Spend, Save and Invest Smartly
You must be knowing the art of comparison. Why do you compare things in life? Isn’t this essentially to aid you in your decision making process? In finance you use the term " Opportunity Cost Of Capital ". What if you invest your hard earned resources in this particular financial instrument vis a vis another financial instrument? Which of these would give you a better return in the allotted time frame? You must have also heard the phrase " Comparisons Are Odious ". This basically means that in the case of certain comparisons the conclusions obtained do not do justice to the financial products involved. Certain products may be good in certain situations while others may be good under a different set of conditions. In the same way the comparison between the traditional endowment plan and the Unit Linked Endowment Plan depends upon the type of investor and his ability and willingness to take risks. However I will attempt to do my best to make a comparison between the two financial products. I would like to remind you that the team of Financial Planners at Moneymindz.com are always there for you to plan your insurance needs in a most effective and efficient manner. You can explore this unique Free Advisory Service just by giving a missed call on 022 6211 6588.
You must be knowing that a traditional endowment plan is one which provides insurance protection as well as investment gains. These plans provide value or a lump sum at certain critical times or phases in your life such as your children’s marriage, children’s education or your retirement. You must be knowing that these plans have quite high premiums owing to the time frame of 5-25 years involved in these plans. You must be knowing that in these plans bonuses accrue at various time frames especially with the profit endowment plan and this results in you obtaining a huge lump sum at your retirement. If you surrender this policy at an early stage you would lose heavily as these policies have very low surrender value compared to the premium paid. These plans are generally taken up by risk averse investors as a traditional plan invests mostly in debt instruments and focuses on the safety of the corpus rather than high returns. The returns of these policies are on the lower side. So Why Must I Be Careful When I Purchase The Traditional Endowment Plan? The obvious answer is the low surrender value and high charges in these policies. If you surrender this policy after a period of 3 years you will have 100% deductions on your first year premium and up to 30% will be returned to you on your second and third year premiums. If you have paid INR 50000 per annum for a period of 3 years on surrendering your policy you will get 30% of the second and the third year premium which is INR 30000.You have invested INR 150000 in this plan and have obtained only INR 30000.Don’t you think this is reason enough to be careful?
You must be knowing that the Unit Linked Endowment Plan in a similar manner as a traditional endowment plan provides insurance protection as well as an investment option. The difference is that you can choose the level of insurance cover and by default the rest of the amount is invested as an investment in various financial instruments depending on the scheme you choose. You must be knowing that the premiums paid minus the charges on this fund and the insurance component would be invested to purchase units of the unit linked endowment plan. So What Are These Units? You must be knowing that your premiums are invested in securities as per your specifications. They could be in debt instruments with a proportion of around 60% in government securities and corporate debt and the remaining 40% in money market instruments. These are known as the bond funds.
You have the balanced option where you invest not less than 30% in debt such as government securities and up to 40% in money market instruments and the rest in equities between a minimum of 30% and a maximum of 70%. You must have heard of the growth option where you have not less than 20% in government securities up to 40% in money market instruments and about 40% in equity instruments and not more than 80% in these equity instruments. The growth option is a very risky instrument but gives you a high rate of return. The funds of all investors are pooled together and after deducting the charges and the insurance and mortality cover the rest of the funds are invested in either the balanced, bond or the growth scheme and you get units based on the proportion of funds you have invested in a particular scheme. You must be knowing that one single part of the total invested amount is called a unit. The value of each unit on a given day is known as the Net Asset Value of the fund. This is basically the difference between the fund’s assets minus the funds liabilities divided by the number of the outstanding units of the fund. You must be knowing that the unit linked endowment policy guarantees a minimum sum assured of 1.25 times the single premium for a single premium policy below 45 years of age and 1.10 times the sum assured for a single premium policy for a person above 45 years of age as a higher proportion of funds is allocated towards the mortality cover due to higher risk on his age. You must be knowing that the maximum sum assured is 30 times the annualised premium for a person less than 45 years of age and 25 times the annualised premium for a person aged between 45-60 years of age for regular premium unit linked endowment plans.
Mr Sandeep a male of 28 years of age invests in Endowment Life Insurance Policy with a 30 year tenure paying a premium of INR 30000 per annum. The sum assured is INR 10 Lakhs per annum in case he dies before the tenure of the policy. The policy yields a sum assured as well as a bonus amount of INR 25 Lakhs after a period of 30 Years. Let us calculate the rate of return of this policy over a time frame of 30 Years.
