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Life Insurance Is Not an Investment
Life insurance is the lynchpin of financial planning because it safeguards all other goals. Don't buy it for the wrong reasons.
Chosen well, a life insurance policy can protect the financial future of the entire family. But, if bought for the wrong reasons, the same policy can become a drain on resources and prevent the policyholder from meeting crucial financial goals. These wrong reasons include tax savings under Section 80C, investment for retirement and gifts for children. Traditional plans are the biggest culprits, combining low life cover with poor returns. The life cover offered is 10-20 times the annual premium while the returns are at best 6-7% (see graphic). Yet, life insurance is a favoured investment option because investors see triple benefits: tax savings, long term savings and life insurance.
Most Indians are underinsured, insurance plans are the usual suspects. Since the premiums of endowment policies and money-back plans are very high, buyers are not able to take a very high cover. For instance, a life cover of `1 crore for 30 years would cost a 30-year-old roughly `20,000 a month if he buys a traditional insurance plan. But, if he buys a term plan, the roughly `20,000 a month if he buys a traditional insurance plan. But, if he buys a term plan, the same cover would cost him about `1,000 a month.
What you should do:
Traditional insurance plans suit ultra-high-net worth investors who are looking for tax-free income under Section 10(10d). Small investors should not combine insurance and investment. Instead, a combination of a term plan and Public Provident Fund works better than an insurance policy. If you have a higher risk appetite, you could invest the savings on the premium in mutual funds which have the potential to give higher returns--though they carry some level of risk.
BUYING INSUFFICIENT COVER
Some people may think that a cover of `1 crore is too much. After all, given that most banks are offering 9% interest on fixed deposits, a corpus of `60 lakh can safely generate an interest of `45,000 a month for the family. That is correct. But, you also have to take into account the tax on this income. Even if the nominee is in the 10% income tax bracket, the tax will shave off `4,500 from this monthly income.
More importantly, you have to consider inflation. Your family's monthly expenses will keep rising with inflation. If `40,000 a month is enough to run the household in 2014, it will require `43,200 a month in 2015, and `46,656 in 2016 to meet the and `46,656 in 2016 to meet the same expenses.
If you take inflation into account, `1 crore won't seem a very large amount. If invested in an option that gives 9% post-tax returns, a sum of `1 crore will sustain inflation-adjusted withdrawals of `40,000 a month for only 25 years. The calculation as only 25 years. The calculation assumes an inflation rate of 8% per annum. While the wholesale inflation rate is lower than this, the consumer price inflation, which reflects our consumption basket more accurately, is much higher.
What you should do:
Buy a term cover that is large enough to generate inflation-adjusted withdrawals till your dependents become self-sufficient. When deciding the life cover, take into account any outstanding loans (especially big-ticket home loans and car loans) as well as other expenses such as your children's education and marriage. Remember, life insurance is very cheap when you are young. As you grow older, the premium goes up exponentially.
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