Death and taxes spare none. What is also unavoidable is the reality that one day your monthly salary will stop. This is why one should start actively investing for retirement as soon as the first salary comes. The average earning years of a person is around 30 years. If life expectancy is assumed as 80-90 years, the length of retired life also becomes 20-30 years. Moreover, the monthly expenses post retirement will be relatively higher due to inflation. If you start saving early, you have the liberty to choose any pension product. However, as you near your retirement age, your capacity to take risk reduces and so does the choice of investments. Apart from age, understanding the concept of finance, especially the impact of inflation on financial goals, as well as risk-taking appetite also affect a person’s choice of pension products.
In this article we will discuss only the top pension/retirement corpus builder products on the basis of their safety of capital, tax efficiency and return generation capacity.
PPF
PPF is a long-term debt scheme of government, in which any individual can invest. The scheme offers regular interest and tax-free return, which is usually higher than those offered by bank FDs.
Risk factor: The protection of capital and accumulated interest on PPF is guaranteed by the government and thus completely safe. However, PPF carries interest rate risk.
Taxation: It comes under exempt-exempt-exempt (EEE) category, that means the investment is tax-exempt u/s 80C and the interest and maturity proceeds are also tax-free.
Return: The rate of interest on PPF is decided generally at the beginning of every year by the government and may not be constant throughout the investment period. The PPF interest rate was as high as 12 per cent during 1990s, but from the year 2000, it gradually went down to 8 per cent during 2003. The rate started going up marginally from 2012 and now stands at 8.7 per cent. The average return on PPF from March 1993 to March 2014 was 9.13 per cent. During the 22-year period (1993-2014), the average rate of inflation was 7.17 per cent per year. So, the rate of return on PPF over inflation was 1.96 per cent in that period. So, PPF not only kept the purchasing power of your money intact, but also earned about 2 per cent extra return over it, which is quite substantial over a long period.
Drawback: The major problem in PPF is the annual investment limit, which is currently Rs 1,50,000, over which a PAN card holder is not eligible to earn any interest, even if he/she opens new accounts in the name of dependent family members.
If one only relies on PPF, he/she may need to invest almost 75 per cent of his/her monthly expenses every month to develop enough corpus to maintain same standard of life after retirement.
Mutual Funds
Mutual funds are managed by asset management companies (AMCs), which channelize people’s money into collective investments in equity, debt and other financial products managed by investment experts. Mutual funds may be broadly categorised into equity funds and debt funds.
Risk factor: Mutual fund investments are subject to market risks. Debt funds are, however, much less risky than equity funds but also give lower returns. Though, non-systemic or company-specific risks are minimised through well-diversified portfolios of equity funds, they still face market-specific risks.
Taxation: Long-term capital gains (when withdrawal is made after one year from the date of investment) on equity funds are tax-free. If withdrawal is made before one year from the date of investment, 15 per cent short-term capital gain tax on equity funds will be charged. Debt fund investors enjoy indexation benefit after three years from the date of investment and are charged 20 per cent long-term capital gain tax if there is any gain over the rate of inflation (i.e. post indexation). The gain on debt fund is added to the annual income of the investor, if withdrawal is made before expiry of three years from the date of investments. The equity-linked savings schemes (ELSS), which have 3-year lock-in period, come under EEE category like PPF.
“Tax-saving funds deliver superior returns compared to other tax-saving investments. Take the past 15-year period (the minimum period for PPF). A yearly investment of Rs 50,000 in the PPF over the past 15 years would have amounted to Rs 16.1 lakh today. In contrast, the same investment in, for example, a well-known moderate risk tax-saving fund would have amounted to Rs 48.3 lakh,” says Bhavana Acharya, mutual fund analyst, FundsIndia.
Return: Equities have out-performed other investment asset classes over the long-term in India as well as globally. 10-year average returns of largecap funds, ELSS and hybrid funds is around 10-11 per cent each year. Midcap and smallcap funds have done slightly better and sectoral bets (FMCG, pharma, banking etc) have got between 14-18 per cent average gain. While these gains are higher than PPF, they were much more volatile. The CAGR on liquid and short-term debt funds are comparable to that of PPF and volatility is also in sync with the PPF rate.
