Life Insurance vs Mutual Funds - Which Is Better?

First things first - investment and insurance simply don't mix. Mutual Funds are investments, and life insurance has barely anything to do with investments. Ironically enough, a majority of Indians consider life insurances to be safe, ideal and the best investment option. The general tendency is to keep a distance from Mutual Funds, which are regarded as "risky" investments. This attitude can be attributed to general ignorance and lack of foresight.

However, investing into the right tax saving fund is a common objective of all working individuals, yet a majority of the Indian working populace is forever confused. So, let's start from scratch by attempting to comprehend the difference between the two before determining which tax saving fund is ideal to invest in.

What are Mutual Funds?

Mutual Funds are professionally managed investments - a managed portfolio of stocks and bonds. Simply put, mutual funds are like baskets containing a diversified blend of stocks and bonds from various companies across different industries. When you purchase a mutual fund, you are basically buying one of these baskets that contains dozens (or even hundreds) of stocks from numerous companies. This is quite different from how stock market invesments work.

However, you don't get to buy a basket and lock it away for a certain period. As these are professionally managed investments, the fund managers decide what proportions of stocks your basket should store after carefully researching and predicting the market growth. They constantly shuffle the goodies in your basket to make sure that you profit from the market fluctuations. On an average, you can expect a steady annual return of at least 8% on these investments. 

So, even if you are a risk-averse person, your money isn't at stake, and you can peacefully invest in these products for a long term. Tax saving mutual funds are all the more safe baits.

What are Insurances?

The Oxford English Dictionary defines insurance as "An arrangement by which a company or the state undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death in return for payment of a specified premium." Drawing on this definition, we can define life insurance as a similar arrangement in which the insurer compensates your survivors if you die; all you need to do is pay a specific amount for a specific period.

This is the pure and unadulterated definition of life insurance, which is commonly marketed as Term Insurance. However, there are several other types of insurances that are quite complicated.

What's the Problem?

The world of insurances is indeed mysterious. Investing your hard-earned money into them without adequate knowledge of what is to become of that amount is the biggest problem. Let us try to understand the complicated world of insurance in extremely simple words.

The Simple Ones

Term life insurances are pure protection products - they are available at a low cost and do not pay dividends. To put it in the simplest of words, if you purchase a term life insurance policy, you keep paying a certain premium towards the policy for a specific period - you won't get back a single penny from this policy. Your family gets a substantial fortune when you depart for your heavenly abode. A purist might not consider this a financial investment.

However, you and I can treat it as an investment in financial security as it pays a cash benefit to your family when you're not around to support them anymore. It just compensates the loss of income arising out of your death. On an average, a 30-year-old non-smoker can easily get a cover of Rs.1 crore by paying just Rs.12,000 a year. The premium amount of such policies is exempted from income tax. That's life insurance - simplified for you.

The Beguiling Ones

Insurance companies, however, have diversified their offerings and introduced several types of life insurance products which claim that they will return the premium after a specific period. Endowment Plans, ULIPs, Money Back Plans, Whole Life Plans, Annuity Plans and the likes belong to this category. These schemes have been cleverly designed by mixing insurance with investment.

The insurance companies position these products in such a way that they appear as lucrative investment options. Millions of Indians are tempted by the plethora of benefits, bonuses, coverage and a lump sum maturity amount that these policies offer. They rampantly purchase these products, not realizing that the apparently lucrative maturity value will be worth very little if inflation is accounted for.

The Dilemma

Let's try to understand how these insurance-cum-investment products work. Well, it's true that the hybrid insurance policies offer insurance coverage and simultaneously allow you to capitalize on various investment instruments like stocks, bonds and mutual funds. Let's say you decide to invest Rs.50,000 into an insurance-investment hybrid product. As insurances are meant to provide death benefits, a chunk of the invested amount is directed towards the life cover.

Let's assume that Rs.10,000 goes towards life coverage, and you don't earn a penny on this amount. The remaining Rs.40,000 becomes your investment. Alternatively, you can buy a term insurance policy with Rs.10,000 out of Rs.50,000 and invest the remainder in mutual funds. What difference does it make?

Most importantly, the hybrid insurance plans pay you round 5-6% return on the invested amount, which is much lesser than the minimum returns of 8% that you can expect from mutual funds. The hybrid insurances don't let your entire money grow. Moreover, term insurances generally insure you for much more than ULIPs and Endowments plans do.

People looking for life insurances undoubtedly want to leave a substantial corpus for their beneficiaries - the hybrid policies do not provide as high a death benefit as term life insurances do. It makes more sense to invest in a mutual fund to grow your money and enjoy it while you live; simultaneously, purchase a term life insurance for your family's future needs. That would be a better and smarter financial move.

To Sum Up

Now that we have clearly established that insurances are not mean to be investments, the choice should no longer be between life insurance or mutual funds. Both are different financial products and strive to serve totally different purposes. Does that mean insurances should be off the table? No! Please, don't get me wrong - my objective is not to dissuade you from purchasing life insurance.

You should definitely buy a life insurance policy for protection. Just don't "invest" in insurance. Channelize your investments into something promising so that you are able to reap the benefits of your hard-earned savings. Would you prefer 5% returns that a traditional endowment policy gives you or a long-term mutual fund investment that returns a corpus that is twice as much? The choice is yours!