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All about the ULIPs – new charges

Unit-linked insurance products or ULIPs are perhaps the most widely discussed and written about financial products in recent times, and not all for the right reasons. First, there was the battle over who would regulate them, and then came a series of regulatory changes to reform the product.

The changes over the past few months have come one at a time, but in rapid succession. They have far-reaching implications for investors who are considering ULIPs. Here is a look at all the recent changes in the ULIP structure and their implications for investors.

Despite all the changes announced, these products still have a long way to go on transparency and disclosures relating to their investments. Though ‘insurance’ is only incidental to ULIPs and the ‘investment’ component is the key to returns, many insurance companies are unwilling to divulge adequate details on the historical portfolios and investment strategies of the ULIPs they manage.

Changes to costs

Cap on recurring charges: Their high expense structure has been a bone of contention with ULIPs.

The IRDA has sought to remedy this in two ways. First, it fixed caps on the overall costs that can be charged to ULIP investors under two slabs, one for a tenor of up to 10 years and another for tenors of 10 years and above.

It specified that the net reduction in yield (return) to investors from a ULIP should not be more than 3 percentage points for terms up to 10 years and 2.25 percentage points for ULIPs of 10 years or more, effectively capping the total expenses insurers may charge their investors. Then, this was modified, based on the experience of policies lapsing in the initial years.

The difference between the gross and net yield for ULIP-holders is now capped at 4 per cent from the end of fifth year, and this cap progressively declines to 3 per cent by the tenth year. This will mean a lower cost structure for investors, even if they seek exit from ULIPs after the fifth year.

For instance, if you invest for five years in a ULIP that earns a 10 per cent gross return, if you withdraw after the lock-in period, the net yield would drop by four percentage points to 6 per cent. These changes are effective from July 1, 2010.

Surrender charges trimmed: One of the key features that curtailed the liquidity aspect of ULIPs was the high surrender charge levied by insurers for premature closure.

If policy-holders stopped paying premiums after two years, the surrender charges would amount to as much as 30-40 per cent of the first year premium. The surrender charges would thus reduce your overall returns substantially. IRDA has now introduced limits on surrender charges to rationalise them.

If the policy is surrendered in the first year, the charge would be 20 per cent of first year premium or Rs 3,000, whichever is lower, for an investment amount up to Rs 25,000. For an investment above Rs 25,000, the charge would be six per cent of the premium subject to a maximum of Rs 6,000.

The surrender charge progressively reduces to Rs 1,000 in case of former or Rs 2,000 in the latter, if the policy is surrendered in the fourth year. As per the new guidelines, there would be no surrender charges from the fifth year. The implication of this is that investors wishing to exit a ULIP after the five-year lock in would not suffer any additional surrender charges, only the overall expenses mandated by the IRDA.

Commission: The high commissions paid to insurance agents have been often highlighted by critics of ULIPs. The IRDA’s new regulations seek to address this through the cap on overall charges and also through disclosure requirements.

With effect from this month, the advisor’s commission in a ULIP will be automatically disclosed in the benefit illustration (the document that spells out the various charges deducted from the unit-holders premium and quantifies the net yield to the customer). It is now mandatory for the advisor to take the signature of the investor on this document.

Increase in mortality: The insurance component in a ULIP is usually quite small; however, IRDA has now sought to raise this component by specifying that ULIPs should carry a life cover for a minimum ten times of their annual premium (this was five times earlier).

Changes and liquidity

Extended lock-in period: All investments in ULIPs carry a three-year lock-in period. This will be increased to a five years from September 1, 2010. This will clearly weed out the mis-selling of ULIPs as short-term products to investors.

Given the buoyant equity market investors are often persuaded by their advisors to invest in ULIPs on the premise that these are three-year products.

With funds locked up for five years, only investors serious about building a long-term investment portfolio would consider buying ULIPs. Incidentally, ULIPs should be bought only that way, because of their front-ended expense structure.

Investors should also be conservative in deciding their premia as they are committed to the investment for several years at a time.

If they fail to pay the renewal premium and discontinue the policy in the first five years, no payment will be made till expiry of the lock-in period. Hence investors not sure of a regular income should set their premium conservatively.

For excess income, one can always add on single-premium policies.

This ensure that you will not surrender the policy within five years. If a ULIP is prematurely discontinued, your fund value on the date (after adjusting for surrender charges) will earn minimum of 3.5 per cent interest during the remaining lock-in period.

Liquidity: Even while extending the lock-in period on ULIPs the regulator has sought to improve their liquidity by introducing norms for loans against ULIPs.

In any ULIP where the equity accounts for more than 60 per cent of total portfolio, investors can be granted loans not exceeding 40 per cent of the investment’s net asset value (NAV). Where debt accounts for more than 60 per cent of the portfolio, the loan can be upto 50 per cent of NAV.

Returns: While the above changes to ULIP costs may help improve effective returns to investors, the IRDA has also laid out special provisions for pension products fashioned as ULIPs.

As per the new regulation, a unit-linked pension plan should carry a minimum guaranteed return of 4.5 per cent a year if all premiums are paid. Such ULIPs will also carry a longer lock-in period than others and no partial withdrawal will be allowed during the accumulation period.

However, on vesting date, policyholders can commute (choose to receive as lump-sum) up to one-third of the accumulated value of the fund to his credit.

Pension policy holders should ensure that they pay premium till the maturity period. In the event of discontinuation, the policyholder would be entitled for a lump-sum refund of not more than one-third of the fund value, while the remaining amount would be used to purchase annuity to ensure pension payments. You will pay tax for the pension received for your respective slab and it will bring down the net yield on the product.

How ULIPs performed

All the above measures may help lift the effective returns to investors from ULIP products. But how have equity-oriented ULIPs performed so far? Details on ULIP performance or portfolios are not as easy to come by as those for mutual funds.

However, an analysis of equity-oriented ULIPs (80-100 per cent invested in stocks) shows that over a one-year period, 56 of 62 schemes managed to outperformed such indices as BSE Sensex, CNX Nifty and BSE 100.

Over a three-year period, 21 of 28 schemes, and for a five-year period 9 out of 13 schemes, comfortably edged past BSE Sensex.

Over three- and five-year periods, the category average clocked compounded annual returns of 10 per cent and 22.7 per cent respectively, against the 5.5 per cent and 19.2 per cent recorded by the BSE Sensex (Nifty returns are 6.3 per cent and 18.1 per cent).

However, investors should note that their effective returns from ULIPs may be 3-4 percentage points lower than the NAV-based return (as ULIP expenses are adjusted based on the unit balance and not the NAV).

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