What is the New Pension System (NPS)?
It is a system where individuals fund, during their work life, their financial security for old age when they no longer work. All those who join up would get a Permanent Retirement Account (PRA), which can be accessed online and through so-called points of presence (PoPs).
A central record keeping agency will maintain all the accounts, just like a depository maintains demat accounts for shares. Six different pension fund managers (PFMs) would share this common CRA infrastructure. The PFMs would invest the savings people put into their PRAs, investing them in three asset classes, equity (E), government securities (G)and debt instruments that entail credit risk (C), including corporate bonds and fixed deposits.
These contributions would grow and accumulate over the years, depending on the efficiency of the fund manager. The NPS in this form has been availed of by civil servants for the past one year. Subscribers can retain their PRAs when they change jobs or residence, and even change their fund managers and the allocation of investments among the different asset classes, although exposure to equity has been capped at 50%.
Where can people sign up for the NPS?
People can subscribe to the scheme from any of 285 PoPs across the country. These are run by 17 banks — SBI and its associates, ICICI, Axis, Kotak Mahindra, Allahabad Bank, Citibank, IDBI, Oriental Bank of Commerce, South Indian Bank, Union Bank of India — and four other financial entities, LIC, IL&FS, UTI Asset Management and Reliance Capital. A subscriber can shift his pension account from one PoP to another. Subscribers can choose from six fund managers — ICICI Prudential, IDFC, Kotak Mahindra, Reliance Capital, SBI and UTI.
Is the scheme open to all?
NPS is available for people aged between 18 years and 55 years.
How often should a subscriber contribute to NPS?
The minimum amount per contribution is Rs 500, to be paid at least four times in a year. The minimum amount to be contributed in a year is Rs 6,000.
How will the subscribers get the money back?
If the subscriber exits the scheme before the age of 60, s/he may keep one fifth of the accumulated saving and invest the rest in annuities offered by insurance companies. An annuity transforms a lump sum spent on buying the annuity into a steady stream of payments for the rest of the annuity holder’s life. Now, how long an annuity buyer would live is something that takes a life insurance company’s expertise to compute and that is how they come into the picture. Insurance companies offer flexible investment and payment options on annuities. A person who exits NPS when his age is between 60 and 70 has to use 40% of the corpus to buy an annuity and can take the rest of the money out in one go or in instalments. If a subscriber dies, the nominee has the option to receive the entire pension wealth as a lump sum.
Is the scheme tax free?
Long term savings have three stages: contribution, accumulation and withdrawal. The NPS was devised when the government was planning to move all long term savings to a tax regime called exempt-exempt-taxed (EET), standing for exempt at the time of contribution, exempt during the period when the investment accumulates and taxed at the time of withdrawal. So, NPS comes under the tax regime EET. However, the government could not muster the political courage to change the taxation regime of EET on several saving schemes. So, the pension fund regulator has taken up with the finance ministry the need to remove the asymmetry in tax treatment between the NPS and other schemes such as the PPF. In any case, the amount spent on buying an annuity would be exempt from tax.
What is the default allocation of savings towards different asset classes for those who do not make an active choice?
For a saver not yet 35 years of age, half the investments will go into asset class E, one-fifth into asset class G, and the rest into asset class C. Above the age of 35, the default proportion going to equities would come down and the proportion going to government securities, go up. By the age of 60, these investments will gradually be adjusted so that only one-tenth remains in equities, another one-tenth in corporate bonds and 80% in central and state government bonds.
How does the NPS compare with mutual funds?
Since the NPS is meant for post-retirement financial security, it does not permit flexible withdrawals as are possible in the case of mutual funds. Fund management charges are ridiculously low (0.0009% a year), as compared with mutual funds. The cost of opening and maintaining a permanent retirement account, and the transaction charge on changing address, pension fund manager, etc are around Rs 400 now.
What kind of returns would the NPS generate?
The NPS generated an average return in excess of 14% in the last financial year, the first one in which it operated, handling the corpus of civil service pensions.
Source :www.economictimes.com
Sunday, May 3, 2009
Saturday, May 2, 2009
Mutual funds primer
Overview
The one investment vehicle that has truly come of age in India in the past decade is mutual funds. Today, the mutual fund industry in the country manages around Rs 329,162 crore (As of Dec, 2006) of assets, a large part of which comes from retail investors. And this amount is invested not just in equities, but also in the entire gamut of debt instruments. Mutual funds have emerged as a proxy for investing in avenues that are out of reach of most retail investors, particularly government securities and money market instruments.
Specialisation is the order of the day, be it with regard to a scheme’s investment objective or its targeted investment universe. Given the plethora of options on hand and the hard-sell adopted by mutual funds vying for a piece of your savings, finding the right scheme can sometimes seem a bit daunting. Mind you, it’s not just about going with the fund that gives you the highest returns. It’s also about managing risk–finding funds that suit your risk appetite and investment needs.
So, how can you, the retail investor, create wealth for yourself by investing through mutual funds? To answer that, we need to get down to brass tacks–what exactly is a mutual fund?
Very simply, a mutual fund is an investment vehicle that pools in the monies of several investors, and collectively invests this amount in either the equity market or the debt market, or both, depending upon the fund’s objective. This means you can access either the equity or the debt market, or both, without investing directly in equity or debt.
Mutual funds: The advantages...
And that, naturally, begs the question: why can’t I invest directly in, say, equity? Why go through a mutual fund at all? Here are some compelling arguments in favour of mutual funds:
Professional management
Take equities. Most of us have neither the skill to find good stocks that suit our risk and returns profile nor the time to track our investments–but still want the returns that can be had from equities. That’s where mutual funds come in.
When you invest in mutual funds, it is your fund manager who will take care of your investments. A fund manager is an investment specialist, who brings to the table an in-depth understanding of the financial markets. By virtue of being in the market, the fund manager is ideally placed to research various investment options, and invest accordingly for you.
Small investments
Today, if you wanted to buy government securities, you would have to invest a minimum amount of Rs 25,000. Much the same is the case if you want to build a decent-sized portfolio of shares of blue-chips. Now, that might be too large an amount for many small investors.
A mutual fund, however, gives you an ownership of the same investment pie– at an outlay of Rs 1,000-5,000. That’s because a mutual fund pools the monies of several investors, and invests the resultant large sum in a number of securities. So, on a small outlay, you get to participate in the investment prospects of a number of securities.
Diversified portfolio
One of the oft-mentioned tenets of portfolio management is: diversify. In other words, don’t put all your eggs in one basket. The rationale for this is that even if one pick in your portfolio turns bad, the others can check the erosion in the portfolio value.
