Using mutual funds to create a pension
Pension plans pose as the only pension schemes on the market, but withdrawal options from mutual funds enable creation of a more flexible, tax-efficient income stream.
Only 13% of India’s workforce receives a formal pension. The rest of us need to create an income stream for our retirement years on our own. This is daunting if you calculate how inflation will eat into your savings year after year (inflation averages 6.9% for the past 63 years!). However, the stock market can help you get there over the long term, if you are a disciplined investor. The most popular way for retail investors to get exposure to equity is through mutual fund houses and insurance companies. Fund houses offer lean products that are flexible and cheap relative to those issued by insurance companies, whose products always appear to be more beneficial, but all considered, offer much less.
This applies particularly to the unit-linked pension plans (ULPPs), which are best avoided. Instead, most investors would be better off with mutual funds, which don’t offer pension plans per se, but only a little effort would enable creation of a more flexible, tax-efficient income stream. Let’s examine why one is better than the other, starting with the pension plans.
What pension plans are about
ULPPs had almost died out four years ago, when the regulatory body IRDA specified that these plans must offer minimum returns of 4.5% per annum, which insurers insisted was unviable. Over the past two years though, most insurers have released schemes – such as HDFC Life Pension Super Plus and ICICI Pru Shubh Retirement – that are compliant with new norms and a brand new investment guarantee charge.
In short, here’s what they are about:
Pension plans can last anywhere from 10 to 35 years, during which you put in money annually. At the end of the term you’ve chosen, the corpus accumulated must be invested in an annuity to create the pension. This annuity then pays out money to you every month in your retirement years. There is an insurance angle too, but this is too small to discuss in depth (for example, with a Birla Sun Life plan, your beneficiaries will receive 101% of all the premiums you’ve paid until your death, in addition to the corpus).
What’s wrong with them
Inflexible: Insurance plans are ridiculously inflexible, what with their policy terms, exit clauses and the like. If today you pick a term of 25 years but retire in 35, you will needlessly have to buy the annuity early. You can’t cease to invest in the product in under five years, no matter how poorly the scheme is performing. Also, you have to purchase an annuity at the end of the term. What if you desperately need the money on retirement?
Inefficient: These schemes are inefficient from every angle, starting with the commissions you pay the agent. In each of the first five years, insurers can charge you up to 4% in commissions and charges. This falls to 3% for years 6 to 10 and 2.25% from year 11. What you get therefore, is a typical front-loaded scheme. Furthermore, any income from an annuity is taxable as regular income. So if you receive Rs10 lakh a year from it, you would find yourself paying tax at a much higher rate than you need pay as a retired individual.
Returns: In the long term, the stock market is your best bet at beating inflation and growing your retirement corpus. If you’ve started investing at 30, you can take a few risks. Many pension plans however, invest only up to 60% of your money in the market, which makes it much harder to achieve your targets.
Why mutual funds
Mutual funds are relatively lean products that exist to give you equity or debt exposure. There’s no insurance, children’s education or retirement angle to any of them. It doesn’t mean there’s no bad investment here of course, but it’s much less likely. And if you have been had, it’s easier to correct your mistake.
The reason it’s a good idea to create a pension via a mutual fund is that mutual funds are more flexible, efficient and capable of generating better returns.
Creating a pension with mutual funds
With open-ended mutual funds (which account for most of the market), your investment is indefinite. You could withdraw one, 10 or even 30 years later. Your investment could be monthly, quarterly or annually (although monthly is the best). As you’re nearing retirement, you could sell off your mutual funds and invest a large chunk or all of the corpus in liquid funds (select the growth option), which offer stable returns, and activate the Systematic Withdrawal Plan (SWP). What the SWP does is create a monthly income for you out of your initial investment in the mutual fund – essentially the same as the ULPP.
What’s better about them?
Flexible: Restrictions here are comparatively non-existent. While some mutual funds do have an exit load, this is only for a maximum of 18 months, when compared with 60 months for ULPPs (does not apply to liquid funds). Then, you can get out of the plan whenever you wish, with no need to buy an annuity. So if you need the money, you’re free to withdraw.
Efficient: Mutual funds are allowed to charge up to 3%, but most are much cheaper. Also, they aren’t front-loaded, so charges are even across the years. Equity mutual funds aren’t taxed at all if held for longer than one year, while debt schemes are taxed at 20% after indexation. These are both better than paying tax on the entire annuity.
Returns: Equity mutual funds, given their lower charges and higher equity exposure, have greater potential to show higher returns over the long term. Liquid funds can give returns of 7%, which are also higher than returns you can expect from an annuity.
The second option may require a little more effort, but given the sums we’re dealing with here, you should find it more beneficial to put in the trouble. For example, if your retirement fund totals Rs5 crore when you’re 60, even a saving of 1% is Rs5 lakh.