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How (not) to invest for children’s education

How (not) to invest for children’s education
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By Deepesh Raghaw  May 14, 2019 9:56:10 AM IST (Published)

When you are planning for kids’ education, your biggest concerns are: Where to invest and if something happens to you, your planned savings for the kid’s education must not suffer.

Whenever I deride an insurance and investment combo plan, I get many queries about how to invest for your kids’ education.

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When you are planning for kids’ education, your biggest concerns are:
  1. Where to invest
  2.  i.e. choosing the right product to accumulate funds for their education
  3. If something happens to you, your planned savings for the kid’s education must not suffer.
  4. For now, let’s focus on the concern no. 2. We will briefly touch upon concern no. 1 in the latter part of the post.
    Now, when we talk about the demise of the parent (and concomitant loss of income stream), the financial product that comes to mind is life insurance.
    Therefore, insurance companies have launched products with the nomenclature or the purpose to save for kids’ education. Let’s call such plans child plans.
    Any child plan will fall in one of the two following structures.
    Let’s call these Structure 1 and Structure 2.
    Structure 1
    1. The child is the life assured.
    2. You have an option to purchase a rider for waiver of premium in the event of the demise of the parent.
    3. Structure 1 is quite idiotic.
      Why, in this world, do you need insurance on kid’s life?
      Insurance companies know that too. However, the problem is that insurance companies sell insurance products. And an insurance product must have an element of insurance. They can’t sell a pure investment product.
      If they cover the parent’s life, the mortality charges will be higher because charges increase with age. That’s why they cover the child’s life. This helps reduce the impact of mortality charges on your returns.
      However, you do not need life cover on your kid’s life. Why, then, would you want to incur a single penny (as mortality charges) for the life cover you do not need?
      In the event of the demise of the parent, such plans don’t really help. After all, the parent’s life was never insured. How will the family pay the premium?
      Insurance companies have figured that out too.
      You do have an option to add a rider for waiver of premium in the event of the demise of the parent. However, the rider comes at a cost (in the form of higher premium).
      And a higher cost compromises returns.
      LIC Jeevan Tarun falls under Structure 1.  As you can read in the post on LIC Jeevan Tarun, the return on the base plan is likely to be between 6 percent and 7 percent p.a. And this is before adding the waiver of premium rider. With the rider, you can expect returns to be much less.
      LIC Jeevan Tarun is not the only plan with such a structure. I am sure there are many other traditional plans and ULIPs from other life insurance companies too.
      Verdict: It is nonsense to purchase any life insurance plan where the insurance is on the life of the child. Insurance plans with structure 1 shall be avoided.
      Structure 2
      1. The parent is the life assured. Life insurance is not on the life of the child.
      2. The plan is a type-I ULIP. Type I ULIP helps reduce the impact of mortality charges. Read this postto find out how.
      3. In the event of the death of the parent, the child gets the Sum Assured. Future premium instalments are waived off. Instead, the insurance company keeps making the premium payment on behalf of the parent. Essentially, the investment for the child’s education continues even in the absence of the parent. At the time of maturity, the child (or the family) gets the Fund Value.
      4. If the parent survives until maturity, the child (family) gets the Fund Value.
      5. There may be similar offerings under traditional life insurance plans too. However, from what I have seen, this structure is quite popular in ULIPs.
        In my opinion, Structure 2 makes far greater sense than Structure 1. Parent’s life is insured (and not the kids).  Structure 2 is easier to understand too.
        However, Structure 2 has issues that any ULIP grapples with.
        1. The life cover you purchase is a multiple of annual premium you can afford. You may end up being under-insured.
        2. Underwriting in ULIPs is quite lax. Therefore, mortality charges (money that you goes towards providing you life cover) is quite high as compared to a term life insurance plan. A term insurance plan has only mortality charges. High mortality charges eat into your returns.
        3. Your age will affect your returns.
        4. You can’t exit an under-performer. You are stuck.
        5. You can always exit after 5 years if required but that’s not enough flexibility.
        6. Point to Note
          Insurance companies may come up with very fancy structures. However, do remember everything comes at a cost.
          If a policy 1 offers better benefits than policy 2, do compare the mortality charges (and other charges) for the two plans. Quite likely, the mortality charges (as per the mortality table) for policy 1 will be much higher (even though policy 1 and policy 2 may be from the same insurer).
          How to invest for children’s education?
          Here is what you should do.
          1. Avoid any plan that has the child as the life insured (Structure 1 plan). Both traditional plans and ULIPs may have this structure.
          2. Avoid any traditional life insurance plan (both Structure 1 and Structure 2). You will get guaranteed poor returns.
          3. Purchase a pure term life insurance plan and invest the remaining amount in mutual funds, PPF, Sukanya Samriddhi accounts.
          4. Have a target for the education corpus and plan investments accordingly.
          5. The exact allocation shall depend on the age of your child (investment horizon) and your risk appetite.
          6. If you are a new investor (and your kid is quite young), you can start with a 50:50 portfolio. 50% in a balanced (aggressive hybrid) or a multi-cap fund and 50% in PPF (or SSY). Experienced investors can manage with more aggressive portfolios too.
            Do remember PPF and SSY have long lock-in periods. You can’t invest in these products (open new accounts) for short or medium term goals.
            I prefer PPF over SSY (despite better returns in SSY) since PPF offers better flexibility. In any case, SSY is available only for the girl child. And you can always have a mix of PPF and SSY for your daughter.
            Fans of traditional life insurance plans may argue that mutual funds do not offer a guarantee of good returns. Investor behaviour can also play spoilsport.  Yes, that’s right.
            However, traditional plans give guaranteed poor returns. I will still take my chances with mutual funds. By the way, ULIPs (both Structure 1 and Structure 2) also provide market linked returns (just like mutual funds).
            I will avoid the discussion on numbers in this post. I have done such analysis in my previous posts. You can refer to Post 1 Post 2. Do remember the spreadsheet analysis can never fully show the lack of flexibility in ULIPs.
            I must concede.
            Structure 2 child plans are easier to understand and relate to. You know, for sure, that the investment for child’s education will continue even if you are not around. You know you have to pay a certain amount every year and that’s it. To be honest, that’s what makes such plans attractive to many investors. And, I wouldn’t blame them for it.
            In case of a mix of a term plan and mutual funds/PPF/ULIP, after the demise of the parent, your family will get the money. However, even with all the money, your spouse still needs to make investment decisions. This may not be as simple, especially for someone who has never taken interest in finance and investments.
            However, this is one part where it is your responsibility to train them or have a trusted friend/financial planner/ investment advisor who can guide them in your absence. To start with, keep a record of all your investments and insurance policies at one place and tell your family about it.
            Taking a minor digression, there are terms plans that you can provide your family with a stream of income in addition to lumpsum payout. If you are worried about how your family will manage investments to generate income, this may provide extra cushion.
            You might argue that maturity proceeds of a ULIP are exempt from tax while Long-term capital gains on the sale of mutual funds are taxable.
            LTCG on equity funds is taxed at 10 percent while LTCG on debt funds is taxed at 20 percent (after indexation). Budget 2018 has handed this great advantage to ULIPs. However, I still prefer mutual funds over ULIPs. I have discussed the reasons in detail in this post. By the way, PPF and SSY are still exempt from tax.
             
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