much lower than with the savings-oriented insurance schemes, and the same tax benefits are applicable. Such a pure-risk insurance plan offers us the ability to manufacture our own ‘unit-linked’ insurance, but this time with any fund of our choice.

A Step-by-Step Guide

  • First decide on the amount of insurance you want to take on a unit-linked scheme and calculate the premium you’d need to pay
  • Then figure out the term assurance premium of an equivalent amount. This would be significantly lower. Take out a term assurance policy for that amount.
  • With the money you have left over – and this is where the beauty of the scheme lies - set up a Systematic Investment Plan (check out my previous post on SIPs here) in any fund of your choice. You’d generally prefer a market-leading diversified equity fund with a long and successful track record, like Franklin Bluechip.
  • If your policy and SIP renewal period is the same (usually annually) then you need to take little extra effort over what you’d have done for a standard unit-linked insurance
  • Sit back and relax – you’re almost certainly going to save more than with any unit-linked insurance scheme

Caveat Emptor!

Thanks to my wife for pointing this out:

Before you rush off to put this idea into action, remember that tax benefits would be available only on the insurance allocation, not on the mutual fund investment. Hence the plan might not hold as much charm for those who purchase insurance for tax benefits alone.

5 comments:

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Anonymous said...

Amit...one point though; where ULIPs help is to bring in huge discipline into wealth creation; while one signs up an SIP for 1-yr or 2, it may be stop in future. With ULIPs one is forced to keep making the annual premium becos if u stop (especially early) most of ur past premiums get wiped off. Essentially while I agree that 1-1.5% difference has a significant compounding effect, the 1% lesser yield is the cost paid for bringing discipline in investing - cheers, Badri

peyote said...

There is also a commonly held belief that not most SIPs last more than 3 years.

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