Unit linked child plans: Should you buy? By Deepesh Raghaw

Every parent wants the best for his/her child. It is every parent’s wish that financial constraints do not come in way of his/her child’s education or career. Hence, when you are approached with a specific investment plan to provide for your child’s future education or wedding expenses, the product becomes too irresistible to ignore. The sales pitch is so strong that you start to feel guilty if you choose not to invest in such a product. After all, the product has everything. It has an element of insurance, offers attractive returns and if the most unfortunate were to happen, the insurance company pays all the future premiums on your behalf. How could a parent say no to such a product? As a parent, you realize that, unlike other financial goals such as purchase of a house or a car or a vacation abroad, child’s education is one goal that cannot neither be compromised nor postponed. You fall prey to your emotions and immediately sign up for the product. These combined insurance and investment products discussed above are advertised as child plans. Child plans are insurance (and investment) products that are structured to help you save for your child’s future.

There are many child plans offered by various life insurance companies. All such products have a similar structure although specifics might vary a bit. Child plans come in two variants: Unit linked insurance plans (ULIP) and Traditional (guaranteed payout) plans. Unit linked child plans provide market linked returns.

Should every parent buy a child plan for his/her child? Or are there better products available? Is a simple combination of term insurance plan and mutual funds better than a child plan? We have always maintained that you must buy those financial products that you need to buy, not what the intermediary (agent/broker) wants you to buy. Therefore, before you purchase any financial product, you must understand all its costs and benefits and compare its performance against the competing products. In this post, we shall focus on unit linked child plans and do an objective assessment of the product features and performance and assess whether such plans should be part of your portfolio. We shall discuss about traditional child plans in a subsequent post.

Similarities between unit linked child plans and regular ULIPs

Like regular ULIPs, unit linked child plans are insurance cum investment products. A part of the premium goes towards life cover (mortality charges) and other policy charges (premium allocation, administration, fund management etc) and the remaining is invested in funds as per policy holder’s discretion. Invested funds provide market linked returns. If the policy holder survives the term of the policy, the fund value is paid to the policy holder. Taxation benefits (entire premium counts under IT section 80C), liquidity restrictions (no withdrawals allowed for 5 years) and cap on charges are same as regular ULIPs. You can read about ULIP features in detail in our post here.

Unit linked child plans are, in fact, a variant of type II ULIPs. Under type II ULIPs, in the event of death of the policy holder, the insurance company pays the beneficiary both sum assured and fund value. Under type I ULIPs, in the event of death of policy holder, the insurance company pays only the higher of sum assured and fund value.

How unit linked child plans differ from regular ULIPs?

Under regular ULIPs, both death benefit(sum assured) and the accumulated fund value are paid to the beneficiary upon death of the policy holder and the policy ceases upon payment of such benefits. Under a child plan, only the sum assured is paid to the beneficiary upon demise of the policy holder and only the risk cover ceases. The fund value is paid to the beneficiary only at maturity of policy. The family of the policy holder need not pay any further premiums to the insurance company. The insurance company will pay the entire or part of all future premiums. These premiums, like other premium installments, will get invested and the beneficiary will receive the accumulated fund value at maturity.

This helps in two ways. First, this structure ensures that the proceeds from the policy do not get utilised (or diverted) towards other uses. Secondly, the fund value continues to grow even after demise of the policy holder. However, since the insurance is taking on additional risk by promising payment of all future premiums, you can expect mortality charges (charges for life cover) to be much higher than in case of a regular ULIP. Be advised, higher the amount that goes towards policy charges, the less is left for investment. Additionally, under a child plan, the policy holder or the beneficiary has an option of taking the maturity benefit as lump sum or in instalments over a few years.

Comparison with a combination of term plans and mutual funds

We have already established that a combination of term plan and mutual funds gives better performance than a regular ULIP plan in a previous post. Let’s see how a unit linked child plan fares against this combination. We will first do a qualitative assessment of how various product features will impact product performance.

Unit Linked Child Plan as an insurance product

Under a unit linked child plan, maximum sum assured is capped at a certain multiple of annual premium. Sum assured allowed under the child plan typically varies from 10 times annual premium to 40 times annual premium for people with age less than 45 years at the beginning of the policy. This is a limitation as your ability to pay premium restricts your life cover. However, your child’s future needs do not depend upon your payment ability.

Additionally, mortality charges for a unit linked child plan (for the same sum assured) are higher than a pure term insurance plan. There are two reasons behind this. First, ULIPs, in general, follow relaxed underwriting norms. Secondly, under unit linked child plans, in event of death of the policy holder, the insurer has to pay for all the future premiums. That increases the sum-at-risk for the insurance company. Thus, the cost of insurance is higher in a child plan than a pure term plan.

Unit Linked Child Plan as an investment product

Under unit linked plans, policy holders have multiple fund options (equity, balanced, debt, money market) etc for parking their investment amounts. For comparison as an investment product (with mutual funds), you need to compare the charges because charges eat into the amount that gets invested. There is no reason to believe that the investment returns will be higher in a particular product. Hence, the more funds that get allocated towards investment, the more you get in terms of maturity benefits. Under ULIPs, there are many types of charges including premium allocation, policy administration etc that will eat into the investment amount. Though the charges vary across policies, it will be around 7-8% of the premium amount in the initial years but tapers down in the later years. In addition to this, there will be annual fund management fees (capped at 1.35%). In comparison, equity mutual funds (regular plans) have expense ratio of 2-2.5%. The expense ratio for debt mutual funds and liquid funds is much lower. Under direct plans (where distributor is bypassed), the expense ratio is likely to be lower by around a 0.5-1%for both equity and debt funds. Please note that fund management charges and expense ratio are expressed as a percentage of fund value while the other charges are expressed as a percentage of annual premium.

