ULIP Exits and the Sunk Cost Fallacy

Deepak Shenoy
Atlas Invested
Opinions - IN

My last column, 'The ULIP War', has yielded a number of responses from anxious readers asking me if I would recommend exiting from ULIPs (Unit Linked Insurance Plans) they already own. I wish there was an easy way out like saying 'yes', but there are no blanket answers. The only correct answer is 'it depends'.

People seem to want to exit ULIPs for, largely, two reasons - either they trusted people who made them buy such policies in ignorance, or they were looking to only invest for a few years and exit anyhow.

So a ULIP holder can:

* Stop paying any further premiums, and consider withdrawal immediately or within a few years.

* Continue the policy, paying further premiums till a point where exit or continuance can be considered afresh.

Stopping further premiums is a knee-jerk reaction. Most ULIPs are designed so that if you stop prematurely there is a significant hit to your 'fund value'; each product has its own idiosyncrasies. Since such surrender charges tend to diminish over time, it might actually make sense to continue your policy.

For instance, in one policy I consider, they mention that should you discontinue paying premiums within three years of starting the policy, they will hold your money until the three years are complete and then pay it back to you after deducting surrender charges. If, like most normal people, you think a small surrender charge is no big deal, the very next page tells you the charge is 75% in the second year, and 50% in the third year, effectively burning a significant hole in your pocket.

Look further. As the brochure says, 30% of your first year's premiums have already vanished through a 'Premium Allocation Charge'. A complex 'Fund Management Charge' results in the loss of about 6% of your premium, additionally. So a person paying Rs. 100,000 annual premium will, after one year, have this kind of decision to make:

* After year 1, I've paid 100,000. I have lost 36,600 to charges, and the remaining amount after some gains is Rs. 70,000.

* If I stop paying any further premiums now, I stand to lose another 75% as surrender charges, and I'll have to wait another two years to get what's left.

* That means if I exit right now, I'll get only about 17,500 out of the 100,000 I invested.

* If I continue to pay premiums for just one more year, and I do similar calculations, including future charges: assuming a 10% gain on my portfolio, I would've invested 200,000 and will get back about Rs. 88,000.

* For another two years, I'll have paid 300,000 and will get back 222,000

* After five years, it starts to make me 'positive' - that is, I invest Rs. 500,000 and get back Rs. 572,000. The main reason - surrender charges after paying five premiums is zero.

What it really means is that all other things being equal, it's better to stay invested for the five-year term in this policy and then consider an exit, because before that date, you lose money in exit charges. While you may have been sold the policy on the idea that you have to pay just three years of premium, the optimal date for this policy is five years. It will differ from policy to policy.

In another case, the insurer charges 100% of the first year's premium as charges. After one year, you have zero in your fund account; which should make the decision very simple - leave now, and incur no further costs.

(A technical issue to consider here is that the first year's premium is actually returned to you after 15 years, if you really want to continue to pay premiums that long, or wait that much. Given their costs are higher than competitive products - mutual funds - in subsequent years, you will make a better return should you exit in the first year and buy those other products instead.)

Note: See a full spreadsheet of both products here. Observe that I don't recommend exits: Exits should be considered with an analysis in mind.

This 'exit after the first year' is a leap of faith for many. Effectively, they would have lost the entire amount of money, and we are psychologically averse to taking a loss. This is categorized as a 'sunk-cost fallacy'. We want to continue the policy even though we have, under all circumstances, lost all the money we have already invested, and continuing the policy is actually much more inefficient compared to saying goodbye and investing in other products instead.

An example of a sunk cost is evident in business - many projects are continued despite all evidence pointing to the fact that there is no further business case for it -- (The Concorde fallacy.) Or, you pay a lot of money to buy a 'membership to a five -star hotel, which offers you discounts - and then you keep wanting to go back there to 'recover' the money, even if you're bored stiff of the food, or it's priced too high even after the membership discount.

Buying timeshares with a large sum upfront also preys on a similar concept - once you buy in, you will rework your holidays according to the timeshare's availability, going to places you might not otherwise go, because you've paid all that much in advance and by golly, you're not going to lose any of it. Except it was lost the minute you paid for it.

In a way, this is throwing good money after bad, and is usually done to satisfy that part of our brain that is wired to avoid losses; it's not rational, but it's the way we are.

Note also that the decision to stay in a policy, like in the first example above, is justifiable because the initial investment is not necessarily a sunk cost; there are no better options available that would make returns better. For instance, quitting in year 1 and putting subsequent amounts in a mutual fund still does not make more sense than continuing on with the policy for five years, because the 'gain' that happens in year 5 because of dropping surrender charges outweighs the loss you take now. On the other hand, the '30% policy allocation charges' are sunk; regardless of what you do now, it's gone.

The problem, unfortunately, is that many such policies, which make sense for a long-term investor, have been sold with the short term in mind. People are told to pay for just three years and you'll see a lot of money. While it is evident now that will not happen, bidding adieu to the product now versus a few years later will depend on a number of factors that are specific to your situation: the surrender charge schedule, additional costs going forward, comparable completion and your ability to continue paying premium. It's sad that products are this complicated, but that is our current reality. I hope there will a less muddled tomorrow.

Deepak Shenoy trades the Indian markets and writes at Capital Mind. He's also working on an upcoming stock market site. You can reach him at deepakshenoy@gmail.com or @deepakshenoy.