Drawback: Short-term investments in equity schemes bear high market risk. Capital is also subject to market risk.
NPS
National Pension System is a voluntary, defined contribution retirement savings scheme designed to enable the subscribers to systematically save during their working life. NPS is regulated by PFRDA, with transparent investment norms, regular monitoring and performance review of fund managers by NPS Trust. The NPS offers two approaches to invest subscriber’s money. First, active choice where the individual would decide on the asset classes in which the contributed funds are to be invested and their percentages (asset class E (maximum of 50 per cent), asset class C, and asset class G). Secondly, auto choice — lifecycle fund — this is the default option under NPS wherein the management of investment of funds is done automatically based on the age profile of the subscriber. NPS is the cheapest product available in terms of charges.
Risk factor: Like mutual funds, fund performance depends on fund manager and the asset class choice.
Taxation: This product is EET (exempt-exempt-taxable). The government has given an attractive sop through additional deduction of Rs 50,000 over and above 80C limit of Income Tax Act. Although you now get extra tax deduction for what you invest in NPS, the maturity proceeds are still taxable.
For example, a person, who invests only for tax savings, puts Rs 50,000 every year in NPS for 20 years. Assuming that the person moves from 10 per cent tax bracket to 30 per cent over the years and the average rate of tax he paid is 20 per cent, he will save Rs 2,00,000 as tax incentive. Further assuming that average CAGR on NPS is 12 per cent, the fund value after 20 years will become Rs 40,34,937 but this amount is not tax-free. The person needs to pay Rs 7,26,289 immediately if he withdraws 60 per cent of maturity as lump sum, and the tax on the annuity portion (at least 40 per cent of the accumulated pension wealth needs to be utilized for purchase of annuity) will be charged as and when he receives it. If the person goes the ELSS, PPF or insurance pension way, he does not have to pay any tax whatsoever on maturity.
Return: Since inception, pension fund managers (with 3 year track record) have given between 8.4-11.16% annualised returns for asset class E. The same for asset class C is 9.25-11.09% and asset class G is 7.88-9.61%. These are for Tier I accounts.
Drawback: Tax on maturity, mandatory annuity and low on equity.
Insurance
Insurance plans, if taken early, can be used as a tool for wealth creation besides offering protection.
Risk factor: Investments in insurances are not only risk free, but it is a mechanism in which individuals can transfer their risk to insurance companies, for a cost. Like PPF, in case of policies taken from LIC, the sum insured (SI) and the accumulated bonus enjoy guarantee from the government. However, apart from LIC, other life insurers don’t enjoy such guarantee from the government.
Taxation: Like PPF, insurance also falls under EEE category.
Return: Under endowment insurance plans, apart from death, SI and bonus are paid back on maturity. As life risk is covered, the premium amount increases with entry age of the life insured and the rate of return diminishes, so insurance is not treated as very good investment vehicle. However, if a person takes insurance at an young age and for entire working life, it may give good return at the time of retirement.
“Life expectancy is on the rise. While this is 69-70 years now, it is estimated that this will rise to 77 years in a few decades. It is important for young people to build a strong foundation of insurance protection and a planned income over their lifetime,” says Suresh Agarwal, head, distribution & strategic initiatives, Kotak Life Insurance.
For example, if a 25-year old person takes Rs 25 lakh plain vanilla endowment plan from LIC for maximum term of 35 years, he will have to pay Rs 64,948 as annual premium. Assuming that the current bonus rates will remain constant throughout the term, at the time of retirement he/she will get Rs 1,24,50,000 as maturity amount apart from enjoying the insurance cover for the entire earning life. So, the annual rate of return in this case comes close to 8.13 per cent, which is not very far from the current rate of return on PPF.
Drawback: The return on endowment plans diminishes with increase in entry age and decrease in length of term. Variability in bonus rate and service tax on premium are also dampeners.
(With inputs from Kumar Shankar Roy)