Though it appears that the child plan has higher costs and is an inferior investment product, but we would do spreadsheet analysis and consider various scenarios to verify.

Illustration:

We compared the performance of a specific unit linked child plans against a combination of term plan and mutual funds. We picked HDFC SL Young Star Premium plan (a unit linked child plan) and HDFC Click 2 Protect Plus term plan (a pure term insurance plan). We kept annual sum assured at Rs 30 lacs, policy term of 15 years and an annual premium of Rs 75,000. Customer is a 30 year old male and a non-smoker. Under the combination of term plan and mutual funds, only a part goes towards term plan premium and the remaining is invested in mutual funds.

The child plan has premium allocation charge of 4% of the premium for the first seven years and 1% thereafter. Additionally, policy administration charge is capped at Rs 500 per month. Fund management charge is 1.35% p.a. The permissible sum assured varies from 10X annual premium to 40X annual premium for age less than 45 years. Insurance company pays all the future premiums in event of death of the policy holder. Let’s look at various scenarios.

Results are surprising for most of us. Unit linked child plan underperforms in terms of benefits if the policy holder survives the policy term. However, child plans are far ahead if policy holder dies during the policy term. The outperformance (in event of death) stems from the policy feature where the insurance company pays all the future premiums on behalf of the policy holder in event of his/her death during the policy term. Under a combination of term insurance and mutual funds, no additional investments in the fund will be made post the death of the policy holder.

All these years, you have been reading in the newspapers that the investment and insurance needs must be kept separate but here is an insurance and investment product that clearly outperforms the combination of term insurance and mutual funds. Though child plan is behind if policy holder survives the policy term, but don’t we buy insurance to ensure that our dear ones don’t suffer financially after we are gone? It is in that situation (death of policy holder) that child plan outperforms the combination of term plan and mutual funds.

So, are all the financial planners who have been deriding child plans wrong? Going by the illustration, that seems the case. Well, let’s not jump to the conclusion. Let’s consider an alternate set of scenarios. We increase the sum assured in case of term plan to Rs 45 lacs. Sum assured in case of unit linked plan remains Rs 30 lacs. Annual premium is retained at Rs 75,000 and policy term is 15 years.

In all these scenarios, the combination of term plan and mutual fund outperforms the unit linked child plan. By going for a higher sum assured (in case of pure term plan), policy holder has ensured higher death benefits, which is what you need from an insurance product. You can argue that we could have gone for higher sum assured in case of child plan too. Yes, we could have but then annual premium amount would have risen to Rs 1,12,500 (since this child plan allows sum assured up to a maximum of 40XAnnual premium). Not every parent may have this extra amount (Rs 37,500 = Rs 1,12,500 – Rs 75,000) for investment but the child’s financial requirements do not change with your ability to pay premium. Even if one has resources to pay such premium amount, we can easily outperform (through term plan and mutual funds) by using an even higher sum assured in the pure term plan. You don’t have such restrictions (on sum assured) in case of pure term plans. It is this flexibility and low cost structure in the combination of term plan and mutual funds that scores over all other insurance cum investment products.

PersonalFinancePlan Recommendation:

Unit linked child plans are certainly not as bad as they are made out to be by most financial planners. Most of us struggle with discipline in our investments. Investment in such plans can enforce serious investment discipline in customers. People find it easier to save when they have a goal in mind. Moreover, with modified ULIP guidelines by IRDA in place, these plans are not too far behind term plan and mutual fund combination in terms of overall costs and investment returns, especially over the long term. You must note all unit linked child plans are not alike and come with different cost structures and conditions. This adds to the complexity and makes it difficult to assess and compare product performance. However, the biggest disadvantage is the cap on maximum sum assured as a multiple of annual premium. In addition to cost structure, it is the lack of flexibility (beyond a point) in the choosing the sum assured that makes a child plan lose out to a term plan and mutual fund combination. Since premium paying ability of a customer may be limited, by opting for child plans, one runs the risk of remaining under-insured (too low sum assured). Hence, for its simplicity, inherent flexibility and low cost structure, term plan and mutual fund combination is a clear winner.

Be advised your child’s education is not your only financial goal. You may have more than one child. You may want to provide for your wife, siblings and parents after you are gone. So, there will be other financial goals too. You cannot buy a separate insurance policy for every possible financial goal. Hence, do not fall prey to your emotions. We recommend that you purchase a single term insurance plan that caters to all your insurance needs. You can seek advice from a financial planner or registered investment advisor to work out your insurance requirements, purchase a cheap term plan and invest the remaining funds into a mix of 4-5 mutual funds through systematic investment plans (SIP).

Deepesh is Founder, PersonalFinancePlan.in

Source : http://www.personalfinanceplan.in

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Trading Discipline: How much to trade By Deepesh Raghaw

This is our second blog post on trading discipline. In our previous post on trading discipline, we had discussed the importance of adequate risk reward in trading. In this post, we shall write about the trade sizing.

You recently landed up a hefty annual bonus and want to park these funds for quick returns. Mutual funds are too conservative for you. You want quick returns; hence long term investments in stock markets do not fit your requirements. You have seen many stocks doubling or tripling over the last 6 months and expect the bull run to continue. Hence, you decide to take short term trading positions in the market.