Take a simple–even if extreme– example. Say, you have Rs 10,000 invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of your investment will halve to Rs 5,000. Now, say you had invested the same amount in a mutual fund, which had parked 10 per cent of its corpus in the Reliance stock. Assuming prices of other stocks in its portfolio stay the same, the depreciation in the fund’s portfolio– and hence, your investment–will be 5 per cent. That’s one of the merits of diversification.
Liquidity
You are free to take your money out of open-ended mutual funds whenever you want, no questions asked. Most open-ended funds mail your redemption proceeds, which are linked to the fund’s prevailing NAV (net asset value), within three to five working days of your putting in your request.
Tax breaks
Last but not the least, mutual funds offer significant tax advantages. Dividends distributed by them are tax-free in the hands of the investor.
They also give you the advantages of capital gains taxation. If you hold units beyond one year, you get the benefits of indexation. Simply put, indexation benefits increase your purchase cost by a certain portion, depending upon the yearly cost-inflation index (which is calculated to account for rising inflation), thereby reducing the gap between your actual purchase cost and selling price. This reduces your tax liability.
What’s more, tax-saving schemes and pension schemes give you the added advantage of benefits under Section 88. You can avail of a 20 per cent tax exemption on an investment of up to Rs 10,000 in the scheme in a year.
...And disadvantages
Mutual funds are good investment vehicles to navigate the complex and unpredictable world of investments. However, even mutual funds have some inherent drawbacks. Understand these before you commit your money to a mutual fund.
No assured returns and no protection of capital
If you are planning to go with a mutual fund, this must be your mantra: mutual funds do not offer assured returns and carry risk. For instance, unlike bank deposits, your investment in a mutual fund can fall in value. In addition, mutual funds are not insured or guaranteed by any government body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India).
There are strict norms for any fund that assures returns and it is now compulsory for funds to establish that they have resources to back such assurances. This is because most closed-end funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to investors.
Restrictive gains
Diversification helps, if risk minimisation is your objective. However, the lack of investment focus also means you gain less than if you had invested directly in a single security.
In our earlier example, say, Reliance appreciated 50 per cent. A direct investment in the stock would appreciate by 50 per cent. But your investment in the mutual fund, which had invested 10 per cent of its corpus in Reliance, will see only a 5 per cent appreciation.
Types of mutual funds
Many people tend to wrongly equate mutual fund investing with equity investing. Fact is, equity is just one of the various asset classes mutual funds invest in. They also invest in debt instruments such as bonds, debentures, commercial paper and government securities.
Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the class(es) of securities it can invest in. Based on the asset classes, broadly speaking, the following types of mutual funds currently operate in the country.
Equity funds. The highest rung on the mutual fund risk ladder, such funds invest only in stocks. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. There are also ‘specialised’ equity funds, such as index funds and sector funds, which invest only in specific categories of stocks.
Debt funds. Such funds invest only in debt instruments, and are a good option for investors averse to taking on the risk associated with equities. Here too, there are specialised schemes, namely liquid funds and gilt funds. While the former invests predominantly in money market instruments, gilt funds do so in securities issued by the central and state governments.
Balanced funds. Lastly, there are balanced funds, whose investment portfolio includes both debt and equity. As a result, on the risk ladder, they fall somewhere between equity and debt funds. Balanced funds are the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments.
Let’s now take a closer look at the working of each of these three categories of funds, the investment options they offer, and how best you can make money from them.
Equity funds
As explained earlier, such funds invest only in stocks, the riskiest of asset classes. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are:
Index funds
These funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portfolio mirrors the index they track, both in terms of composition and the individual stock weightages. For instance, an index fund that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds don’t need fund managers, as there is no stock selection involved.
Investing through index funds is a passive investment strategy, as a fund’s performance will invariably mimic the index concerned, barring a minor "tracking error". Usually, there’s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. So, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent.
To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualised return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualised return to 16.2 per cent. Obviously, the lower the tracking error, the better the index fund.
Diversified funds
Such funds have the mandate to invest in the entire universe of stocks. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager.
This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager’s picks languish, the returns will be far lower.
The crux of the matter is that your returns from a diversified fund depend a lot on the fund manager’s capabilities to make the right investment decisions. On your part, watch out for the extent of diversification prescribed and practised by your fund manager. Understand that a portfolio concentrated in a few sectors or companies is a high risk, high return proposition. If you don’t want to take on a high degree of risk, stick to funds that are diversified not just in name but also in appearance.
Tax-saving funds
Also known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, you can claim a tax exemption of 20 per cent from your taxable income. You can invest more than Rs 10,000, but you won’t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that you are locked into the scheme for three years.
In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.
Sector funds
The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.
Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.
How to pick an equity fund
Now, that you have an idea of the investment profile and objective behind each type of equity fund, let’s get down to specifics: what you should look for while evaluating an equity fund. First, narrow down your investment universe by deciding which category of equity fund you would like to invest in. That decided, seek the following four attributes from a prospective fund.
Track record. It’s always safer to opt for a fund that’s been around for a while, as you can study its track record. You can see how the fund has performed over the years, which will facilitate historical comparison across its peer set.
Although past trends are no guarantee of future performance, it does give an indication of how well a fund has capitalised on upturns and weathered downturns in the past. The fund’s track record also gives an indication of the volatility in its returns. Avoid funds that show a volatile returns patterns.
Diversified portfolio. Unless you are willing to take on high risk, avoid funds that have a high exposure to a few sectors or a handful of stocks. Such funds will give superior returns when the selected sectors are doing well, but if the market crashes or the sector performs badly, the fall in NAV will be equally sharp. Ideally, a diversified equity fund should have an exposure to at least four sectors and seven to 10 scrips.
Diversified investor base. Just as the fund needs diversified investments, it also needs to have a diversified investor base. This ensures that a few investors do not own a significant part of the fund, as it would belie the very principle of a mutual fund.
Sebi (Securities and Exchange Board of India) regulations stipulate that a fund must publish, in its half-yearly disclosures, details of the number of investors who hold more than 25 per cent of the scheme’s corpus. Avoid such funds, as they could well be catering to the interests of the large investors–at your expense.
Transparency in operations. Before investing in a fund, always go through its offer document and fact sheet. If the fund house doesn’t give out such information regularly, avoid that fund. Funds that do not disclose details on a regular basis to their unitholders are better left alone, as you may not be told what will happen to your money once you invest.
Debt funds
Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.
Income funds
By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.
Gilt funds
They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.
Liquid funds
They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.
The ‘risk’ in debt funds
Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.
Interest rate risk. This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities.
Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper. If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.
Credit risk. This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies.
The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper. The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper.
Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.
Liquidity risk. This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper.
As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.
How to pick a debt fund
It’s evident there is an element of risk associated with debt funds. Hence, some care and thought has to go into picking a debt fund. Here are some factors you ought to look at while scouting for a debt fund.
Investment horizon. The first thing you need to get a fix on is your investment horizon. If you wish to invest in a debt fund for anything up to one year, opt for a liquid fund. Anything above that, you should be looking at a gilt fund or an income fund.
Track record. As with equity funds, a debt fund with a good track record is always preferable. The longer the track record, the better–to be on the safe side, choose funds that have been in the market for at least a year.
Credit quality. One of the most important factors you need to look for in an income fund is the credit rating of the debt instruments in its portfolio.
A credit rating of AAA denotes the highest safety, while a rating of below BBB is classified as non-investment grade. Although rating agencies classify BBB paper as investment grade, you should budget for downgrades, and set the minimum acceptable rating benchmark at AA. In order to ensure the safety of your investment, opt for a fund that has at least 75 per cent of its corpus in AAA-rated paper, and 90 per cent in AA and AAA paper.
Diversification. In order to limit the loss from a possible default, an income fund should be reasonably diversified across companies. Say, a fund manager invests his entire corpus in debt instruments of just one company. If the company goes under, the fund loses everything. Now, had the fund manager diversified and invested 10 per cent of his corpus in 10 companies, with one-tenth in the troubled company, his loss would be lower. Assuming the other companies meet their debt obligations, the fund’s loss would be restricted to 10 per cent.
Diversified investor base. Similar to the pre-condition for equity funds, avoid debt funds where a few large investors account for an abnormally high portion of the corpus.
Balanced funds
As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.
How to pick a balanced fund
The same criterion that applies to selecting an equity fund holds good when choosing a balanced fund. The one additional factor you should check for a balanced fund is the equity and debt split. The offer document will state the ratio of equity and debt investments the fund plans to have. Mostly, this takes on a range, and varies from time to time depending on the fund manager’s perception of the financial markets.
Before investing in an existing balanced fund, go through a few of its past fund fact sheets, and look up the equity-debt split. If you are a conservative investor, opt for a fund where equity investments are capped at 60 per cent of corpus. However, if you are the aggressive sort, you could even go along with a higher equity holding.
The intelligent investor's seven rules
It’s one thing to understand mutual funds and their working; it’s another to ride on this potent investment vehicle to create wealth in tune with your risk profile and investment needs. Here are seven must-dos that go a long way in helping you meet your investment objectives.
Know your risk profile
Can you live with volatility? Or are you a low-risk investor? Would you be satisfied if your fund invests in fixed-income securities, and yields low but sure-shot returns? These are some of the questions you need to ask yourself before investing in a fund.
Your investments should reflect your risk-taking capacity.
Equity funds might lure when the market is rising and your neighbour is making money, but if you are not cut out for the risk that accompanies it, don’t bite the bait. So, check if the fund’s objective matches yours. Invest only after you have found your match. If you are racked by uncertainty, seek expert advice from a qualified financial advisor.
Identify your investment horizon
How long you want to stay invested in a fund is as important as deciding upon your risk profile. A mutual fund is essentially a savings vehicle, not a speculation vehicle–don’t get in with the intention of making overnight gains.
Invest in an equity fund only if you are willing to stay on for at least two years. For income and gilt funds, have a one-year perspective at least. Anything less than one year, the only option among mutual funds is liquid funds.
Read the offer document carefully
This is a must before you commit your money to a fund. The offer document contains essential details pertaining to the fund, including the summary information (type of scheme, name of the asset management company and price of units, among other things), investment objectives and investment procedure, financial information and risk factors.
Go through the fund fact sheet
Fund fact sheets give you valuable information of how the fund has performed in the past. You can check the fund’s portfolio, its diversification levels and its performance in the past. The more fact sheets you examine, the better.
Diversify across fund houses
If you are routing a substantial sum through mutual funds, you should diversify across fund houses. That way, you spread your risk.
Do not chase incentives
Don’t get lured by investment incentives. Some financial intermediaries give upfront incentives, in the form of a percentage of your initial investment, to invest in a particular fund. Don’t buy it. Your focus should be to find a fund that matches your investment needs and risk profile, and is a performer.
Track your investments
Your job doesn’t end at the point of making the investment. It’s important you track your investment on a regular basis, be it in an equity, debt or balanced fund. One easy way to keep track of your fund is to keep track of the Intelligent Investor rankings of mutual funds, which are complied on a quarterly basis (log on to iinvestor.com to see the rankings for the quarter ended June 2001). These rankings allow you to take note of your fund’s performance and risk profile, and compare it across various time periods as well as across its peer set. In addition, you should run some basic checks in the fund fact sheets and the quarterly reports you get from your fund.
Equity funds are subject to market volatility, and the pace of change can be quite brisk. Check your fund’s quarterly reports for changes that could have severe implications on your investment. If you find a high degree of concentration in a few stocks or sectors, it means the fund manager is banking on the performance of these sectors. If they keep up to his expectations, you could end up making hefty returns, but if they don’t, chances are that the NAV will depreciate heavily.
In the case of debt funds, check the portfolio distribution and the fund’s holding in AAA and equivalent papers. If you find your fund is holding a significant quantity (above 10 per cent) in below AA-rated paper, your investment is not safe. Remember, even a single default can drag the NAV of your debt down.
If you come across negative reports of the fund, ask your financial advisor or broker about it, especially if there’s a possibility of your investment depreciating in value. If the threat is real, reduce your exposure to the fund.
Source : money.outlookindia.com
The one investment vehicle that has truly come of age in India in the past decade is mutual funds. Today, the mutual fund industry in the country manages around Rs 329,162 crore (As of Dec, 2006) of assets, a large part of which comes from retail investors. And this amount is invested not just in equities, but also in the entire gamut of debt instruments. Mutual funds have emerged as a proxy for investing in avenues that are out of reach of most retail investors, particularly government securities and money market instruments.
Specialisation is the order of the day, be it with regard to a scheme’s investment objective or its targeted investment universe. Given the plethora of options on hand and the hard-sell adopted by mutual funds vying for a piece of your savings, finding the right scheme can sometimes seem a bit daunting. Mind you, it’s not just about going with the fund that gives you the highest returns. It’s also about managing risk–finding funds that suit your risk appetite and investment needs.
So, how can you, the retail investor, create wealth for yourself by investing through mutual funds? To answer that, we need to get down to brass tacks–what exactly is a mutual fund?
