Choose the right option

Your retirement plan should be a mix of different investments. We analyse the various instruments and tell you how they can fit into your plan.

Which is the best financial instrument to invest in for retirement? A difficult question, not because there are so many options but because investing is not a onesize-fits-all exercise. Different options suit investors at various stages of their lives. It all depends on their risk appetites and financial situations.

Also, one should not lose sight of one's overall asset allocation while choosing an investment option. The PPF is a good tool, but it would be counterproductive to  put all your eggs in the safety of a debt instrument that is often overtaken by inflation. Stocks and equity funds are wealth creators, but it would be foolhardy to binge on them when retirement is less than 10 years away. A black swan like 2008 could have wiped out 50% of your life savings.

A good retirement plan should ideally be a combination of a variety of investments. Just as you use different tools to perform a multitude of tasks, all these options can work for you in diverse ways. We look at the investment options commonly used to save for retirement and tell you how and where they can fit into your plan.

Since its birth two years ago, the National Pension System (NPS) has been in the crosshairs of too many people. Investors found it too complicated. Distributors shunned it for lack of incentives. And financial planners didn't like the tax on withdrawals or the limited liquidity that it offered. But changes in the NPS structure and tax laws have turned this unwanted, ugly duckling into a beautiful swan, which perhaps offers the best way to save for retirement. In December 2009, a second tier was added to the NPS structure, which injected liquidity into it.

Investors in the Tier-II accounts are allowed to withdraw from the corpus, unlike in Tier-I, which can be accessed only when the account holder turns 60. The bigger and more significant change was the tax exemption proposed for income from annuities under the revised Direct Taxes Code.

If passed, this will change the way Indians save for retirement and make the NPS the household name that its architects had envisioned. This is how the NPS scores over other options: Flexibility: One needs to invest a minimum of Rs 6,000 a year in the NPS, with at least four contributions in a year. There is no upper limit.

The scheme is portable and can be operated from anywhere in the country. Costs: The NPS charges are very low compared with those of Ulips and pension plans from insurance firms. For somebody investing Rs 50,000 a year in NPS, this works out to less than 1%. The Tier-II account is more of a low-cost mutual fund.

Choice: A subscriber can choose from six fund houses to manage his money and switch if he is not satisfied with the fund. He also gets to pick the debt-equity mix of his investments.

Availability: Anybody between 18 and 55 years can join the NPS. It is sold through almost 10,000 outlets across the country, including bank branches and post offices.

Tax efficiency: The revised DTC draft proposes to make annuity income from the NPS tax-free. Besides, there are no tax implications when you switch between options or change from one fund house to another. The other good thing about the NPS is the lifecycle choice of funds that is the default option. Under this option, the asset allocation is defined by the age of the subscriber and changes as he grows older.

So, even if the subscriber does not know the ABC of investing, his money will be deployed in a way that suits his lifestage. In the first year of its operation, the NPS generated average returns of 12%, which is a good 4 percentage points higher than the yield of a PPF account. This was possible largely because the NPS invests up to 50% in equities.

However, experts point out that a 50% allocation to equities may be too cautious for someone who has 25-30 years to retirement. "The immediate cost should not be the only criterion for selecting a plan. Pension plans from insurance companies may allow an individual to take higher risk and allocate more towards equities," says Ranjeet Mudholkar, principal adviser & director of the Financial Planning Standards Board, India. Also, the NPS works best if you are investing more than Rs 30,000 a year. The bulk of the charges are fixed and a subscriber who pours in Rs 6,000 a year in the scheme will end up paying roughly 8%. However, somebody who puts in Rs 10,000 a month (Rs 1.2 lakh a year) will pay less than 0.5%. The PFRDA has announced that the charges will come down further as more people join the NPS.

Fixed-income investments act as ballast in a portfolio, lending it stability and preventing it from tipping over when the going gets rough. As we have seen in the past two years, equity markets can behave like the ECG graph of a person with heart condition.

For many salaried people, the monthly contribution to their Provident Fund (PF) account and a matching contribution by their employers is a neat way to build a retirement corpus. There's also the Public Provident Fund (PPF), where a contribution of Rs 70,000 every year grows to a gargantuan Rs 25 lakh in 15 years. What's more, the PF and PPF are protected from the taxman at every stage. There's tax exemption on the amount invested, interest earned and withdrawals.

This is what makes fixedincome investments the most popular savings option for retirement in India, with almost Rs 42,000 crore of household savings locked in bank deposits. After all, isn't it better to be safe than sorry? As it turns out, you can be sorry for being so safe. With wholesale price inflation in double digits, you are losing money in your PF and PPF accounts. The purchasing power of your money is diminishing faster than the returns it is earning. Bank deposits earn even less and the income is taxable. So the posttax return works out to less than 4-5%. Investors need to factor in inflation while lining their nest egg with only debt.