We want to reiterate that trading is inherently risky and requires, in addition to deep understanding of chart patterns, a lot of discipline. Be advised that trading is not a quick way to make money. Retail investors, in general, lack trading discipline and struggle to keep emotions out of trading. Therefore, we do not recommend active trading to retail investors. However, if you have decided to trade actively, we suggest you work hard towards your technical analysis skills and allocate only a small portion of your investable funds towards active trading. Do not act on tips or hot stock ideas, do your homework before entering a trade and keep emotions out of trading.

You have spent a lot of time developing your skills in technical analysis. You understand the importance of a favourable risk reward in the trade but are not sure about how big a position you should take. Should you bet all your capital on a single trade or divide the capital and take multiple trades? Well, it makes sense not to put all your eggs in one basket. However, the more important part is how much risk you are willing to take on the each trade undertaken. You put all your capital in a single trade and lose 50% on that trade or divide your capital among 5 different trades and lose 50% of each of those trades. You lose 50% of your capital in both the cases. We are not arguing that you put all of your money in a single trade. We are arguing that you must not lose 50% of your capital so soon.

Our recommendation

We suggest you should not be willing to bet more than 0.5% to 2% of your capital on a single trade. The more experienced the trader you are, the more you should be willing to bet. However, in no case, should the money at risk be more than 2% of your trade capital. Let’s try to understand this with the help of an example.

Example

Suppose you have Rs 20 lacs of trading capital (funds you have kept for active trading). On a trading capital of Rs 20 lacs, you cannot lose more than 2% of Rs 20 lacs i.e Rs 40,000 on a single trade. Suppose you want to buy Reliance Industries (RIL). Suppose RIL stock is currently trading at Rs 1,000. Using your skills of technical analysis, you have identified Rs 1100 as the target price with Rs 950 as stop loss, giving you a risk reward of 1:2. To better understand the importance of risk and reward in a trade, please read our blog post. Since you can lose a maximum of Rs 50 per share and you can only lose up to Rs 40,000 (2% of Rs 20 lacs), you can buy only 800 shares (40,000/Rs 50) of Reliance Industries for the trade. Thus, your trade size, in this case, shall not exceed Rs 800,000 (Rs 1000 per share X 800 shares). So, even if you have Rs 20 lacs at your disposal, trade discipline requires you not to take a position greater than Rs 8 lacs.

Alternatively, if you had identified a trade in XYZ stock (Current market price: Rs 25, Target Rs 35 Stop loss: Rs 20), your trade size would have been 8000 shares (40000/5). Hence the total trade size would have been only Rs 2 lacs (25 per share X 8000 shares). You can see that the size of your trade position depends on both total trading capital and the trade opportunity. In the previous trade, you could have taken a position of Rs 8 lacs but in this case your trade size is limited to Rs 2 lacs. This is because in the RIL trade stop loss was 5% below the current market price while in this case the stop loss is 20% below the current market price.

Trading is about living to fight another day

You may argue that this may cost you profits in case the trade goes right but what if the trade goes wrong. This approach limits your profits but cuts your losses too. Assume a scenario where you had put the entire Rs 20 lacs in the trade (XYZ stock) and trade had gone wrong, you would have lost Rs 4 lacs (20% of your total corpus) in a single trade. Five such wrong trades in a row and almost 70% of your capital would be wiped out. You can ask any experienced trader. It is not uncommon to get 4-5 trades wrong in a row. If that happens, would you still have the courage to take another trade in the market?  Not only would you be mentally shaken, you would be financially bruised too. Trading is all about living to fight another day. In you had followed the trading discipline as we have suggested, you would have lost only approximately 10% of your capital (even after getting five trades wrong in a row).

Even the best traders/technical analysts do not get all their trades right. It is not that they do not know their profession well. It is just that chart patterns (price and volume patterns) have associated probabilities of success. For example, theory suggests that higher tops and higher bottoms on the price chart point to a bullish price structure and hence the price (after occurrence of such pattern) should go up. However, this does not happen all the time. Sometimes, price goes down (after occurrence of such pattern) too. Markets have a habit of surprising participants. So, even though traders/technical analysts can identify the chart patterns, they can never be sure if the particular trade will go as expected. Hence, while trading one needs to guard against situations where the trade goes wrong and cut losses. That is why you would have seen expert traders on TV business channels giving buy/sell recommendations along with stop loss triggers.

Adopt a low risk approach with strict discipline

Technical skills and trading discipline play an equally important role in achieving trading success. Getting yourself up to the level of experienced traders in terms of knowledge may take some time but you can easily match them in trading discipline by being patient, exercising self-control and keeping emotions out of trading. Experienced traders may find out 50 good trading ideas in a week with 70% success ratio while you may be able to find only 10 trading ideas with 50% success ratio, but you have to be patient enough to take trades with only favourable risk reward, risk only a small part of your trading capital in each trade and book losses quickly when the trade has gone wrong. The size of your trade position should be a function of your trading capital and parameters of the trade identified (current price, target and stop loss). By taking these simple measures, you do not risk losing your capital too fast and in a few trades. You will give yourself a chance to be in the market for a longer time and a chance to make a comeback even after suffering initial trading losses.

