ULIPs vs. Mutual Funds – Which Is the Better Investment Option for You?

When it comes to growing your wealth, it is like choosing between two types of dishes—both can satisfy your hunger, but which one is right for you? The same debate exists between Unit Linked Insurance Plans (ULIPs) and Mutual Funds (MFs). Some swear by the flexibility and growth potential of mutual funds, while others prefer the safety net that ULIPs provide with their dual insurance-investment feature.

Both options are designed to create long-term wealth, but just like your choice between spicy and mild, picking the right one depends on your financial taste buds—what kind of risk are you willing to take, and how soon do you want to savour the returns? Let’s dive into this comparison and help you determine which one better aligns with your financial goals and risk appetite.

What is a ULIP?

A Unit Linked Insurance Plan (ULIP) is a hybrid product that combines both insurance and investment. When you invest in a ULIP, a part of your premium goes toward life insurance coverage, providing financial protection for your loved ones. The remaining portion is invested in market-linked funds, that give exposure to asset classes such as equity, debt, or a mix of both, allowing your money to grow over time.

ULIPs offer the dual advantage of financial protection and wealth creation through professionally managed investments. With more than ₹69,000 crore in renewal premiums paid up to March 2023, ULIPs are increasingly popular in India, reflecting the growing awareness of combining protection and investment under one tool.

What is a Mutual Fund?

A mutual fund is a pure investment vehicle. It pools money from multiple investors and invests in a diversified portfolio of stocks, bonds, or other securities, depending on the fund’s objectives. MFs are managed by fund managers who aim to optimise returns based on market performance. Unlike ULIPs, mutual funds do not include an insurance component.

Key Differences: ULIP vs. Mutual Funds

1. Objective

• ULIPs: The primary objective of ULIPs is to offer life insurance coverage alongside an investment. This means that while your money works towards wealth creation, your family remains financially protected in case of an untimely event. The growing popularity of ULIPs suggests that many investors value the security and flexibility they provide.
• Mutual Funds: The focus of mutual funds is only on investment growth. There is no insurance cover, so your returns are entirely dependent on the ups and downs of market performance.

2. Taxability

• ULIPs: Premiums up to ₹1.5 lakh per financial year paid towards ULIPs are eligible for deductions under Section 80C, while the maturity benefits are tax-exempt under Section 10(10D) if certain conditions are met. However, for policies issued post-February 2021 with annual premiums exceeding ₹2.5 lakh, the maturity benefits are taxable. Thus, ULIPs in general offer twin tax benefits, leading to potential for better corpus.
• Mutual Funds: Equity mutual funds are subject to short-term capital gains (STCG) tax at 20% if held for less than a year, while long-term capital gains (LTCG) are taxed at 12.5% for investments held over a year. Additionally, most mutual fund investments do not typically qualify for deductions under Section 80C.

3. Risk and Return

• ULIPs: ULIPs strike a balance between risk and return. They allow you to choose between equity, debt, index or balanced funds based on your risk tolerance, and provide the flexibility to switch between funds to manage risk over time. Thus, ULIPs offer peace of mind with the added security of life cover. In many ULIPs, the minimum Life Cover offered is 10 times your annual premium amount.
• Mutual Funds: With MFs, your returns are directly tied to the performance of the underlying assets. Equity MFs offer higher growth potential but also come with greater risks, especially in the short term. Mutual funds are often favoured by higher-risk investors aiming for maximum returns, but with higher exposure to market fluctuations.

4. Costs and Charges

• ULIPs: ULIPs come with charges such as premium allocation charges, mortality charges, fund management fees (up to 1.35% p.a.), and policy administration charges. Thus, ULIPs are structured for long-term growth while also ensuring your loved ones remain protected.
• Mutual Funds: MFs have expense ratios (up to 2.5% per year), which include management fees and operational costs. MFs do not charge any mortality charge as they do not offer the protective element of life insurance that ULIPs provide.

5. Lock-In Period

• ULIPs: ULIPs come with a mandatory 5-year lock-in period, encouraging disciplined long-term investing. This lock-in ensures that your investment grows steadily while keeping your life cover active, providing a sense of security over time.
• Mutual Funds: There is no lock-in period for open-ended mutual funds, except for certain categories like ELSS, which have a 3-year lock-in. While MFs may appear to offer higher liquidity, investors often end up pulling out investments prematurely. For instance, 50% of MF investments are redeemed within a year, thus defeating the practical purpose of long-term investing and long-term financial goals.

6. Flexibility

• ULIPs: One of the standout features of ULIPs is the ability to switch between funds as market conditions change. You can move between equity, debt, index or balanced funds without incurring extra costs. This allows you to manage risk effectively as markets fluctuate. The flexibility makes ULIPs a versatile tool for both wealth creation and financial protection.
• Mutual Funds: MFs offer a wide variety of categories—equity, debt, hybrid, and sectoral/thematic funds. However, switching between funds involves redemption and reinvestment, which may trigger taxes and additional charges such as exit load.

While both ULIPs and MFs offer flexibility and growth, ULIPs provide built-in features that cater to changing life priorities. As you approach retirement or other key life stages, you can easily shift from equity to safer debt funds within your ULIP, without incurring additional costs. ULIPs also offer significant savings in terms of tax benefits.

In contrast, mutual funds often require active decision-making to rebalance your portfolio, and switching between funds can be more complex.

For investors who prioritise safety, ULIPs offer a more secure option thanks to the life insurance component. Even if market performance falters, the life cover serves as a safety net.

On the other hand, mutual funds are geared towards those who are focussed on growth and willing to take on higher risk.

In volatile market conditions, ULIPs provide greater peace of mind due to the insurance protection and the ability to reduce exposure to market fluctuations by switching funds.

Final Thought

Choosing between ULIPs and mutual funds ultimately depends on your financial objectives and risk tolerance.

If you're seeking a product that offers both life insurance and investment under one roof along with significant tax benefits, ULIPs may be the better fit. They provide the dual benefit of protecting your family’s financial future while allowing your money to grow over time. The best 5-year returns delivered by ULIP funds easily cross 30% CAGR, while 10-year returns are 15-20% CAGR.

On the other hand, if your sole focus is on investment growth and you're comfortable with higher risks and no safety net, mutual funds might suit your needs better.

If you’re looking for a combination of security and wealth creation, ULIPs strike the perfect balance, offering the flexibility to grow your wealth while ensuring your family remains financially protected.

Moneycontrol Journalists are not involved in creation of this article.