Very simply, a mutual fund is an investment vehicle that pools in the monies of several investors, and collectively invests this amount in either the equity market or the debt market, or both, depending upon the fund’s objective. This means you can access either the equity or the debt market, or both, without investing directly in equity or debt.
Mutual funds: The advantages...
And that, naturally, begs the question: why can’t I invest directly in, say, equity? Why go through a mutual fund at all? Here are some compelling arguments in favour of mutual funds:
Professional management
Take equities. Most of us have neither the skill to find good stocks that suit our risk and returns profile nor the time to track our investments–but still want the returns that can be had from equities. That’s where mutual funds come in.
When you invest in mutual funds, it is your fund manager who will take care of your investments. A fund manager is an investment specialist, who brings to the table an in-depth understanding of the financial markets. By virtue of being in the market, the fund manager is ideally placed to research various investment options, and invest accordingly for you.
Small investments
Today, if you wanted to buy government securities, you would have to invest a minimum amount of Rs 25,000. Much the same is the case if you want to build a decent-sized portfolio of shares of blue-chips. Now, that might be too large an amount for many small investors.
A mutual fund, however, gives you an ownership of the same investment pie– at an outlay of Rs 1,000-5,000. That’s because a mutual fund pools the monies of several investors, and invests the resultant large sum in a number of securities. So, on a small outlay, you get to participate in the investment prospects of a number of securities.
Diversified portfolio
One of the oft-mentioned tenets of portfolio management is: diversify. In other words, don’t put all your eggs in one basket. The rationale for this is that even if one pick in your portfolio turns bad, the others can check the erosion in the portfolio value.
Take a simple–even if extreme– example. Say, you have Rs 10,000 invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of your investment will halve to Rs 5,000. Now, say you had invested the same amount in a mutual fund, which had parked 10 per cent of its corpus in the Reliance stock. Assuming prices of other stocks in its portfolio stay the same, the depreciation in the fund’s portfolio– and hence, your investment–will be 5 per cent. That’s one of the merits of diversification.
Liquidity
You are free to take your money out of open-ended mutual funds whenever you want, no questions asked. Most open-ended funds mail your redemption proceeds, which are linked to the fund’s prevailing NAV (net asset value), within three to five working days of your putting in your request.
Tax breaks
Last but not the least, mutual funds offer significant tax advantages. Dividends distributed by them are tax-free in the hands of the investor.
They also give you the advantages of capital gains taxation. If you hold units beyond one year, you get the benefits of indexation. Simply put, indexation benefits increase your purchase cost by a certain portion, depending upon the yearly cost-inflation index (which is calculated to account for rising inflation), thereby reducing the gap between your actual purchase cost and selling price. This reduces your tax liability.
What’s more, tax-saving schemes and pension schemes give you the added advantage of benefits under Section 88. You can avail of a 20 per cent tax exemption on an investment of up to Rs 10,000 in the scheme in a year.
...And disadvantages
Mutual funds are good investment vehicles to navigate the complex and unpredictable world of investments. However, even mutual funds have some inherent drawbacks. Understand these before you commit your money to a mutual fund.
No assured returns and no protection of capital
If you are planning to go with a mutual fund, this must be your mantra: mutual funds do not offer assured returns and carry risk. For instance, unlike bank deposits, your investment in a mutual fund can fall in value. In addition, mutual funds are not insured or guaranteed by any government body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India).
There are strict norms for any fund that assures returns and it is now compulsory for funds to establish that they have resources to back such assurances. This is because most closed-end funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to investors.
Restrictive gains
Diversification helps, if risk minimisation is your objective. However, the lack of investment focus also means you gain less than if you had invested directly in a single security.
In our earlier example, say, Reliance appreciated 50 per cent. A direct investment in the stock would appreciate by 50 per cent. But your investment in the mutual fund, which had invested 10 per cent of its corpus in Reliance, will see only a 5 per cent appreciation.
Types of mutual funds
Many people tend to wrongly equate mutual fund investing with equity investing. Fact is, equity is just one of the various asset classes mutual funds invest in. They also invest in debt instruments such as bonds, debentures, commercial paper and government securities.
Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the class(es) of securities it can invest in. Based on the asset classes, broadly speaking, the following types of mutual funds currently operate in the country.
Equity funds. The highest rung on the mutual fund risk ladder, such funds invest only in stocks. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. There are also ‘specialised’ equity funds, such as index funds and sector funds, which invest only in specific categories of stocks.
Debt funds. Such funds invest only in debt instruments, and are a good option for investors averse to taking on the risk associated with equities. Here too, there are specialised schemes, namely liquid funds and gilt funds. While the former invests predominantly in money market instruments, gilt funds do so in securities issued by the central and state governments.
Balanced funds. Lastly, there are balanced funds, whose investment portfolio includes both debt and equity. As a result, on the risk ladder, they fall somewhere between equity and debt funds. Balanced funds are the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments.
Let’s now take a closer look at the working of each of these three categories of funds, the investment options they offer, and how best you can make money from them.
Equity funds
As explained earlier, such funds invest only in stocks, the riskiest of asset classes. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are:
Index funds
These funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portfolio mirrors the index they track, both in terms of composition and the individual stock weightages. For instance, an index fund that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds don’t need fund managers, as there is no stock selection involved.
Investing through index funds is a passive investment strategy, as a fund’s performance will invariably mimic the index concerned, barring a minor "tracking error". Usually, there’s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. So, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent.
To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualised return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualised return to 16.2 per cent. Obviously, the lower the tracking error, the better the index fund.
Diversified funds
Such funds have the mandate to invest in the entire universe of stocks. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager.
This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager’s picks languish, the returns will be far lower.
The crux of the matter is that your returns from a diversified fund depend a lot on the fund manager’s capabilities to make the right investment decisions. On your part, watch out for the extent of diversification prescribed and practised by your fund manager. Understand that a portfolio concentrated in a few sectors or companies is a high risk, high return proposition. If you don’t want to take on a high degree of risk, stick to funds that are diversified not just in name but also in appearance.
Tax-saving funds
Also known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, you can claim a tax exemption of 20 per cent from your taxable income. You can invest more than Rs 10,000, but you won’t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that you are locked into the scheme for three years.
In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.
Sector funds
The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.
Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.
How to pick an equity fund
Now, that you have an idea of the investment profile and objective behind each type of equity fund, let’s get down to specifics: what you should look for while evaluating an equity fund. First, narrow down your investment universe by deciding which category of equity fund you would like to invest in. That decided, seek the following four attributes from a prospective fund.
Track record. It’s always safer to opt for a fund that’s been around for a while, as you can study its track record. You can see how the fund has performed over the years, which will facilitate historical comparison across its peer set.