"Retirement is a phase when one has nothing to risk and everything to lose. So there is an undue emphasis on the need to be 'safe'," says Arindam Ghosh, head of retail sales, J.P. Morgan Mutual Fund. Incidentally, headline wholesale price inflation is not the only way rising prices can hurt your retirement kitty. "There is not only inflation but also the ever-changing lifestyle and social norms. A microwave or a washing machine, which people could do without earlier, has become quintessential for living today," points out Mahhendra Jajoo, executive director and CIO, fixed income, Pramerica Asset Managers. There is also the interest rate risk to watch out for while investing in long-term deposits. If interest rates go up and your money is locked in at a lower rate, you miss out on the chance to earn a higher return. The only option is to foreclose the FD after paying a penalty.

Little Known Alternative: Debt  Funds
Returns: 7-9%, Risk: Low

For most Indian investors, the assurance of returns is very important, perhaps more than the returns themselves. So, even though some debt funds have the potential to earn higher returns, it is fixed deposits that get the lion's share of household savings. "The investor knows from day one that his investment of Rs 10,000 in a bank deposit will become Rs 10,700 in a year. It gives an element of certainty," says Rahul Pal, vice-president and head of fixed income, Taurus Mutual Fund.

Debt funds, on the other hand, cannot hand out any assurance and, therefore, don't get that kind of attention. Barely 10% of the AUM of debt funds is from retail investors. This, despite the several benefits offered by debt funds. "They can effectively substitute other fixed-income options," says Pal. A liquid fund is better than money idling in a savings account. Income funds can replace long-term bonds in a portfolio. Floating rate funds give higher returns than short-term bank deposits.

One-stop planning shop: ULIPS
Returns: 6-9% (Debt), 10-15% (Equity), Risk: Low (Debt), High (Equity)

There's one investment tool that can take care of all your financial goals, including retirement planning. Ulips not only help you save tax and create longterm wealth but also offer life cover. However, one can go horribly wrong if one chooses an unsuitable policy or follows the wrong strategy. Recently, Irda has introduced several investor-friendly changes in Ulips, such as a cap on the charges levied by insurers over the term of a plan. Despite the cap, a Ulip has very high charges in the first few years and the plan turns profitable only if held for the long term. Buying a plan for less than 15 years is, therefore, not a very good idea. An unscrupulous agent will try and push a 10-year plan because he would want to sell you another Ulip when the first one matures. Don't fall for it.

Also, don't be taken in by promises that a Ulip does not levy high charges in the first year or that it offers 100% allocation. Ulips deduct policy administration charges by cancelling units every month. In some cases, these can be as high as 2-2.5% of the premium per month, which add up to 24-30% in a year. The other point to consider is the insurance offered by the Ulip. It is best to take the maximum cover offered by the plan.

A bigger cover also means a higher deduction as mortality charge, but don't let that deter you. Opting for a smaller cover will defeat the whole purpose of taking life insurance. There's also a tax angle here. Currently, the income from Ulips is tax-free under Section 10 of the Income Tax Act. But this rule may change after the DTC comes into effect.

Plans bought after 31 March 2011 must offer a life cover of at least 20 times the annual premium if the income from a Ulip is to be tax-free. This means a Ulip with an annual premium of Rs 50,000 must offer an insurance cover of at least Rs 10 lakh. If the cover is lower, withdrawals from the Ulip will be taxed. So, if you don't want the taxman to come knocking when you withdraw from the plan, make sure your Ulip is DTC-compliant.

 Leg up for pension

Under the revised draft of the Direct Taxes Code (DTC), pension products, including the NPS and annuity schemes, will come under the EEE (exempt, exempt, exempt) regime.

While this is certainly taxpayer-friendly, it is not clear whether the EEE treatment refers to the annuity stage in general (whereby pension income will become tax-free) or remains limited to the purchase of annuity (whereby pension income will be taxed as regular income).

It would only be right to make the entire annuity (regular pension income) tax-free as the individual in question would by then be well past his earning years.

The government's avowed goal is to promote greater long-term savings, and a friendlier tax regime has proven to be the most effective way to mobilise it. Another aspect that merits consideration is the proposal mooted in the original DTC discussion paper to make the Pension Fund Regulatory and Development Authority (PFRDA) the approving authority for 'permitted savings intermediaries' (PSIs).

A 'life insurer' is classified as one of the PSIs. Currently, pension plans issued by insurance companies are approved by the Insurance Regulatory Development Authority, while the PFRDA deals with the NPS.

The DTC should ensure explicitly that pension plans approved by either regulator enjoy parity. The attractive tax breaks offered under the DTC, combined with factors such as the cap on charges and optional life or health cover as riders, will give pension plans a holistic appeal, making them an attractive proposition for investors.

- G. Murlidhar COO, Kotak Mahindra Old Mutual Life Insurance

Multi-utility Investment: Mutual Funds
Returns: 10-12% (Balanced), 12-15% (Equity), Risk: Moderate (Balanced), High (Equity)

Financial gurus advise that you should invest in the instruments you understand. A mutual fund is a fairly simple instrument, an effective tool that cuts through the clutter of myriad options. It offers everything you want in an investment - diversification, flexibility and tax efficiency. Mutual funds are transparent, wellregulated and can be used by investors at any stage of their life. There's something for all types of investors. If you have just started working and retirement is more than 25-30 years away, diversified equity funds is the way to go. As we all know, equities tend to outperform all other asset classes in the long term.

