Will ULIP debt funds offer better return if RBI cuts key interest rates?

Financial advisors warn against mixing investments with buying insurance policies. Traditionally, ULIPs draw flak for their high-cost structure, including charges levied on premium allocation, policy administration, mortality and fund management. “However, in many new-age ULIPs, these charges have been reduced to nil in a bid to attract policy buyers,” says Deepak Jaggi, Co-Founder & Managing Director at Satco Wealth.

Also see: How to choose the right annuity plan in NPS?

Most insurance companies offer ULIPs with zero allocation charge and invest 100 per cent of the premiums in funds. They deduct the bare minimum charges, Jaggi adds. However, what cannot be wished away is the mortality charge. If you do not need the life cover and are treating ULIPs only as an instrument of investment, bear in mind that these mortality charges will eat into your returns.

Why are ULIP debt funds more attractive?

The amendment to the Finance Bill 2023 took away the indexation and long-term capital gains tax benefit from debt mutual funds, making them on a par with fixed deposits' (FDs) returns offered by banks.

The maturity proceeds received from ULIPs enjoy tax-free status subject to certain conditions. The rule stipulates that after a lock-in period of five years, the maturity amount is tax-free if your annual premium for ULIPs is up to Rs 2.5 lakh. Hence, ULIPs' debt funds are more attractive for small investors than debt mutual funds and FDs.

The proceeds from ULIPs will lose their tax-exempt status if the total premiums for all ULIP policies (single or multiple) surpass Rs. 2.5 lakh annually. Capital gain tax is applicable on those maturity proceeds. (Read here: I-T department clarifies taxation rules of ULIP maturity proceeds). This makes ULIP debt funds are more attractive for small investors than the debt mutual funds and bank FDs.

Also see: MC30 Fund pick: This debt fund will help you benefit from likely interest rate cuts

On the flip side, the options available under ULIPs are limited. “ULIPs offer limited flexibility in investment choices, as compared to debt mutual funds, which offer a broader selection and allow investors to select funds based on their preferences” says Kartik Sankaran, Founder, Fiscal Fitness. Debt mutual funds provide as much as 18 sub-categories, he adds.

Switching facility

ULIPs offer the flexibility to switch between funds enabling the policyholders to use the asset allocation strategy efficiently to create long-term wealth. “Arguably, a ULIP’s biggest advantage is to allow free switches between equity and debt funds without the need to pay capital gains tax and exit loads till its maturity,” says Jaggi.

“Switching among asset classes without tax implication is an advantage in ULIPs that matured investors can use to rebalance their portfolio by changing investment preferences and risk profile,” says Peeyush Pandey, a Bhopal-based registered investment advisor. Debt and equity portions can be parked in  funds under these two buckets, advises Pandey.

Also see: How ‘bucket strategy’ can ensure regular income after retirement, while protecting nest egg

Majority of ULIPs provide free switches. But some insurers levy a nominal charge of Rs 100 per switch, says Jaggi.

There is another caveat. If your mutual fund underperforms, you can easily redeem the units and invest the proceeds in a better-performing fund. In the case of a ULIP, you are tied to the company and its fund managers. You can surrender your ULIPs if you are dissatisfied with your fund’s performance, but will still hit the five-year-lock-in hurdle.

Should you invest in ULIP debt funds ?

Experts advise that allocation to ULIP debt funds should be in line with your long-term asset allocation strategy. “Since insurance is a long-term product with premium to be paid  for a minimum of five years, buying a plan just to take advantage of peak interest rates is not the right way to allocate funds,” Jaggi advises.

Also see: NPS debt funds shine over long run beating MF counterparts comfortably

Pandey says it is prudent to rebalance the ULIP debt investment in your portfolio while factoring in changing investment preferences and risk profile. These factors ensure the stability and safety of your portfolio, he adds.

How are ULIP debt funds categorised?

As per Morningstar Investment Research India, they are categorised under the following funds: liquid, ultra-short duration, money market, short duration, long duration, medium to long debt, and government bonds.

Short-duration funds invest in debt securities with residual maturity between three and five years. They generate income from both accrual and duration strategy.  For instance, Edelweiss Tokio Life-Bond fund has invested about 69 per cent of the assets in corporate bonds and about 23 per cent in government security (G-sec) as of September, 2024.

Similarly, one of the top performing long-duration bond funds — ICICI Prudential Life-Protector Fund II — invested 54 and 42 per cent, respectively, in G-sec and corporate bonds, as of September, 2024.

See here: Should retirees invest in tax-free bonds in secondary markets?