 Deepesh is Founder, PersonalFinancePlan.in

Source : http://www.personalfinanceplan.in

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Trading Discipline: Risk and Reward By Deepesh Raghaw

Ever felt you are getting enough trading calls right, but aren’t still making significant profits? An unfavourable risk-reward ratio could be the answer. At the outset, we want to mention that trading is inherently risky and requires, in addition to deep understanding of chart patterns, a lot of discipline. Be advised that trading is not a quick way to make money. A trader must not have irrational expectations (starting out with Rs 1 lac and hoping turn it into Rs 10 lacs in a year). In order to make quick money or recover losses incurred, traders sometimes take excessive risk. Such trading is akin to gambling and is equally harmful to your finances as gambling is. Retail investors find it difficult to separate emotions from trading and are averse to book losses. They exit winning trades too early and stay in the losing trades for too long. Therefore, we do not recommend active trading to retail investors. If you are willing to take such risk, we suggest you work on your skills of technical analysis and allocate only a small portion of your investable funds towards active trading. In this series, we will not focus on technical analysis but shall focus only on the discipline aspect of trading.

What is risk and reward?

We start with the importance of getting the risk reward ratio in a trade right. Risk means the amount of your money you are willing to put to risk in a particular trade. For example, if you buy a stock for Rs 100 with stop loss of Rs 90, the maximum risk for you in the trade can be Rs 10. Reward is the potential profit that you can make from the trade. So, if your target price for the above stock is Rs 115, the reward is Rs 15. The stop loss and target levels shall be decided before entering the trade. In this example, the risk reward ratio 1:1.5 (Rs 10: Rs 15).

The stop loss levels (for limiting losses) and target levels (to book profits) are not based on whims of the trader and have their basis in the theory of technical analysis. Stop loss levels should ideally be determined based on support levels on price/volume charts. Target price can similarly be determined by identifying a resistance zone on the charts. Support/resistance zones are price levels where demand/support of a security increases to halt price decline/advance. Previous peaks and bottoms on price charts are potential support and resistance zones. Identifying support and resistance zones for a stock is beyond the scope of this blog post. You may refer to various resources available on the internet for better understanding of technical analysis and support/resistance zones.

The minimum risk reward ratio

Having the correct risk-reward ratio for any trade that you plan to enter is a must if you want to be a successful trader. The potential reward to the maximum loss in a trade should always be in excess of 1.5 (2 is ideal). The target profit from the trade shall be at the least 1.5 times the risk taken in the trade. You may be adept at reading chart patterns but if you trade with an unfavourable risk reward ratio, you are headed for big losses on your trading portfolio.

Let’s illustrate this with the help of an example. Suppose you enter 10 trades. You put an equal amount of Rs 1 lac in each of the trades. You have 1000 units of 10 different securities at Rs 100 each. Additionally, you have kept a risk-reward ratio of 1:2. This means you will exit the position if the stock drops to 90 or if the stock hits 120. Even the best traders will find it difficult to get more than 6-7 trades out of every 10 trades right. Let’s assume you get 6 trades right.

As is evident from the above example, you have made Rs 80,000 or 8% by just getting 60% of your trades right. Now let’s reverse the risk reward ratio to 2:1. This means you will exit the position if the stock drops to 80 or if the stock hits 110.

You have incurred a loss of Rs 20,000, even though you got the same number of trades right. The above example illustrates the importance of getting the risk reward ratio right before entering the trade. Even though you got only 60% of your trades right, you ended up netting a decent 8% return because your risk reward ratio was favourable.

You may have the ability to identify a lot of winning trades. However, you will still be sitting with heavy losses on your trading portfolio at the end of the year if your risk reward ratio is not right. In the same example, if your risk reward ratio was 1:3 and you got only 4 out of 10 trades right, you would have still ended up making 6%. Surprised. You are making money even when you got more than half of your trading calls wrong. By opting to enter trades with favourable risk reward, you increase your odds of making money through trading.

Recommended Trading Process

Please bear in mind target and stop loss levels have to be decided before you enter the trade. So, the trading process should be like this.

1. Identify a favourable chart pattern based on your technical analysis skills.
2. Decide upon the stop loss and target levels.
3. Enter the trade only if the risk reward is favourable.
4. Once entered, keep the emotions out and stick to the trade plan

 We advise against entering the trade with an unfavourable risk reward ratio no matter how good the chart pattern is. This is because chart patterns do not succeed all the time and have a probability of success attached to them. This is the reason even the best traders do not all their trades right. However, they are smart enough to cut their losses when the trade goes wrong. So, once you have entered the trade, keep emotions out of the trade.

In this blog post, we have highlighted an aspect of trading that is often neglected by traders. Trading discipline is as important determinant of trading success as technical analysis skills are. A favourable risk reward ratio will increase your chances of trading success. Happy Trading!!!

Deepesh is Founder, PersonalFinancePlan.in

Source : http://www.personalfinanceplan.in

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Loan against PPF Account: All you need to know By Deepesh Raghaw

In some of our earlier posts, we have discussed many great features of Public Provident Fund (PPF) account. We have shown how you can use PPF account as an excellent pension tool. We discussed the deposit limits and the benefits of opening PPF account for your children in anotherpost. We know withdrawals are possible only from the 7th year of opening the account. If you need emergency funds from your PPF account before the 7th year, withdrawal rules won’t permit that. Is there a way where you can use your PPF funds in the 4th or 5th year? Yes there is. PPF rules allow you to take out loans against your PPF account from the 3rd year. Loan against PPF account is a facility that can provide you funds in case of emergency before the 7th year. In this post, we will tell you everything about PPF loans i.e. the loan rules, eligibility, repayment terms and applicable interest rates.

When can you avail PPF loan facility?

