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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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How ‘Highest NAV Guarantee’ schemes fool you?

Posted by Muthu on June 22, 2010

ULIPs are back again. Good fortune for insurance agents and absolutely bad for investors.

When I write against Share Trading, Life Insurance Products (both traditional and ULIPs, with the sole exception of Term Plans), Portfolio Management Services (both legal and illegal) etc., the question invariably put forward by the advisor community who are selling these products are as to if the Government itself have allowed these products to exist, who am I to question them.

This is a very strange argument. Have not Government allowed selling of alcohol, country made liquor, smoking, Lottery, bull fight etc.? Many countries have legalised casinos, one night stands etc. Some Governments allow suppression of minority rights, ethnic cleansing etc. One state Government in India is accused of actively sponsoring killing of minorities. Governments in power have encouraged demolition of minority places of worship. 

Many Governments in the world actively promote ethnic cleansing, drug trafficking, arms trading etc. Have not Governments in the world which prevents equality to woman, equal rights to all races, freedom to follow various forms of worships etc.?  There are Governments which actively encourage terrorism. Just because Government is allowing some thing, does it mean it is a good thing to do? Government may allow or follow so many things. But as an Individual, it is for us to choose what is good and ethical.

People have asked me in various meetings and forums, how it is possible for an Insurance company’s ULIP to guarantee highest NAV, which a Mutual Fund cannot do.

Initially I was also caught by the surprise, but definitely I knew intuitively that it is misselling and there should be details in the fine print. Because in a product which is ‘marked to the market’, how can you guarantee the highest NAV? It is impossible. After doing some study, I realised it is nothing but a marketing gimmick. Here are the details I gathered from ‘Valueresearch’ and ‘Moneylife’.

“One after another, a number of insurance companies have launched ULIPs which promise to repay the investor on the basis of the highest NAV that the fund has achieved. The pitch is that these funds’ NAV effectively does not drop. Once a level is achieved, then the investor is assured of getting at least as much, no matter what happens to the market. It’s certainly a very attractive idea. 

Any investor who is told of this concept will immediately start salivating at the thought. Imagine how rich you could have been had you been invested over the last ten years and had been able to lock your investments at the magical value that the markets achieved on the day when the Sensex touched 20,873!

Any investor thinking about this product would say, “What a wonderful idea!” Why don’t all investment schemes-whether mutual funds or ULIPs or even portfolio management schemes offer this kind of a protection on all their products anyway?

The answer to this obvious question is simple. There is no free lunch. These products don’t actually offer what you think they are offering. That is, they do not offer equity returns that never fall. Instead, they offer an investment system with a very long lock-in (seven to ten years) in which protection is achieved by progressively putting your gains in a fixed income assets which will give returns far more slowly than a pure equity option. The lock-in and the non-equity assets make this a very different kind of investment than the equity-gains-without-losses dream that these funds’ advertising seems to imply.

First, how do guaranteed NAV plans work? The most important point to understand is that insurance companies are guaranteeing NAVs, not returns. Are the two different? Yes. NAV is a number at a point in time and returns happen over a period of time.

For instance, your 10 year plan may have hit an NAV of Rs.14, after five years. At that point, it is the highest NAV. This Rs.14 is guaranteed for the next five years. What if the NAV remains at Rs.14 for the next 5 years or goes down to Rs.13? You would still get this NAV of Rs.14. But Rs.14 happens to be 4% over 10 years! Not worth the trouble. There is no free lunch in life.

If you want to know how the schemes would work in practice, take a look. In the above mentioned example, when the NAV goes up to Rs.14, all that the manager has to ensure is that this amount remains intact at the end of the next five years. What he would do is simply invest X amount of money in the bond market so that it fetches Rs.14 at the end of 5 years. Now, whatever happens, getting Rs.14, at the end of 5 years in ensured. In the 6th year, if the market goes down, the NAV also will god won. But your Rs.14 is ‘guaranteed’ for 5 years, at a pathetic rate of return.

If the market goes up, the NAV also goes up – say to Rs,16. Now, more money will be shifted from equity to bond funds to retain the NAV of Rs.16 at the end of the balance period. Notice that more and more money shifted to debt to lock up the highest NAV. This is because to guarantee on anything, you must get a guarantee on the Principal. And it is debt is one that protects the principal amount. So, in effect what you are buying is a progressively timed debt fund.

But ask yourself what a debt fund will do to your returns. We don’t think you will get than more than 6%-7% returns on the guaranteed NAV schemes. And, most important, what will a debt fund do to your insurance / risk protection? Surely, when you want an insurance plan, you don’t want to end up with a bank fixed deposit with some insurance thrown in!

The truth is that in a growing economy like India’s it’s extremely hard to lose money over a long period like seven years. If you are willing to lock in your money for seven years, then for all practical purposes, you have a guarantee of making a profit.

However, even that’s not the real reason that these funds are useless. The real reason is that if you are willing to lock-in for seven to ten years, then practically any equity mutual fund would deliver this dream of equity-gains-without-losses. Seven years is a very long time. Over such a period practically any equity portfolio into which any kind of thought has gone would capture substantial gains. This is not mere conjecture. Since at least 1997 the minimum total return that the Sensex has generated over its worst seven is 12 per cent, which was over the seven year period from 6th July 1997 to 5th July 2004.

Of course, this is not a guarantee that is signed in a contract and legally enforceable, but it’s the kind of guarantee that any thoughtful investor would be willing to believe in. Mind you, this is also not a guarantee that you will get the highest NAV achieved but again, that’s the kind of thing that can’t be attained if you want the gains of pure equity anyway.

The most instructive thing in this whole business of guaranteed highest NAV products is the contrast between the illusions spun by those peddling complex financial products and the reality of simple, straightforward investing. It just reinforces one’s belief that financial products are being designed whose goal is nothing more than to create a marketing hype which can manipulate the psychology of the ordinary saver.

(with inputs from Valueresearch & Moneylife)

2 Responses to “How ‘Highest NAV Guarantee’ schemes fool you?”

  1. NAMAN MEHROTRA said

    SIR , I HAVE OFFERED BY HDFCSL A HIGHEST NAV GARENTED PLAN (HDFCSL CREST) SHOUL I INVEST IN IT OR NOT WITH 50000 PREMIUM p.a. WITH

  2. Muthu said

    The details given by you are incomplete. Better to go for a term insurance policy for risk cover. The balance amount may be invested. Investments may be spread across both debt and equity.Discuss with your financial advisor on debt equity allocation and modes of investment.

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