Tenure: 30 Years
Yearly Premium: INR 30,000 Per Annum
Sum Assured : INR 10 Lakhs
Maturity amount : INR 25 Lakhs
Let us use the Annuity Formula to calculate the return on investment.
Future Value = Present Value * [(1+r) ^ n – 1.0] / r] * (1+r)2500000 = 30000 * (1+0.050) ^30-1)/0.050)*(1+0.050)
The L.H.S and R .H.S are almost equal.
Therefore r= 5.0%
The value of r which satisfies both the equations is 5 %.This means that return on investment obtained from an Endowment Policy is just 5.0% which is too low. The reason why an investment in the Endowment policy is preferred by people is because of the insurance cover provided by this policy. However this amount is very less and cannot provide sufficient coverage or financial protection to the dependents of the policy holder. If Mr Sandeep survives for the tenure of his Endowment policy he will get a sum assured of 10 Lakhs and maturity benefits of INR 25 Lakh, basically a return of 5%.Thus at the end of 30 Years or when Mr Sandeep is 58 Years of age he gets an amount of INR 35 Lakhs Consequently if he doesn’t survive the term of the policy returns are subsequently lesser than 35 Lakhs.
Let us consider that you take up the unit linked endowment plan. You have invested INR 50000 under the unit linked regular premium investment plan. The premium allocation charge would be 7% of the premiums in the first year and around 5% of the premium in the second to the fifth year. The mortality cover charges are INR 1-3 per INR 1000 as a life insurance cover for a person in an age group of 25-45 years. The policy administration charges are in the range of INR 30-50 per month and increases at a nominal rate of around 2-3% throughout the term of the policy The fund management charges are in a range of 0.5-0.8% per annum depending on the type of fund involved charged on the value of units held. A portion of your premium is deducted as charges and the rest is invested in financial instruments depending on the fund chosen and units are allocated to you. These units have a Net Asset Value. If you choose to invest in balanced or the bond fund you will get returns compounded annually as per debt and money market instruments rate of return. If it is a growth plan you will get a considerably higher rate of return as these have a sizeable proportion between 40-80% invested in equity .
Let us consider Mr Ramesh purchases a Unit Linked Endowment plan for a period of 20 years paying a premium of INR 20000 per annum. For illustrative purposes we consider a rate of return of 6% per annum. The sum assured is 4 lakhs .This example is for illustrative purposes only and does not include bonus accrued as well as charges deducted from your premium.
You must be knowing that the charges in a traditional endowment plan are very high. They give a very low surrender value when you want to exit these policies. Hence it is very important to know what you are looking for when you make such an investment. In the example you must have noticed that the traditional endowment plan gives returns as low as 5% and is suitable only for risk averse investors. These plans have very high charges in the initial years and these charges are conveniently ignored when we compare these plans vis a vis any unit linked plan as unit linked plans are perceived to have very high charges. They initially did have very high charges but these were considerably reduced in the September 2010 insurance sector reforms. Traditional Endowment plans continue to have high charges particularly in the first few years and you have to exercise great caution while picking up such a policy. You have to make a sure decision whether you require them or not. You might be mis sold such a policy by an insurance agent who might advise you to churn your insurance portfolio asking you to surrender your unit linked insurance policy and purchase a traditional endowment plan in order to pocket the 30-40% commission on these traditional endowment life insurance products. After reading this article you certainly know what questions to ask. You must be knowing that in a Unit Linked Endowment Plan you have a guaranteed sum assured. The charges are relatively lesser than in a traditional endowment plan. You also have the option to invest in bond, balanced or growth fund scheme depending on your risk appetite. For the risk averse they could invest in a debt scheme and for the risk takers in a growth scheme. The returns are considerably higher than in a traditional endowment plan .You have the flexibility to choose the policy term, sum assured, insurance cover and a host of other options. Since these plans are market linked they can declare bonuses in addition to your declared sum assured. They are a percentage of the sum assured and after declaration they become guaranteed .They are usually declared at the end of each year. This is for the unit linked participating endowment plan. For the non –participating endowment plan the benefits are declared at the time of purchasing the policy as these benefits are pegged to an index. Here you know both the costs involved and the benefits are obtained based on the performance of the market. Clearly the benefits of the unit linked endowment plan outweigh the benefits of the traditional plan. However in the growth option since these plans are market linked they do have market risks. You have read this article and come to know about the advantages and disadvantages of both unit linked endowment plan and the traditional investment plan. You must have seen the movie " Indiana Jones And The Last Crusade " where Indy is asked to choose wisely as he seeks the Holy Grail from among other cups by the ancient Knight Templar. You too have to choose wisely remembering all that Glitters is not Gold.