You can take loan from your PPF account one year from the end of financial year in which the account was opened (initial subscription was made) but before expiry of 5 years from the end of financial year in which the initial subscription was made. The maximum loan amount is 25% of the PPF balance at the end of second year immediately preceding the year in which the loan is applied for. Sounds confusing? Let’s consider an example.

Suppose you open your PPF account in October 2014, you shall be eligible for the loan facility from April 1, 2016. You can avail the facility till March 31, 2020. From April 1, 2016 to March 31, 2017, you can avail loan up to 25% of your PPF balance as on March 31, 2015. Similarly, From April 1, 2017 to March 31, 2018, you can avail loan up to 25% of your PPF balance as on March 31, 2016. And so on. From April 1, 2020, you will be eligible for withdrawals from your PPF account. Hence, no further loans are allowed.

The rationale is quite simple. You are allowed to take loans till such time you cannot withdraw from the PPF account. Since withdrawal is allowed from the 7th year (5 years after the end of financial year in which the PPF account was opened), no loan facility shall be available from the 7th year.

Who cannot avail the PPF loan facility?

You won’t be eligible for loan if you have not maintained minimum subscriptions (1 per year) or not made minimum payment to your PPF account. You need to revive the account by paying applicable penalty and arrear subscriptions before you avail loan facility.

Additionally, you will not be eligible for a fresh loan till such time you repay the earlier loan along with interest. This means you cannot have 2 PPF loans running at the same time. You have to repay the first loan before you take out the second loan.

PPF Loan Repayment

The PPF loan has to be repaid within 36 months. Interest rate applicable is 2% p.a. more than prevailing PPF interest rate.  Hence, if the prevailing interest rate is 8.7% p.a., you will get the loan at 10.7% p.a. Let’s consider an example. If you PPF balance is Rs 6 lacs and you take out a loan of Rs 1 lac from your PPF account, you will have to pay interest at the rate of 10.7% p.a. However, at the same time, you will keep earning interest (8.7% p.a.) on the entire Rs 6 lacs of your corpus. Hence, the net loan cost is 2% p.a.

Please note, while comparing with interest rates for other types of loans such as personal loans, you must consider 10.7% for comparison (and not 2%). This is because you will keep earning 8.7% on your funds irrespective of whether you go for a PPF loan or any other type of loan.

The repayment of principal can be made in lump sum or monthly instalments. In a PPF loan, you first repay the principal amount. After repayment of principal, applicable interest has to be paid in not more than two monthly instalments. This is unlike EMIs (equated monthly instalments) where principal and interest are repaid (or paid) simultaneously.

In case you have repaid the principal but have not paid the interest (during the prescribed period of 36 months), the interest amount will be debited from your PPF account.

If the principal amount is not repaid within thirty six months, you will have to pay penal interest on the outstanding amount at 6% p.a. (above PPF interest rate) till such time the loan is repaid. The penal interest will debited from your PPF account at the end of each financial year.

What are the benefits?

Loan against PPF account is likely to be cheaper as compared to personal loans, credit card loans, car loans etc. Thus, in cases of emergency, loans against PPF account can prove to be a less expensive option. However, a housing loan is likely to be cheaper than a PPF loan. Secondly, you have flexibility in repaying the loan. You can repay the loan as you wish within those three years. Moreover, you will not require much documentation for taking out PPF loan. So, the process is likely to hassle-free and swift. Hence, this facility can be handy if you need the funds soon.

When should you use Loan against PPF account facility?

Ideally, you should never use it. PPF investments are typically used to build retirement corpus. This facility should be availed only in cases of emergency (medical) or to meet important life goals such as child education or marriage. You are advised to refrain from using the facility to meet lesser goals such as purchase of an expensive car or any other urges of entitlement (purchase of an item beyond your means because you think you deserve it).

PersonalFinancePlan Take

Unnecessary debt must be avoided. Loan against PPF account is no different. You must plan in a way that you do not have to use the loan facility from PPF account. However, things do not always go as planned. Therefore, you must use this facility only in such unavoidable cases as medical emergency or when there are no other funding options available to meet important life goals. You must build enough emergency corpus and take wealth preservation measures (health insurance, vehicle insurance etc) that you don’t have to dip into your PPF corpus. Moreover, if you have taken the PPF loan, try to repay the loan as early as possible (even before 3 years) to save on interest cost.

Edited: For clarification on interest rate charged on PPF loan

Deepesh is a SEBI registered Investment Adviser and Founder, www.PersonalFinancePlan.in

Source : http://www.personalfinanceplan.in

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NAV of Direct Plans is higher than Regular Plans of MF schemes By Deepesh Raghaw

In one of earlier posts, we discussed how you can avoid distribution costs by investing in direct plans of mutual fund schemes. We also established the quantum of long term savings you stood to make by investing in direct plans of MF schemes. To find out more about direct plans, read our post in Business Standard about direct plans of mutual funds here.

We have received a lot of queries on e-mail, social media forums and phone seeking clarification on direct plans. In this post, we will address some of common doubts investors have regarding direct plans of mutual fund schemes.

NAV of direct plans is higher than NAV of regular plans. You get lesser number of units.

Yes, you get lesser number of units of direct plans because the NAV is higher. And NAV of direct plans is higher than NAV of regular plans because direct plans provide better returns.

A few investors think that they are getting a better deal in regular plans because they are getting more number of units. Nothing could be further from the truth. Such approach is akin to investing in new fund offers (NFOs) because the NAV is low or in a stock because its market price is low. A low NAV does not mean that the fund is cheaper or better. In fact, it may mean quite to the contrary. A lot of investors preferred to invest in NFOs for the same reason. Fortunately, due to regulator intervention and investor awareness, most investors have shunned this approach.

