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Monday, January 24, 2011

Why endowment plans are almost always a bad buy

Ulips, which were hailed by insurance agents and companies as magic wands capable of giving you the triple benefits of insurance, investment and tax-saving, are suddenly being branded unappealing, as they are market-linked and thus, volatile.

“The value of your investments in Ulips can yo-yo, so it is better to invest in endowment plans,” goes the new sales pitch. Insurance agents promise potential customers that endowment plans offer stable returns in the form of bonuses declared by an insurance company every year in addition to providing a life cover.

“Recently, I came across a case where an agent convinced a couple to liquidate their investment in a Ulip and switch to an endowment plan instead,” says financial writer Uday Kulkarni. The bait was, of course, the assured returns these plans offer.

“While people often talk about the high-commission structure of Ulips, there is little focus on endowment plans where the charges are simply not revealed. If the commissions are in the range of 8-10% in the case of Ulips, in endowment plans it could be as high as 30-40% in the first year,” he adds.

So now you know where the newfound love of agents for endowment plans comes from. What’s more, with the insurance regulator categorically ruling out measures to cap charges on traditional policies, it seems that the new form of mis-selling is here to stay. On your part, you can stonewall this old-wine-in-a-new-bottle strategy, by asking the right questions and taking a decision on what suits your needs the best on the basis of your knowledge.

Here is the truth about endowment plans.

Behind the opaque veil

By design, endowment policies are debt-heavy—that is, they invest only in approved debt or government securities, and not equities. Consequently, they cannot generate returns comparable to Ulips with an equity component.


“Most endowment policies yield returns of around 5% per annum, which, at best, could up to 6% in some cases, particularly LIC policies,” says certified financial planner (CFP) Pankaj Mathpal.

Or let’s put it this way. Even if the actual returns earned were to cross these figures, you will never know. Why, you may ask.

The answer to that question is that under endowment plans, an insurance company is under no obligation to reveal where your money is being invested or what portion of your money is being invested. In other words, the brochures of these plans do not specify the charges that will be deducted from the premium paid before investing the balance.

Of course, agents are putting this lack of transparency to good use by telling prospective customers that unlike

Ulips these plans have no charges and all their money gets invested. This is not correct. Endowment plans have higher charges than Ulips. It’s just that the insurance company is not obliged to give an exact breakdown as is the case with Ulips.

The products, therefore, lack transparency offered by Ulips, which, despite their much-maligned status, at least gave a clear indication of how your money was being used.
High charges, low returns

In an endowment policy, a policyholder is insured for a certain amount. This amount is referred to as cover (or sum assured). Over and above this, an insurance company announces a bonus, which is a certain percentage of the cover, from time to time. When the policy matures the accumulated bonus as well as the cover is paid out.

Before Ulips became popular, agents used the entire concept of a bonus to mis-sell endowment plans. So if you had taken a 25-year policy with a cover of Rs 10 lakh, and paid a premium of Rs 38,000-40,000.

On this, if a company paid a bonus of 5%, or Rs 50,000 (5% of Rs 10 lakh), the agents would go to town telling people that the bonus of Rs 50,000 is more than the premium of Rs 40,000.

Of course, what they did not tell is that this bonus is not payable immediately and also will not compound. Put another way, what this means is that if an insurance company declares a bonus of 5% for the first year of the policy, a bonus of Rs 50,000 would accumulate.

And this Rs 50,000 would stay at Rs 50,000 till the 25th year when the policy matures. This explains the low returns that should be expected from investing in endowment plans.

Ignoring the principle of compounding is primarily why at maturity, the returns are unable to break the 5-6% barrier. This is inadequate if you have a long-term horizon in mind. Remember that there are better (read more remunerative and liquid) investment avenues at your disposal.

“When someone is looking to invest for a long period of time, debt instruments (where endowment policies invest) are not the ideal vehicles. In that context, I would say endowment plans are not advisable,” feels Suresh Sadagopan, principal financial planner, Ladder 7 Financial Services.

Instead, you could look at investing the money in a diversified equity fund for the long term. Also those who are not comfortable with equity can try a combination of investing in a public provident fund and getting a term plan. As can be seen from the table on the left, that is indeed a better bet.

So, the next time your agent tries to entice you to buy an endowment policy by dangling the carrot of yearly bonus that exceeds the annual premium, remember that at the end of day, it is the accumulated corpus that matters. A simple term plan along with a large-cap equity mutual fund can do better than a complex endowment product. 

Courtesy: ET

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