In the past 10 years, the Sensex has risen 14% against the 18% notched by gold, 9% by bonds and 12% by real estate. What many don't know is that an actively managed basket of stocks can do even better than the broader market. The equity diversified category has risen 25% during the same period. If you take the plunge in equities, be prepared for years when your investments will not grow but actually fall in value, as it did in 2008. But don't let this prevent you from adopting an aggressive strategy, which involves investment primarily in stocks.

As we have mentioned before, if you adopt an ultrasafe strategy when you are very young, you may end up with a retirement corpus smaller than you might have wanted. As an investor turns older and his responsibilities increase, it is prudent to scale down the exposure to equities. Balanced funds, which invest in a mix of debt and stocks, are the best vehicle at this stage.

They may not match the scintillating returns of equity funds but they carry a lower risk. Consider index funds too, which invest in the stocks of an index in the same proportion as their weightages in the benchmark. The passive investing by index funds is cheaper than the churning by actively managed funds. Index funds have lower expense ratios than diversified equity funds and are, therefore, good bets over the long term. Balanced and index funds are appropriate options if your retirement is about 10-15 years away. If this is too complicated for you and you want someone else to do the reviewing and rebalancing for you, opt for asset allocation funds.

These funds switch between debt and equity depending on market conditions. They do away with the need for the investor to check his asset allocation and make changes. "An investor who wants to outsource the process of asset allocation to a fund manager could look at investing in these funds," says Ghosh. As it turns out, it pays to be cautious.

Take the case of the Franklin Templeton Dynamic PE Ratio Fund, which divides its corpus between two schemes of the fund house. In the past five years, this fund of funds has earned annualised returns of 18.86%, which is marginally better than the 18.12% earned by diversified equity funds. Monthly income plans (MIPs) are suitable for conservative investors who don't want a large exposure to volatile assets. They are specially designed for retirees, who want to earn a monthly income from their investments. MIPs provide a regular income by way of dividends from the distributable surplus.

These funds are fairly stable because they invest around 80% of their corpus in the safety of debt, and the balance 20% is invested in equities to help beat inflation. The result is stable growth, which outperforms the returns from debt funds but carries far lower risk than an equity fund. In case the dividend is insufficient, the investor can opt for a systematic withdrawal plan, under which a predetermined amount is redeemed and paid to the investor on a specified date of the month.

If you want to know about the best funds for your retirement portfolio, there's help on page 56. The MONEY TODAY-Value Research Lifestage Model Fund Portfolios are designed for long-term investing. Find out which of these you can use for your retirement planning.


Building Blocks

Mutual funds, with their wide range of options for different riskreturn profiles, are perhaps best suited for retirement planning.

Apart from the versatility and convenience factor, they are a low-cost option for wealth creation when compared with Ulips and structured products. In most developed markets, mutual funds have been effectively used as building blocks to create retirement assets. The 401k in the US, which is an employer-sponsored, defined contribution retirement plan, held 55% of its assets in mutual funds as on 31 December 2009.

The Individual Retirement Account (IRA), which is a tax-advantaged voluntary retirement plan, had 46% of its assets in mutual funds as on 31 December 2009. In the UK, individuals saving for retirement through Self Invested Pension Plans (SIPPs) can include mutual funds as a means for creating a retirement corpus.

Also, employees covered under employer-sponsored, defined contribution retirement plans can invest in mutual funds covered under the plans. In Hong Kong, individuals investing in the mandatory pension fund (MPF) can also opt for investing in mutual funds to build their retirement corpus.

In India, the Public Provident Fund (PPF), which is a voluntary retirement account, does not invest in mutual funds. At a current rate of return of 8%, it is not a great option to either beat inflation or maximise wealth creation for retirement.

For those contributing to an Employee Provident Fund (EPF), the return is capped at 8.5% and there is no choice for an employee to invest in mutual funds under it. Although investments in PPF and EPF enable you to save tax, investment in an equity mutual fund, such as an equity-linked savings scheme, would have helped you to accumulate more to meet your retirement goal.

When it comes to retirement planning, lifestage funds are very popular among investors and retirement plan sponsors in the US. Also known as target date funds, these schemes follow a predetermined reallocation of risk over time to a specified target date, and typically rebalance their portfolios to become more conservative and incomeproducing as they approach and pass the target date, which is usually indicated in the fund's name.

A simple way to start using mutual funds for your retirement plan is to begin an SIP in an equity mutual fund. By investing regularly, you can benefit from the equity markets.

The key is to stay focused on your goal and continue to invest irrespective of market levels. On retirement, you could use the systematic withdrawal facility to withdraw monies for your monthly needs or buy an annuity plan with the accumulated corpus. Happy investing!
- Ashu Suyash, MD & Country Head, India, Fidelity International