While comparing two investment products, you must compare the associated risk and return levels. Since the risk is same in direct and regular plans, you must compare the return levels. Direct plans cannot underperform regular plans. It is a mathematical construct. As long as 2+2=4, direct plans will continue to outperform regular plans.  Everything (portfolio, fund manager etc) is same under direct and regular plans except the distribution cost. Since there is no intermediary in direct plans, distribution costs are avoided and that reflects in better returns.

Let’s consider an example. We will consider an investment of Rs 10 lacs each in direct and regular plans of the same scheme. We have assumed an annual return of 10% in regular plan and 10.75% in direct plan.

You can see that even though you got lesser number of units in direct plans, you still ended up with a larger corpus at the end of the year. This is because the difference between the NAVs has grown. Earlier, it was Rs 10. After one year, it is Rs 11.8. The difference in NAV will keep getting bigger.

Hence, direct plans will give you better returns than regular plans. It is a FACT.

Can I purchase direct plans under the same folio?

Yes, you can. If you have been investing through a distributor and already have a folio with a MF house, your investment in direct plans of the scheme can be kept under the same folio. So, under the same folio, you can have direct and regular plans of MF schemes. Folio number is a unique identifier for your investments with a particular mutual fund house.  All your investments with a fund house can be identified with a unique folio number.

Are you comfortable with online transactions?

If you have invested with a MF house before and have online login credentials, you can simply login into MF website and invest in direct plans of your choice.  Before the advent of direct plans, I had been investing in HDFC MFs through an online portal. I requested the HDFC MF to provide me online login credentials. You do not always have to request MF house to provide you online credentials. Most mutual funds allow login through folio number and other investor information such as PAN and bank account details. You can check the exact method with MF customer care if you are an existing investor.

Now, I can invest in direct plans directly from HDFC MF website. You can see the following snapshot from HDFC MF website:

I have struck out the folio number and investor name. You can simply select the Direct Plan and start investing in the direct plans of MF. The units purchased will be added to the same folio. “Existing Plans” are the regular plans.

What if you are not comfortable with online transactions?

If you are not comfortable with online transactions, you can visit the MF office and submit a purchase/SIP registration form. To avoid any confusion, remember to write “Direct Plan” in front of scheme name. For instance, in the scheme name field, mention “HDFC Balance Fund- Direct Plan”. You must also specify the folio number for the new units to be allocated in the same folio.

Here is the list of scenarios possible while filling out the purchase form and the treatment (available on HDFC MF website). This is the treatment by HDFC MF. Other MF houses may have a different treatment. You can find this information on HDFC MF website.

ARN code is the identifier for the distributor. While making an application for investment in direct plans, you can strike off this field or leave the field blank.

To avoid any confusion, write “Direct Plan” in front of scheme name and strike off ARN code field. The new units will be allocated under the same folio.

Going through a bank will get you invested in Regular plans

A few people have complained that they went to a bank to invest in direct plans but got invested in a regular plan. You must understand banks act as distributor/intermediary of mutual fund houses and get commissions just like other distributors. If you go to banks for investing in mutual funds, you will always get invested in regular plan of mutual fund schemes.

So, if you go to Axis Bank and invest in any MF scheme of Axis MF, you will always end up investing in a regular plan. Visit the nearest local branch of the mutual fund house if you want to invest in direct plans.

PersonalFinancePlan Take

Direct plans of a MF scheme will always outperform regular plan of the same MF scheme. However, before you invest in the direct plan of MF scheme, you need to find a good mutual fund to invest in.

Direct plans are best suited to do-it-yourself investors, who are willing to devote time and energy to research mutual funds on their own. Such investors can save costs by investing in direct plans.

If you do not have time and skill to research the best mutual funds for you, you can approach a MF distributor for advice. Though distributors will get you invested in regular plans, they will be in a position to guide you better about your MF investments. I would rather invest in a regular plan of an excellent fund than a direct plan of a mediocre fund.

Alternatively, you can seek services of a fee-only financial planner or a SEBI registered investment adviser. Such advisers/planners can help you with MF recommendations for a small fee and you can invest in direct plans subsequently.

Image Credit: Simon Cunningham/LendingMemo[dot]com, 2013. Original Image and information about usage rights can be downloaded from Flickr.

Deepesh is a SEBI Registered Investment Adviser and Founder, PersonalFinancePlan.in

Source : http://www.personalfinanceplan.in

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Say NO to Traditional Life Insurance Plans By Deepesh Raghaw

You have been looking to buy an insurance plan. You don’t want to purchase a pure vanilla term insurance plan since you do not get anything back. You have read about so many bad things about Unit linked insurance plans (ULIPs). So, you don’t want to purchase those either. You meet an insurance company representative/agent who talks about traditional insurance plans (kind of plans LIC sold to your parents or even some of us) which offer steady and almost guaranteed returns. Some people refer to these traditional insurance plans as endowment plans. You get excited. This is what you were looking for. Steady returns and life insurance cover. You go ahead and purchase the plan.

Well, you have committed a big financial mistake. By purchasing a traditional insurance plan, you guarantee yourself steadily poor returns and grossly inadequate life insurance cover. If that was your goal, then you have done just that. Congrats!!!

Where did you go wrong? You fell for this trap of steady and guaranteed returns. Traditional insurance plans are opaque, have hidden cost structures and have historically provided poor returns. Additionally, life cover is too low. A pure term plan or even a ULIP would have been a far better choice.

