Monday, August 6, 2007

Retirement planning: Start early, save prudently

Mutual Fund a better option amongst all

You may wonder how to go about planning for retirement. You may have been procrastinating, thinking that it is a complicated exercise, which is beyond you. That’s not true. Retirement planning can be as simple as you want to make it.

Mutual funds offer a host of scheme-types to suit varied needs of investors. One such need is retirement planning. Stocks and post-office schemes in isolation may not be the ideal investment avenues for individuals to plan for retirement.

Stocks, because they are too complex and post-office schemes because they may not be able to give you an adequate return considering the high cost of living.

Start planning
The first step is to start setting aside some of your income to build up your retirement kitty. If you are young, even setting aside a modest amount (say, 10% of your income) will suffice. However, if you are older, set aside as much as possible. Make sure you do this on a regular basis. Merely doing this once or twice is not enough.

Invest what you set aside
Simply allowing the amount set aside towards retirement to lie ‘in a coma’ in your savings bank account, earning a measly interest, will get you nowhere. You should invest this amount.

Invest regularly
Investing a lump sum amount at one go, will not fetch the same kind of returns that you will get by investing the same amount in smaller portions over a period of time. This is referred to as systematic investment plan (SIP) by fund houses and allows investors to benefit from rupee-cost averaging.

Avoid drawing from your retirement savings as this defeats the very purpose of starting early.

Review your retirement portfolio from time to time (every 2 years or so). If there is an increase in expenses at present or if you anticipate higher expenses later, you may have to commit more resources to meet that shortfall.

Retirement investment options
‘Where should I invest?’ If you are young, the best investment option for you is equity. Stock markets around the world, including the Indian stock markets, have proven that investing in equity over the long term (over a decade and above) ensures significant wealth creation.

Why are we so gung-ho on equity funds vis-à-vis relatively safer instruments like bonds, fixed deposits, property and gold? There are several reasons for that, but we list the three most important below.

Equities have a proven track record over the long term. Several studies have shown that over the long term (about 20 years) stocks have, in most instances, outperformed all other comparable asset classes viz. bonds, property, gold, fixed deposits. So if you do your homework well, there is a good chance that you will benefit from better than average long term returns.

Equities are your best bet to counter inflation. The abovementioned study also reveals that gains on equities have been highest after accounting for inflation. In other words, equities counter the inflationary impact better than other asset classes.

Currently, given the concerns about inflation and interest rates, investors are better placed to appreciate this point.

If you are uncomfortable with investing in equity directly, use the mutual fund route. Mutual funds offer various equity schemes; the basic equity schemes are diversified equity funds (these invest in equity of companies across different industries), sector funds (these invest in equity of companies in a particular industry like pharma, telecom, banking, etc.) and index funds (these invest in equity of companies forming a particular stock market index like the BSE Sensex, NSE Nifty, etc.).

By investing in equity through mutual funds you are relieved of having to track the markets regularly. However, do keep an eye on the scheme’s performance. Ideal option in early part of your career is to systematically invest in diversified equity funds. While in 20s and 30s, consider small-mid cap funds and even contrarian funds.

If you are older, you should invest a portion of your retirement corpus in equity and the balance in debt. A ratio between equity and debt of approximately 50% each, would be suitable. Again, mutual funds come to the rescue. They offer hybrid schemes, which invest a portion of the corpus in equity, and a portion in debt. Some of these schemes are Monthly Income Plans (MIPs), which invest about 25-30% of their corpus in equity and the balance in debt, Capital protection schemes, which also invest like MIPs, but with the added comfort of guaranteeing return of your capital, and balance funds, which invest about 35-40% of their corpus in debt and the balance in equity.

If you are moving headlong into retirement, you could use debt schemes of mutual funds. These schemes invest in a number of debt securities, most of which are not directly accessible to individuals. Some debt securities that debt schemes invest in are commercial paper, call and money markets, government treasury bills, corporate bonds, corporate debentures, government securities, etc. Some debt schemes suitable for building your retirement corpus are income funds (which invest in medium-to-long-term debt securities, i.e., securities with tenures of 5-7 years and above), gilt funds (these invest mainly in government securities) and floating rate funds (these invest in debt securities which have a floating rate i.e. the interest rate on these securities is reset when there is a change in market interest rates).

Charges
Market-linked pension plans are very similar to mutual funds in their functioning. They also offer various options, growth, balanced and income according to the risk preference of the customer. However, there is a vast difference between mutual funds and insurance companies when compared on the basis of investment or management charges. Market-linked pension plans offered by insurance companies charge a hefty sum in the form of administration and investment charges. The first is knocked off even before your contributions are invested and can make a dent in your corpus.

Moreover, given the intense competition in the sector, mutual funds have stared phasing out entry/ exit loads. The same might happen with insurance companies too with the entry of more players and with more schemes becoming available.

If you are investing in such plans now, do build in the charges while computing your overall returns.

Tax implications
From a taxation perspective too, mutual funds and insurance companies differ. From the assessment year 2006-07, the total amount of deduction available under Sections 80C, 80CCC and 80CCD cannot exceed Rs 1 lakh. Since the contribution to pension plans qualifies for deduction under Section 80CCC, the maximum deduction available is Rs 1 lakh only.

Mutual fund pension plans do not qualify for rebate under the section. However, contributions towards certain specified funds, such as the UTI Retirement Benefit Plan and Frankin Templeton India Pension Plan, qualify for rebate. Both funds envisage redemption of amount invested (along with growth) when the investor reaches the age of 58. Option is then provided to either retain the amount with the fund or opt for pension in the form of dividends/systematic withdrawal or withdrawal of the lump sum at the prevailing NAV or a combination of the two. Both funds invest in a mix of debt and equity. Since investment in equity in the case of both funds is below 65% of assets, both the funds do not qualify to be equity-oriented funds.

Plain vanilla mutual fund Systematic Investment Plans (SIP) do not qualify for either deduction or rebate. Therefore, you should opt for SIP only if you have exhausted your limits under section 80 CCC. Taxation policies may change over a long period and it makes sense to make the most out of it, when it is available.

Exit option
Market-linked plans and mutual funds are more flexible. They not only allow you to choose your asset mixture according to your risk - return requirements and give you an opportunity to earn a higher return, you can also walk away with your accumulation (equal to the NAV of your units) if you are not too happy with the performance and invest elsewhere.

Here mutual funds score over normal (not market linked) insurance plans. Mutual fund schemes require a lock-in of three years and thereafter you can exit any time by encashing your units at the prevailing net asset value (NAV). In case of non-market linked pension plans, only a portion of your contribution is returned if you surrender an insurance plan during the contribution period. All these factors must be borne in mind before you decide on the product that is right for you.

End Note
Retirement planning is still at a nascent stage in India, and the options are limited, as of now. But this is a growing area, and many choices will become available soon enough.

As of now, you can allocate funds among the Employees Provident Fund (EPF), Public Provident Fund (PPF), Post Office Monthly Income Scheme (POMIS), systematic investment plans (SIP) of various mutual funds (they allow you to contribute a sum of money regularly, like a recurring deposit scheme), the UTI Retirement Benefit Plan, the Franklin India Pension Plan or pension plans offered by various insurance companies.

You can opt for a market-linked plan that operates much like a mutual fund or a simple plan that allows you to pay a fixed premium every year and gives the option of taking an annuity at the end of the contribution period.

But do consider the positives and negatives of all the products before choosing the one that suits your requirement best.

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