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 one-size-fits-all exercise. Different options suit investors at different 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 Public Provident Fund, or 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 per cent of your life savings. A good retirement plan should ideally be a combination of various investments. 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.
NATIONAL PENSION SYSTEM
Your Best Bet
Returns: 6-8% (Debt), 9-12% (Equity) Risk: Low (Debt), Moderate (Equity)
Since its birth two years ago, the National Pension System, or NPS, has been in the cross hairs 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, DTC. 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 Unit Linked Insurance Plans, or ULIPs, and pension plans from insurance firms. For somebody investing Rs 50,000 a year in NPS, this works out to less than one per cent. The NPS works best if you are investing more than Rs 30,000 a year. 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 the ages of 18 and 55 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 life cycle 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 life stage.
In the first year of its operation, the NPS generated average returns of 12 per cent, which is a good four percentage points higher than the yield of a PPF account. This was possible largely because the NPS invests up to 50 per cent in equities.
OUR ASSESSMENT: By bringing annuities under the exempt, exempt, exempt, or EEE, regime, the revised DTC has made the NPS the best way to save for retirement
PF, PPF AND BANK DEPOSITS
Returns: 7-8.5% Risk: Nil to very low
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, or PF, account and a matching contribution by their employers is a neat way to build a retirement corpus.
There's also the PPF, where an annual contribution of Rs 70,000 grows to Rs 25 lakh in 15 years. And, 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 fixed income investments the most popular savings option for retirement, 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 post-tax return works out to less than four to five per cent. 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 at JPMorgan 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 Mahendra Jajoo, Executive Director and CIO of Fixed Income at 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 Fixed Deposit, or FD, after paying a penalty.
OUR ASSESSMENT: With wholesale price inflation in double digits, you are losing money in these ultra-safe investments
Little Known Alternative
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. Debt funds, on the other hand, cannot hand out any assurance and, therefore, don't get that kind of attention. Barely 10 per cent of the assets under management, or 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 Rahul Pal, Vice President and Head of Fixed Income at Taurus Mutual fund. 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.
OUR ASSESSMENT: They are tax-efficient and flexible, offer high liquidity and can earn higher returns
One-stop Planning Shop
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, the Insurance Development and Regulatory Authority, or IRDA, has introduced several investorfriendly 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 per cent allocation. ULIPs deduct policy administration charges by cancelling units every month. In some cases, these can be as high as 2-2.5 per cent of the premium per month, which add up to 24-30 per cent 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.
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 March 31, 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. So, if you don't want the taxman to come knocking when you withdraw from the plan, make sure your ULIP is DTC-compliant.
OUR ASSESSMENT: ULIPs pack in long-term wealth creation, tax savings and life insurance in a single product. But make sure you buy the policy that suits you
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 per cent against the 18 per cent notched by gold, nine per cent by bonds and 12 per cent 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 per cent 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 ultra-safe 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 JPMorgan Mutual Fund's 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 per cent, which is marginally better than the 18.12 per cent 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 per cent of their corpus in the safety of debt, and the balance 20 per cent is invested in equities to help beat inflation.
OUR ASSESSMENT: Transparent, low on costs and versatile, mutual funds offer everything you need to plan for your golden years
Leg Up for Pension
Under the revised draft of the DTC, pension products, including the NPS and annuity schemes, will come under the EEE 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. A friendlier tax regime has proven to be the most effective way to mobilise long-term savings.
Another aspect that merits consideration is the proposal mooted in the original DTC discussion paper to make the Pension Fund Regulatory and Development Authority, or 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 IRDA, while the PFRDA deals with the NPS.
The DTC should ensure that pension plans approved by either regulator enjoy parity. The attractive tax breaks offered under the DTC, combined with factors like 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