Traditional life insurance plans come in two broad variants. Participating and non-participating life insurance plans. Both the types are BAD and you should never invest in any of these plans. In this post, we will show you why. We will also demonstrate how a simple combination of a pure term and public provident fund (PPF) is far better than these traditional life insurance plans.

Before we move on to different types of traditional insurance plans, let’s first discuss a few common life insurance terms.

Common Life Insurance Terms

Maturity benefit is the amount that the insurance company pays you if you survive the policy term. Death benefit is paid to the nominee if the policy holder dies during the policy term. Sum Assured is the minimum death benefit.

Policy payment term is the number of years you pay the premium. Policy term is the number of years you are covered under the insurance plan. You get the maturity benefits after expiry of policy term. Policy term and premium payment term can be different.

Non-participating Insurance plans

Under such plans, you are aware of the death and maturity benefits upfront i.e. maturity amount is guaranteed upfront. So, you know upfront how much you are going to pay (in premium) and what you are going to get at maturity/death.

We have picked up a non-participating insurance plan ICICI Pru Assured Savings Insurance Plan to explain you the product features.

Maturity benefit = Accrued Guaranteed Additions (GA) + Guarantee Maturity Benefit (GMB).

Death benefit = Highest of (Sum Assured + GA, GMB+GA, 105% of sum of premium paid till date)

Sum Assured = 10 times the annual premium

Accrued Guaranteed Addition (GA): It is 9% for 10 year policy term and 10% for 12 year policy term. GAs will be added to the policy at the end of every year. Annual Guaranteed addition = GA rate* sum of all premiums paid till date.

Guaranteed Maturity benefit (GMB) is set at policy inception and depends on policy term, premium payment term, premium, age and gender. GMB will be known to you upfront. The details about GMB calculation are provided in the policy brochure.

Let’s consider the following example. A 30 year old male chooses a premium of Rs 50,000 per annum for a policy payment term of 10 years and policy term of 12 years. This means the policy holder will pay Rs 50,000 per annum for 10 years and will get the coverage for 12 years. Sum assured will be Rs 5 lacs. GMB will be Rs 3.18 lacs.

If the policy holder survives the policy term, he/she will get the maturity benefits. The maturity benefit will be Rs 693,269. This is composed of GA (Rs 375,000) and GMB (Rs 318,269). The net return is 4.35% p.a.

If the policy holder dies after 5 years, his/her nominee will get Rs 5.75 lacs.

You can clearly see that the returns are poor. In an insurance product, we can live with poor returns. Term plans provide zero returns. The bigger problem is the amount of life cover. For someone who can spare Rs 50,000 per year towards life insurance premium, he/she would want a better life style for his/her family than Rs 5.75 lacs can buy. So, with such products, you get guaranteed poor returns and low life cover.

Comparison with PPF and Term plan

Let’s try to build a product that provides similar risk and tax benefits as a non-participating plan does. Non-participating plans provide both insurance and investment benefits. We will pick up a pure insurance product and a pure investment product.

A term plan provides a pure life cover. There is no element of investment in a term plan. If the policy holder survives the policy term, nothing is paid to the policy holder. If the policy holder dies during the policy term, the nominee of the policy holder gets Sum Assured. We pick up a term insurance plan from ICICI Prudential (ICICI Pru iProtect Term Insurance Plan).

To take care of the investment part, we pick Public Provident Fund (PPF). PPF provides guaranteed returns (although Government announces the return every year). Hence, there is little volatility from PPF investments.

A combination of term plan and PPF will provide the same tax benefits as the non-participating plan. Insurance premium for non-participating plan qualifies for deduction under Section 80C. The maturity and death proceeds are exempt from income tax. Both term insurance premium and PPF investment can be claimed for deduction under Section 80C. Interest from PPF is not taxable and proceeds from PPF are tax-free. Hence, a non-participating plan and our combination of PPF and term provide exactly the same tax benefits.

We could have picked up mutual funds (instead of PPF) as mutual funds are better suited for long term investments. However, the risk characteristics of mutual funds and a non-participating plan would have been different. MFs carry far greater risk.

For the same 30 year old male, we take a life cover of Rs 50 lacs (greater than Rs 5 lacs in the non-participating plan). The premium for a term of 15 years will cost Rs 5,985 (inclusive of service tax). We invest the remaining amount in PPF (Rs 44,015) every year. Let’s compare the returns.

You can see simple combination of term plan and PPF beats the non-participating plan in each and every scenario. You would have got better returns if you had purchased a term insurance and invested the remaining amount in PPF (Public Provident Fund) account. Not only that, your life cover is much higher under a term plan.

We have always recommended keeping your investment and insurance needs separate. This above table just shows why. With the non-participating plans, you guarantee yourself poor returns and a low life cover. Why would you want to purchase such a product?

Participating Life Insurance Plans

Under participating insurance plan, only a minimum amount is guaranteed (upfront) at maturity and the rest depends on the quantum of bonuses announced over the policy term by the insurance company. The level of bonus depends on the performance of the participating/life fund.

What is a Participating/Life fund?

Let’s see how it works. Premium amount from the participating plans is pooled into a fund (participating fund). Every year, based on the investment performance of the fund, insurance company generates surplus returns. The surplus, if any, also depends on insurance claims of the participating plans, existing contractual obligations, future bonuses and actuarial assessment of the surplus. IRDA has mandated a minimum 90% of the surplus to be distributed among the policy holders as bonuses. Since the assessment of surplus is so subjective, performance of a participating plan is difficult to predict.