Although past trends are no guarantee of future performance, it does give an indication of how well a fund has capitalised on upturns and weathered downturns in the past. The fund’s track record also gives an indication of the volatility in its returns. Avoid funds that show a volatile returns patterns.
Diversified portfolio. Unless you are willing to take on high risk, avoid funds that have a high exposure to a few sectors or a handful of stocks. Such funds will give superior returns when the selected sectors are doing well, but if the market crashes or the sector performs badly, the fall in NAV will be equally sharp. Ideally, a diversified equity fund should have an exposure to at least four sectors and seven to 10 scrips.
Diversified investor base. Just as the fund needs diversified investments, it also needs to have a diversified investor base. This ensures that a few investors do not own a significant part of the fund, as it would belie the very principle of a mutual fund.
Sebi (Securities and Exchange Board of India) regulations stipulate that a fund must publish, in its half-yearly disclosures, details of the number of investors who hold more than 25 per cent of the scheme’s corpus. Avoid such funds, as they could well be catering to the interests of the large investors–at your expense.
Transparency in operations. Before investing in a fund, always go through its offer document and fact sheet. If the fund house doesn’t give out such information regularly, avoid that fund. Funds that do not disclose details on a regular basis to their unitholders are better left alone, as you may not be told what will happen to your money once you invest.
Debt funds
Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.
Income funds
By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.
Gilt funds
They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.
Liquid funds
They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.
The ‘risk’ in debt funds
Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.
Interest rate risk. This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities.
Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper. If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.
Credit risk. This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies.
The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper. The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper.
Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.
Liquidity risk. This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper.
As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.
How to pick a debt fund
It’s evident there is an element of risk associated with debt funds. Hence, some care and thought has to go into picking a debt fund. Here are some factors you ought to look at while scouting for a debt fund.
Investment horizon. The first thing you need to get a fix on is your investment horizon. If you wish to invest in a debt fund for anything up to one year, opt for a liquid fund. Anything above that, you should be looking at a gilt fund or an income fund.
Track record. As with equity funds, a debt fund with a good track record is always preferable. The longer the track record, the better–to be on the safe side, choose funds that have been in the market for at least a year.
Credit quality. One of the most important factors you need to look for in an income fund is the credit rating of the debt instruments in its portfolio.
A credit rating of AAA denotes the highest safety, while a rating of below BBB is classified as non-investment grade. Although rating agencies classify BBB paper as investment grade, you should budget for downgrades, and set the minimum acceptable rating benchmark at AA. In order to ensure the safety of your investment, opt for a fund that has at least 75 per cent of its corpus in AAA-rated paper, and 90 per cent in AA and AAA paper.
Diversification. In order to limit the loss from a possible default, an income fund should be reasonably diversified across companies. Say, a fund manager invests his entire corpus in debt instruments of just one company. If the company goes under, the fund loses everything. Now, had the fund manager diversified and invested 10 per cent of his corpus in 10 companies, with one-tenth in the troubled company, his loss would be lower. Assuming the other companies meet their debt obligations, the fund’s loss would be restricted to 10 per cent.
Diversified investor base. Similar to the pre-condition for equity funds, avoid debt funds where a few large investors account for an abnormally high portion of the corpus.
Balanced funds
As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.
How to pick a balanced fund
The same criterion that applies to selecting an equity fund holds good when choosing a balanced fund. The one additional factor you should check for a balanced fund is the equity and debt split. The offer document will state the ratio of equity and debt investments the fund plans to have. Mostly, this takes on a range, and varies from time to time depending on the fund manager’s perception of the financial markets.
Before investing in an existing balanced fund, go through a few of its past fund fact sheets, and look up the equity-debt split. If you are a conservative investor, opt for a fund where equity investments are capped at 60 per cent of corpus. However, if you are the aggressive sort, you could even go along with a higher equity holding.
The intelligent investor's seven rules
It’s one thing to understand mutual funds and their working; it’s another to ride on this potent investment vehicle to create wealth in tune with your risk profile and investment needs. Here are seven must-dos that go a long way in helping you meet your investment objectives.
Know your risk profile
Can you live with volatility? Or are you a low-risk investor? Would you be satisfied if your fund invests in fixed-income securities, and yields low but sure-shot returns? These are some of the questions you need to ask yourself before investing in a fund.
Your investments should reflect your risk-taking capacity.
Equity funds might lure when the market is rising and your neighbour is making money, but if you are not cut out for the risk that accompanies it, don’t bite the bait. So, check if the fund’s objective matches yours. Invest only after you have found your match. If you are racked by uncertainty, seek expert advice from a qualified financial advisor.
Identify your investment horizon
How long you want to stay invested in a fund is as important as deciding upon your risk profile. A mutual fund is essentially a savings vehicle, not a speculation vehicle–don’t get in with the intention of making overnight gains.
Invest in an equity fund only if you are willing to stay on for at least two years. For income and gilt funds, have a one-year perspective at least. Anything less than one year, the only option among mutual funds is liquid funds.
Read the offer document carefully
This is a must before you commit your money to a fund. The offer document contains essential details pertaining to the fund, including the summary information (type of scheme, name of the asset management company and price of units, among other things), investment objectives and investment procedure, financial information and risk factors.
Go through the fund fact sheet
Fund fact sheets give you valuable information of how the fund has performed in the past. You can check the fund’s portfolio, its diversification levels and its performance in the past. The more fact sheets you examine, the better.
Diversify across fund houses
If you are routing a substantial sum through mutual funds, you should diversify across fund houses. That way, you spread your risk.
Do not chase incentives
Don’t get lured by investment incentives. Some financial intermediaries give upfront incentives, in the form of a percentage of your initial investment, to invest in a particular fund. Don’t buy it. Your focus should be to find a fund that matches your investment needs and risk profile, and is a performer.
Track your investments
Your job doesn’t end at the point of making the investment. It’s important you track your investment on a regular basis, be it in an equity, debt or balanced fund. One easy way to keep track of your fund is to keep track of the Intelligent Investor rankings of mutual funds, which are complied on a quarterly basis (log on to iinvestor.com to see the rankings for the quarter ended June 2001). These rankings allow you to take note of your fund’s performance and risk profile, and compare it across various time periods as well as across its peer set. In addition, you should run some basic checks in the fund fact sheets and the quarterly reports you get from your fund.
Equity funds are subject to market volatility, and the pace of change can be quite brisk. Check your fund’s quarterly reports for changes that could have severe implications on your investment. If you find a high degree of concentration in a few stocks or sectors, it means the fund manager is banking on the performance of these sectors. If they keep up to his expectations, you could end up making hefty returns, but if they don’t, chances are that the NAV will depreciate heavily.
