Endowment plans looking attractive post-debt funds tax mess? Think again

Traditional endowment policies come with longer lock-in periods and recurring premium payment commitments

A rollback of the long-term capital gains tax advantage on debt mutual funds has presented an opportunity to life insurance agents reeling under the tax blow dealt to endowment plans by Budget 2023. In the Budget, the finance minister, with effect from April 1, 2023, imposed tax on income earned from endowment policies at maturity if the aggregate annual premium the policyholder pays were to exceed Rs 5 lakh. So, agents and the life insurance industry went on an overdrive to get individuals to buy endowment policies before March 31, 2023.

Also read | Beware! Insurance agents pushing high-premium policies before March 31 to escape tax

Last-minute amendments to Finance Bill 2023 that made debt mutual funds less tax-efficient, however, have fuelled the hopes of a section of the life insurance industry.

“With the government removing LTCG (long-term capital gains) benefits from debt mutual funds and a few other fund categories via amendments in the Finance Bill 2023, suddenly there seems to be some optimism emerging regarding non-linked life insurance products (that is, participating and non-participating endowment policies),” securities firm Emkay Global wrote in a research note. Traditional endowment life insurance policies invest in secure debt instruments.

Also read | How Finance Bill amendment will affect debt mutual fund investors post April 1

Budget 2o23 blow to endowment plans

Effective April 1, if you pay aggregate premiums of over Rs 5 lakh across your endowment policies, the income earned (gains made) on such policies will attract tax.

Even as the insurance industry was coming to terms with this loss of a key benefit, Finance Minister Nirmala Sitharaman pulled the rug from under its competing industry’s – mutual funds’ – feet too.

Unlike earlier, when gains made on debt fund units held for more than three years attracted a concessional tax of 20 percent along with indexation benefits, April 1 onwards, the gains will simply be taxed at the marginal rate applicable to your income slab.

Long commitment, modest returns a drag on endowment plans

Despite the obvious tax edge, however, financial planners do not recommend buying traditional endowment plans if investment is your primary objective.

For one, they involve a recurring premium payment commitment – if you stop paying premiums due to a liquidity crunch in the following years, your policy could lapse.

These plans have long tenures of close to 20 years although they offer limited premium payment terms. The minimum term for a regular premium policy is at least five years, but data shows that even 61st month persistency rates are dismal across life insurance companies.

Put simply, poor persistency means a large number of policyholders choose to exit early. If you wish to wriggle out of the investment, you will have to shell out high surrender charges.

For instance, if you decide to call it quits after paying two annual premiums, you will only get 30 percent (the minimum guaranteed surrender value) of the annual premiums paid back.

Also, higher commissions and mortality charges (for older individuals) eat into potential returns, which at best can range from 5-6 percent. For instance, a Moneycontrol analysis shows, the recently-launched Jeevan Azad plan by Life Insurance Corporation of India (LIC), offers an internal rate of return of just 3.76 percent for a 30-year-old.

Also read | LIC’s Jeevan Azad: Should you buy a traditional endowment policy with assured returns?

Guaranteed, tax-free maturity proceeds may sound inviting but low rate of return is a dampener for Jeevan Azad, as is the case with most non-participating, guaranteed endowment plans

“With this increased nudge towards an exemption-free new tax regime and adding taxation on proceeds of high-ticket policies, life insurance savings products need to improve their competitiveness versus other savings/investment products. This cannot be done unless the industry acknowledges and addresses the high direct cost (operational expenditure and commissions) and indirect cost (lower persistency),” says the Emkay Global report.

Lack of liquidity in the interim is a crippling handicap, something that debt mutual funds are free of.

“Long-term, recurring premium commitments and lack of flexibility to exit remain the key challenges when it comes to endowment plans,” says Suresh Sadagopan, founder of Ladder7 Financial Advisories.

Moreover, elimination of this tax arbitrage in the next Budget cannot be ruled out.

“…this will most likely be a temporary thing and will be corrected by the next union budget. On a net basis, for below Rs 5 lakh annual premium, non-linked life insurance products, especially guaranteed non-par, become most tax-efficient. However, given the illiquidity and high surrender charges in life insurance saving products, it is not a direct one-to-one substitution of other financial products,” Emkay Global says.

Kalpesh Ashar, founder of Full Circle Financial Planners, concurs. “Debt mutual funds vs. traditional endowment plans is a completely apples and oranges comparison. For one, you need to keep your investment and insurance needs separate. Insurance is meant for protection, but the life covers these policies offer are minuscule. Further, debt funds offer you liquidity that life insurance policies cannot,” he says.

The minimum cover offered under such policies is 7-10 times the annual premium. A lower cover will mean losing out on tax benefits and a larger cover will eat into your returns due to higher mortality charges.

Limited suitability

Endowment policies – with a bonus as well as guaranteed return plans – are aimed at risk-averse individuals looking for secure returns over the long-term. Add tax benefits – under section 80C (old tax regime) as well as section 10(10D) – to the mix and they may seem like a perfect solution to their requirements and concerns of such inviduals.

“For individuals with low risk appetite who are satisfied with 5-6 percent assured returns and whose aggregate endowment premium outgo does not exceed Rs 5 lakh, traditional polices could still be a good fit,” says Sadagopan.

If the returns go any lower, then there is no case to be made, he adds.

On their part, insurers often argue that only investment-cum-insurance products can offer assured, tax-free returns of 5-6 percent over a long period of, say, 20-30 years, making them a must-have in portfolios meant for long-term goals such as retirement or children’s education.

If assured returns over the long-term are what you seek, you can also consider Public Provident Fund (PPF), Sukanya Samriddhi Yojana (SSY) and Voluntary Provident Fund (VPF) for your long-term goals.

These instruments offer partial liquidity and, more importantly, do not entail long-term, recurring premium payments.