All you need to know about ULIPs

Here's why ULIPs have become an attractive long-term investment option

ULIP, or unit linked insurance plan, is a word often used in both the insurance and investment industry. A ULIP is a financial instrument which performs a dual role.

It provides a life cover for the person for whom it is bought and it also acts as an investment mechanism similar to mutual funds. Earlier ULIPs had proved as a not very beneficial investment instrument due to the high charges levied by the insurance houses, but IRDA had stipulated strict guidelines in 2010 to safeguard and protect the investors. These guidelines have made ULIPs an attractive long term investment option.

How does it work?

A portion of the policy premium amount is set aside for the insurance cover. The rest of it is invested in debt and equity as per the investor's preference. X number of units are allocated (in a manner similar to mutual funds) depending on the NAV (net asset value) of the ULIP at the current market rate. Typically ULIPs provide the investor with three main investment categories: equity, debt, and balanced or hybrid (equal exposure to both equity and debt).

The intent is that the investor is provided with the flexibility to leverage advantages provided by both the debt and equity markets. When the interest rates have hit a low and an upward trend starts emerging, the investor can use it to their benefit by switching the portfolio allocation to a predominantly debt one.

Similarly, they can shift to an equity oriented one when the equity markets are on an upward swing. Every year a few stipulated numbers of switches in portfolio are free of cost beyond which the fund house may charge a fee for switching.

There are two kinds of ULIPs: Type I and Type II.

Type I will give the higher of either the fund value or the sum assured in case of death, while Type II ULIPs will give both.

There is a minimum lock in period of 5 years after which partial withdrawals are allowed.

Sum assured and other associated charges

Previously the minimum sum assured was kept at 5 times the annual premium but now it has been increased to a minimum of 10 times the annual premium if the age of entry is before 45 years, and at 7 times the annual premium for entry thereafter. For single premium payments it is 125 per cent of the premium amount or 110 per cent of the premium amount for age of entry below 45 and above 45 respectively.

IRDA has capped the maximum combined charges on premium allocation, fund management, and mortality at 2.25 per cent per annum for the premium paid for the first ten years of the policy. Further, the limit on fund management fees is 1.35 per cent per annum.

In case a policy is surrendered before its full tenure, the surrender charges cannot exceed Rs 6,000.

Furthermore, agent commissions are restricted to 15 per cent in the first year, 7.5 per cent in the second year, and 5 per cent from the third year onwards.

Tax benefits

 The premium paid under ULIPs is eligible for tax deduction under 80C in accordance with the cap on the 80C amount. However this is valid only if the sum assured is 10 times the annual premium. Hence single premium ULIP policies will not qualify for any tax benefits.

Similarly if an investor does not continuously pay the premium for their ULIP policy for 5 years, then the years for which they had availed tax benefits will be adjusted and the benefits will be negated.

There is no tax either on the partial withdrawals made after 5 years of lock in or on the maturity amount, as long as the sum assured is 10 times the annual premium. This again implies that single premium policies will be taxed on maturity.

Who can invest?

Anyone looking to stay invested long term can invest in ULIPs. By long term we mean a horizon of 8-12 years.  A person investing in ULIPs should look to pay all the premiums as that's when the returns will be higher. Even though the agent may state that one need not pay the premium after 5 years, it is best to pay the premiums to reap the benefits.

ULIP pension plans are a good retirement option to consider as there is a minimum guarantee of assured returns along with a compulsory life or health cover. At the time of maturity the investor has the option of taking one-third of the corpus while the rest is invested in annuities which give regular returns.

ULIPs are a good investment option if the investor is investment savvy and can manage their portfolio. They should be able to spot trends and keep swapping the fund allocation.

Anil Rego is the founder and CEO of Right Horizons, an investment advisory and wealth management firm that focuses on providing financial solutions that are specific to customer needs.