In the case of debt funds, check the portfolio distribution and the fund’s holding in AAA and equivalent papers. If you find your fund is holding a significant quantity (above 10 per cent) in below AA-rated paper, your investment is not safe. Remember, even a single default can drag the NAV of your debt down.
If you come across negative reports of the fund, ask your financial advisor or broker about it, especially if there’s a possibility of your investment depreciating in value. If the threat is real, reduce your exposure to the fund.
Source : money.outlookindia.com
Monday, April 13, 2009
Equities can be a great tool for retirement planning
Equities can be a great tool for retirement planning provided you look at the cash-flow aspect of it. Unfortunately, equities are most often sold as trading opportunity to investors, which is hardly helpful
"Retirement can be a great joy. If you can figure out how to spend time without spending money." Retirement can be the beginning of a new life, but what comes in way of fun is the money. What''s needed is retiree ability to maintain his/her lifestyle and monetary pride even after monthly salary cheques stop arriving. This requires a long-term investment strategy, spanning at least 15-20 years. Though capital appreciation matters, key is to plan for post-retirement cash flows. Here I am assuming that a typical retiree would have done with big-ticket expenses, such as buying a house, kids'' marriage, among others, by the time he/she turns 60. This needs choosing a matching asset class. Equities are considered to be classic long-term assets. Companies raise shareholders equity and use it to build up businesses that may typically last a life-time or longer. And shareholders are rewarded for their patience with regular and dividends payments. Over time share price also appreciates as the earnings and dividends grow. This means that equities are both a store of wealth (or value) and a source of consistent cash flows. This separates equity from other asset classes, such as commodities and gold, which are only store of wealth with no underlying cash-flows. This aspect of equities is, however, not equally highlighted. For equities, the only principle that discussed is buying when it''s low and selling at high. Trading advisors, however, forget to mention that (trading) profit is a slave of timing that you may or may not get right. Further, trading also requires constant monitoring and portfolio churning to stay ahead of the market swings. This is beyond the capacity of a typical retail investor, who has a regular job to attend to.
Given this, a retirement plan should depend on dividend-income rather than capital returns. But you may ask, can dividend payments be sufficiently large to help you retire with pride. We at ETIG decided to test this idea by building a model portfolio of 20 stocks and tracked their dividend record over the last 15 years. The portfolio is equally divided between defensive stocks (belonging to non-discretionary consumer goods sector) and cyclical stocks. Further, we gave equal weightage to every stock in our portfolio, i.e. investor will invest equal amount in all stocks. Click here to view "The Model Portfolio" What we found out that, the dividend strategy works the best, when you invest in bear phase as was the case in 2002-03 or now. As stock price falls, dividend yield improves dramatically. If you had invested Rs 1,500 per stock (Rs 30,000 in all) in 1994, you would have earned a total dividend of Rs 4,381 during the year ended March 2008. In contrast, if you have invested in 2002, a year before the market bottomed out, your dividend income at the end of 15 years would have topped Rs 15,000 for the same rate of growth. This is shown in the chart (Money Plant) where we show the relative growth in dividend and market-cap of our portfolio of companies. As is evident, in the last 15 years, dividend receipts jumped by 15 times, while capital value of the portfolio grew by 9 times its initial value. The total annual dividend payments by our portfolio grew at a compounded annual rate of 21.2% during the period between FY94 and FY08.
A hybrid Approach
Now that the model is tested, we are suggesting investors to follow a "hybrid-approach" for retirement planning. This means taking an advantage of both the equities and the fixed-income instruments for example public provident funds (PPF). For example, if your investment horizon is 20 years, deposit an amount equivalent to your annual dividend income in PPF for the next 20 years and let its grow there. The cumulative impact of this strategy is shown in the second chart (Figure Watch). The chart is based on the following two assumptions. You invest one and for all Rs 200,000 in the first year (equally divided between 20 stocks) and that dividend receipts grows at the historical rate. Additionally, we expect you to invest when dividend yields high as in 2002-03. As can be discerned from the chart, in the first year, total dividend income is just Rs 7,000, which works to be yield of just over 3.5%, too low to be noticed. But if you wait, the annual booty steadily grows to Rs 3.2 lakh in the 20th year. But what makes this strategy magical is growth in accumulated dividends, which are invested in PPF in the interim period (earning an annual interest of 8%). By the end of 20th year, the cumulative dividend income grows to a whopping Rs 25 lakh. And remember, this is over and above the then market value of the stocks in your portfolio.
Another beauty of our "hybrid-model" is that the entire gains are tax-free. Both dividend income and PPF are tax-free, which saves you from the hassle of filing returns every year. Besides, there is hardly any cost of time involved in managing this strategy. Dividends are credited to your bank account electronically. This brings us to the current market situation, where the dividend yield on most stocks has shot up to historic highs levels. This is the time you start thinking of retirement planning. You should not necessarily copy our "model" portfolio. We picked this portfolio just to illustrate the point. The exact composition of your portfolio should depend on your specific requirement and risk appetite. So, what are you waiting for?
"Retirement can be a great joy. If you can figure out how to spend time without spending money." Retirement can be the beginning of a new life, but what comes in way of fun is the money. What''s needed is retiree ability to maintain his/her lifestyle and monetary pride even after monthly salary cheques stop arriving. This requires a long-term investment strategy, spanning at least 15-20 years. Though capital appreciation matters, key is to plan for post-retirement cash flows. Here I am assuming that a typical retiree would have done with big-ticket expenses, such as buying a house, kids'' marriage, among others, by the time he/she turns 60. This needs choosing a matching asset class. Equities are considered to be classic long-term assets. Companies raise shareholders equity and use it to build up businesses that may typically last a life-time or longer. And shareholders are rewarded for their patience with regular and dividends payments. Over time share price also appreciates as the earnings and dividends grow. This means that equities are both a store of wealth (or value) and a source of consistent cash flows. This separates equity from other asset classes, such as commodities and gold, which are only store of wealth with no underlying cash-flows. This aspect of equities is, however, not equally highlighted. For equities, the only principle that discussed is buying when it''s low and selling at high. Trading advisors, however, forget to mention that (trading) profit is a slave of timing that you may or may not get right. Further, trading also requires constant monitoring and portfolio churning to stay ahead of the market swings. This is beyond the capacity of a typical retail investor, who has a regular job to attend to.