To confuse you further, there are many kinds of bonuses. There is simple reversionary bonus, compounded reversionary bonus, special reversionary, terminal bonus, interim bonus, loyalty addition and a few more. Enough to keep you confused and unduly excited.

Once declared, these bonuses are guaranteed and paid to the policy holder/nominee at maturity/death. These bonuses are not really hefty. You will get 2.5% to 3.5% of the Sum Assured per year. An insurance company may or may not declare bonus every year. Hence, there is no guarantee of bonus every year.

Problems with Participating plans

Hidden cost structure

There is no mention about the cost structure in policy brochures of traditional participating plans. There is no mentioned about agent commissions, fund management fees, policy administration charges etc. In absence of such information, it is difficult to do return analysis, even if you make assumptions about the performance of the participating fund.

Lack of transparency

It is not exactly clear how the performance of a participating fund translates to bonuses for the policyholders. For customers, a participating plan is as good as a black box. Every year, a bonus amount would pop up. You wouldn’t be able to figure out how. At least, I couldn’t. Where there is lack of transparency, you can be rest assured that customer will make the least amount of money in the entire value chain (agents, insurance company and the customers).

You can look at historical bonuses for a particular plan to get an idea of returns. Such plans typically provide 3-6% p.a. compounded returns, which is quite low over the long term.

Comparison with PPF and Term plan

We pick LIC New Endowment Plan and we will compare its performance with a combination of term plan and PPF.

Under LIC New Endowment Plan,

Death/Maturity Benefit= Sum Assured + Vested Simple Reversionary Bonus + Final Additional Bonus, if any

Simple reversionary bonus (declared annually) and Final Additional Bonus (one-time) are not guaranteed.

For the last two years, LIC has paid simple reversionary bonus of Rs 38/per Rs thousand of Sum Assured. At this rate, on a sum assured of Rs 10 lacs, you would Rs 38,000 as bonus every year. Please note that this will be paid to you only at maturity. And there is no element of compounding. So, at this rate, your total bonus at maturity will be Rs 5.7 lacs (Rs 38,000 X 15 years). This bonus can be greater or lesser than Rs 38 (per Rs 1000 of sum assured) and may even vary across years.

Final Additional Bonus (FAB), if any, is a one-time bonus and is paid in the year of claim or at maturity. This bonus is not guaranteed and you may or may not get this bonus. The FAB is paid at maturity only when the policy is in force for at least 15 years. We have considered the information about bonuses available on LIC website and a few other online resources available. For a policy term of 15 years and Sum Assured of Rs 10 lacs, the FAB mentioned was Rs 20 per Rs thousand of Sum Assured. It may be greater or less.

With this information in hand, let’s see how the plan performs as insurance and investment product. For a 30 year old male and Sum Assured of Rs 10 lacs for a policy term of 15 years, the annual premium is Rs 67,070 (exclusive of service tax). We will assume simple reversionary bonus to be Rs 38 per thousand of SA and FAB to be Rs 20 per thousand of SA.

You can see PPF and term plan combination outperforms a participating plan in every possible scenario. So, we do not see any rationale in purchasing participating life insurance plans. The participating plans are no good either as an insurance product or as an investment product.

Traditional life insurance plans have heavy surrender penalty

A traditional plan (whether participating or non-participating) acquires surrender value after premium has been paid for three years if the premium payment term is 10 years or more. That means you get nothing back if you surrender your policy before premium instalments have been paid for three years. Even if you surrender after 3 years, you get back only a fraction of your total premium payments.  If the premium payment is less than 10 years, the plan acquires surrender value if the premium has been paid for two consecutive years. So, the penalty for surrendering/cancelling traditional plans is extremely high.

PersonalFinancePlan Take

We advise to keep your investment and insurance needs separate. By mixing these two, not only do you consign yourself to lower returns but also run the risk of remaining underinsured.

The only reasons why you can end up purchasing a traditional life insurance plan are the lack of knowledge on your part or remarkable salesmanship on part of the salesman or both. Insurance products require long term financial commitment. So, if you purchase such products, you will be reminded of your mistake every year at the time of premium payment.

Though we do not recommend unit linked insurance plans (ULIPs), you can still make a case for investment in ULIPs as the cost structure becomes quite competitive after a few years.

With traditional insurance plans, you do not have to think much. Simply say NO. There is no element of subjectivity. Such plans offer poor returns and provide low life cover. There is no reason why you should purchase a traditional insurance plan. Stay away from traditional life insurance plans. These are neither good as an insurance product, nor any better as an investment product.

What do you do if you have already purchased a traditional plan? You do not plan to continue paying the premium. However, if you surrender/cancel the plan, you face heavy surrender charges and a possibility of reversal of tax benefits availed under Section 80C. Heavy surrender charges eat away most of your premium instalments already paid. You don’t want to continue and you don’t want to cancel. What should you do? We will address this issue in one of our subsequent posts.

Please understand the problem does not lie with ICICI Prudential Life Insurance Company or LIC or HDF Standard Life. The problem lies with the product structure itself. You can pick up a traditional life insurance plan from any life insurance company. The plan will be as bad. However, the insurance companies will keep selling as long as you keep buying such plans. So, you have to learn to say NO.

Image Credit: Moolanomy, 2012. Original Image and information about usage rights can be downloaded from Flickr.com

Deepesh is a SEBI Registered Investment Adviser and Founder, PersonalFinancePlan.in

Source : http://www.personalfinanceplan.in

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