The columnist answers readers' queries about financial investment…
I have a two-year-old son. I would like to start planning for his future, financially. I see that many insurance companies offer a wide variety of Children's Plans. How good are these? What are the pros and cons?
Congratulations on taking the most important step in planning for your child's future. i.e. realising that you need to put together a financial plan before it's too late. Yes, believe it or not, many parents face a lot of heartburn when their children near high school/college-age because they failed to act early. As I have described in my earlier article on ‘compounding', when it comes to long term financial planning, investing early is sometimes more important than the actual amount invested.
Providing for your kid financially is very much an integral and emotional part of parent-child relationship. But the truth is, when it comes to making financial decisions, what is required is a dispassionate view of options. This is the only way to ensure rational behaviour and stay away from marketing traps designed especially to lure parents on emotions rather than financial logic.
Now, let's first discuss what Children's Plans are. Children's Plans are insurance-cum-investment plans offered by insurance companies. In other words, they are similar to ULIPs (Unit Linked Insurance Plans). A part of the premium is used to provide life cover for the parent and the remaining portion is invested in debt and/or equity instruments. The term period normally ranges between 10 yrs to 25 years, so that you can time your policy's maturity around the time your child reaches adulthood. Of course, some plans do allow intermediate withdrawals, but usually they come with a stiff penalty. The policy is purchased in the name of the parent and insures against the premature death of the earning parent. The beneficiary on maturity would be your child or the appointee in case your child is under 18 at time of maturity. The premiums are paid quarterly, half yearly or annually.
The good thing about Children's Plans is that they offer both insurance cover and investment benefit. They also provide a disciplined approach to save for your kids.
The problem with Children's Plans is that they come with the usual baggage associated with ULIPs. To begin with, the insurance companies tend to deduct premium allocation charges upfront. These charges are meant to pay the distributor commissions. As a result, very small portion of the premium gets invested during the initial years, which by the way are the most precious years from a compounding perspective. Also, if you opt for any features provided by the insurer like switching option etc., the charges for the same are deducted from the amount invested. Due to the above factors, the return on your principal is extremely low in the initial years and if you stop the plan without completing the entire tenure, you may even end up with a loss on principal after all the fees.
On the insurance front, these products usually provide less coverage per rupee premium paid compared to traditional term insurance. In many cases the sum assured is inadequate for the family to sustain, in case the earning parent meets untimely death. A better alternative would be to buy plain term insurance at lower premium that provides you with very high life cover. For investments, equity mutual funds or index exchange traded funds (ETFs) are the best. You can invest large amounts in these funds at very low fees. Also if the fund tends to perform poorly, you can redeem your investment and switch over to another fund, without paying any penalty.
On the tax front, while Children's Plans do provide you with tax benefits under section 80c and section 10, you can get the same tax benefits with a combination of term insurance and mutual funds.
In summary, term insurance and mutual fund or index fund combination beats the so called Children's Plans in terms of costs and returns. No doubt Children's Plans offer instant appeal to the heart, but they don't quite live up to the rationale of the mind and hence worth giving it a miss.
The writer is a finance specialist. He can be reached at firstname.lastname@example.org or www.shyamscolumn.com.