Given this, a retirement plan should depend on dividend-income rather than capital returns. But you may ask, can dividend payments be sufficiently large to help you retire with pride. We at ETIG decided to test this idea by building a model portfolio of 20 stocks and tracked their dividend record over the last 15 years. The portfolio is equally divided between defensive stocks (belonging to non-discretionary consumer goods sector) and cyclical stocks. Further, we gave equal weightage to every stock in our portfolio, i.e. investor will invest equal amount in all stocks. Click here to view "The Model Portfolio" What we found out that, the dividend strategy works the best, when you invest in bear phase as was the case in 2002-03 or now. As stock price falls, dividend yield improves dramatically. If you had invested Rs 1,500 per stock (Rs 30,000 in all) in 1994, you would have earned a total dividend of Rs 4,381 during the year ended March 2008. In contrast, if you have invested in 2002, a year before the market bottomed out, your dividend income at the end of 15 years would have topped Rs 15,000 for the same rate of growth. This is shown in the chart (Money Plant) where we show the relative growth in dividend and market-cap of our portfolio of companies. As is evident, in the last 15 years, dividend receipts jumped by 15 times, while capital value of the portfolio grew by 9 times its initial value. The total annual dividend payments by our portfolio grew at a compounded annual rate of 21.2% during the period between FY94 and FY08.
A hybrid Approach
Now that the model is tested, we are suggesting investors to follow a "hybrid-approach" for retirement planning. This means taking an advantage of both the equities and the fixed-income instruments for example public provident funds (PPF). For example, if your investment horizon is 20 years, deposit an amount equivalent to your annual dividend income in PPF for the next 20 years and let its grow there. The cumulative impact of this strategy is shown in the second chart (Figure Watch). The chart is based on the following two assumptions. You invest one and for all Rs 200,000 in the first year (equally divided between 20 stocks) and that dividend receipts grows at the historical rate. Additionally, we expect you to invest when dividend yields high as in 2002-03. As can be discerned from the chart, in the first year, total dividend income is just Rs 7,000, which works to be yield of just over 3.5%, too low to be noticed. But if you wait, the annual booty steadily grows to Rs 3.2 lakh in the 20th year. But what makes this strategy magical is growth in accumulated dividends, which are invested in PPF in the interim period (earning an annual interest of 8%). By the end of 20th year, the cumulative dividend income grows to a whopping Rs 25 lakh. And remember, this is over and above the then market value of the stocks in your portfolio.
Another beauty of our "hybrid-model" is that the entire gains are tax-free. Both dividend income and PPF are tax-free, which saves you from the hassle of filing returns every year. Besides, there is hardly any cost of time involved in managing this strategy. Dividends are credited to your bank account electronically. This brings us to the current market situation, where the dividend yield on most stocks has shot up to historic highs levels. This is the time you start thinking of retirement planning. You should not necessarily copy our "model" portfolio. We picked this portfolio just to illustrate the point. The exact composition of your portfolio should depend on your specific requirement and risk appetite. So, what are you waiting for?
Tuesday, December 9, 2008
Safe options for your debt bucket
Here’s a headstart on safe investments, making sure you have explored all the choices that you have.
We have often spoken about asset allocation and the split between equity and safe debt. But what should you put into that risk-free debt bucket? That's what well tackle today.
We're so besotted with equity markets and its ups and downs; we almost tend to forget there's a whole universe of investments out there which is steadily building wealth for you. These are the investments in your debt bucket- hugely safer investment options than equity.
Some you definitely are invested in and perhaps don’t even count when you tally up your savings like provident fund. Then there are a few you may have missed out on not having enough information about them. So we decided to do a checklist of whether you've explored all your really safe debt investment options and making the best of them.
Safe is music to the ears right now, isn’t it?
Markets are irrelevant; these are products are those that you will use in any kind of market. We're looking at safe fixed return products that you will use for the debt part of your asset allocation.
Beginning with a checklist; what are debt investments?
What is a debt instrument?
# Gives fixed return
# At a fixed time
# Usually guaranteed
Role of a debt product?
# Provide safety of money
# Target an assured sum
# Give regular income
# Give stability to portfolio
Bank FDs, post office deposits, PPF and now bonds. It is always difficult to choose. The best way to choose is to look at utility:
# Products that allow us to build a corpus
# Products that give off a regular income.
We first talk of products that allow us to build a corpus. It can be done in two ways:
# Lump sum investing
# Regular investment
So let me take you through safe investment options of lumpsum investing; right now we feel the best in the market is a Bank FD. The rates are phenomenal and all of you should be booking some FDs in your portfolio; also we believe the rates could come down, so this window of high FD rates is not a big one. Here's a list of best Bank FDs going round bank town:
# DBS Bank- 1 year-2 years: 11.25 per cent
# Axis Bank- 500 days: 11 per cent
# ING Vysya Bank-1 year: 11 per cent
# IndusInd Bank- 400 days: 11 per cent
In case you need to block in for 5 years, a bank FD is paying about 10.75 per cent, that's the best return.
This is seriously good, risk free returns; aren't they?
Post office savings and the KVP as the other two options for lump sum savings:
Bank FDs today work the best when you compare them to other products in the same space - like the post office deposits and the KVP.
# Post office deposits are returning at most 7.5 per cent on a 5 year deposit
# KVP gives 8.4 per cent over 8.7 years
So this is what you will end up earning if you put away some money in Post Office savings- a lakh will fetch you1 lakh 6000 rupees and a little more in one year. The interest is compounded quarterly and if you can keep it for longer than 3 years you can get 7.25 per cent safe returns.
In 3 years, you will get (Int. 7.25 per cent) Rs 1,24,055, and in 5 years- just 5 rupees short of a lakh and a half.
Then there's one other long term option of lumpsum investment- Kisan Vikas Patra- your money is blocked for 8 years and 7 months and doubles in this period ( 2 lakhs).
There's one more product right now being advertised heavily - a bond from Nabard offering over 12 per cent returns. That's mouthwatering risk free returns, aren't they?
NABARD Bonds
# NABARD Bhavishya Nirman Bonds: Rs 1 lakh will become Rs 2.35 lakh in 10 years (rate of interest is 8.93 per cent)
NABARD is advertising 12.18 per cent but that is simple interest. There has been some argument with the CBDT on the taxation of the return - whether it is interest or capital gain. According to the Nabard Offer document this is capital gains and that works better for us than an income tax.
We are talking about how to choose debt products to fill our debt bucket. We saw that bank FDs are the best option today to target a corpus if we have a lump sum today. But what if we want to use a safe product to use regular savings to target a future goal? There are two products here and we all know about them, don't we?
Here's a quick look at your regular investment options to build a long term corpus:
# Bank recurring deposit: You get Rs 3.6 lakh if you invest Rs 5,000 a month for 5 years; that’s at 7.5 per cent interest per annum.
# Much better option of course is PPF; 70,000 is the limit, which you and your spouse should definitely be maximising every year.
In PPF you get Rs 19 lakh in 15 years at Rs 70,000 saved a year.
# And there's EPF; you get Rs 1.5 crore in 30 years if your present basic salary is Rs 15,000 and growing at 10 per cent per annum- 8.5 per cent per annum. That's a lot of safe money in every employed person's kitty.
1.5 crore- now that's a nice whole number. This number is on the assumption of a starting salary of Rs 15,000 a month that grows at 10 per cent per year and this person works for 30 years without withdrawing from the EPF account. EPF is one of the best ways to target our retirement since the money is deducted before the salary comes into our hands. A little known fact is that if you maintain a EPF account for more than 10 years you become eligible for pension. A checklist to get the best out of your EPF:
# Max your contribution to 12 per cent of your basic salary plus dearness allowance.
# Don't encash your EPF account when you move jobs. Get a transfer.
# If you stay in the EPF for at least 10 years, you can get pension when you turn 58.
# Don't withdraw your pension scheme money even if you encash your EPF.
# Instead, get a scheme certificate, which you can give to your new employer and carry forward your pension account.
What if you've already build a substantial kitty of savings and are looking safe regular investments- these are the options you could look for regular investments:
# Post Office Monthly Income Scheme (MIS): Here each individual can invest upto 3 lakh rupees, not more and you are allowed a joint account with spouse that can take this upto 6 lakhs per annum and this 6 lakh invested gives back Rs 48,000 a year. That's 8 per cent per annum, interest payable monthly.
# For senior citizens there also Senior Citizen Bonds: Rs 15 lakh invested gives back Rs 1,35,000 a year. 9 per cent per annum is your returns and you get money back quarterly.
In ranking these investments, you will have to mix and match here. If you need regular money right away- you should look at the Senior Citizen Bond. If you have more than Rs 15 lakh, you can use the post office MIS.
But if you are able to defer this income need by 1 or 2 years, I would use the bank FD to get that over 11 per cent rate of interest and then use MIS and Senior citizen bonds to give me a regular return.
A checklist for you:
# Have you and your spouse maximised investment of 70,000 rupees each year in public Provident Fund ?
# We also recommended you should be Maxing your EPF or employee provident fund contribution to 12 per cent of your basic salary plus dearness allowance. Must talk to your company today and tell them to do that.
# Then we recommended that for 1 to 5 years lumpsum investments- with rates likely to come down we would recommend that you do put some of your surplus investments in those.
# There are also government backed investments like Post Office deposits and Kisan Vikas Patras which most of us tend to ignore simply because they are not available easily; only a select list of agents sell these products.
Source:ndtvprofit.com
We have often spoken about asset allocation and the split between equity and safe debt. But what should you put into that risk-free debt bucket? That's what well tackle today.
We're so besotted with equity markets and its ups and downs; we almost tend to forget there's a whole universe of investments out there which is steadily building wealth for you. These are the investments in your debt bucket- hugely safer investment options than equity.
Some you definitely are invested in and perhaps don’t even count when you tally up your savings like provident fund. Then there are a few you may have missed out on not having enough information about them. So we decided to do a checklist of whether you've explored all your really safe debt investment options and making the best of them.
Safe is music to the ears right now, isn’t it?
Markets are irrelevant; these are products are those that you will use in any kind of market. We're looking at safe fixed return products that you will use for the debt part of your asset allocation.
Beginning with a checklist; what are debt investments?
What is a debt instrument?
# Gives fixed return
# At a fixed time
# Usually guaranteed
Role of a debt product?
# Provide safety of money
# Target an assured sum
# Give regular income
# Give stability to portfolio
Bank FDs, post office deposits, PPF and now bonds. It is always difficult to choose. The best way to choose is to look at utility:
# Products that allow us to build a corpus
# Products that give off a regular income.
We first talk of products that allow us to build a corpus. It can be done in two ways:
# Lump sum investing
# Regular investment
So let me take you through safe investment options of lumpsum investing; right now we feel the best in the market is a Bank FD. The rates are phenomenal and all of you should be booking some FDs in your portfolio; also we believe the rates could come down, so this window of high FD rates is not a big one. Here's a list of best Bank FDs going round bank town:
# DBS Bank- 1 year-2 years: 11.25 per cent
# Axis Bank- 500 days: 11 per cent
# ING Vysya Bank-1 year: 11 per cent
# IndusInd Bank- 400 days: 11 per cent
In case you need to block in for 5 years, a bank FD is paying about 10.75 per cent, that's the best return.
This is seriously good, risk free returns; aren't they?
Post office savings and the KVP as the other two options for lump sum savings:
Bank FDs today work the best when you compare them to other products in the same space - like the post office deposits and the KVP.
# Post office deposits are returning at most 7.5 per cent on a 5 year deposit
# KVP gives 8.4 per cent over 8.7 years
So this is what you will end up earning if you put away some money in Post Office savings- a lakh will fetch you1 lakh 6000 rupees and a little more in one year. The interest is compounded quarterly and if you can keep it for longer than 3 years you can get 7.25 per cent safe returns.
In 3 years, you will get (Int. 7.25 per cent) Rs 1,24,055, and in 5 years- just 5 rupees short of a lakh and a half.
Then there's one other long term option of lumpsum investment- Kisan Vikas Patra- your money is blocked for 8 years and 7 months and doubles in this period ( 2 lakhs).
There's one more product right now being advertised heavily - a bond from Nabard offering over 12 per cent returns. That's mouthwatering risk free returns, aren't they?
NABARD Bonds
# NABARD Bhavishya Nirman Bonds: Rs 1 lakh will become Rs 2.35 lakh in 10 years (rate of interest is 8.93 per cent)
NABARD is advertising 12.18 per cent but that is simple interest. There has been some argument with the CBDT on the taxation of the return - whether it is interest or capital gain. According to the Nabard Offer document this is capital gains and that works better for us than an income tax.
We are talking about how to choose debt products to fill our debt bucket. We saw that bank FDs are the best option today to target a corpus if we have a lump sum today. But what if we want to use a safe product to use regular savings to target a future goal? There are two products here and we all know about them, don't we?
Here's a quick look at your regular investment options to build a long term corpus:
# Bank recurring deposit: You get Rs 3.6 lakh if you invest Rs 5,000 a month for 5 years; that’s at 7.5 per cent interest per annum.
# Much better option of course is PPF; 70,000 is the limit, which you and your spouse should definitely be maximising every year.
In PPF you get Rs 19 lakh in 15 years at Rs 70,000 saved a year.
# And there's EPF; you get Rs 1.5 crore in 30 years if your present basic salary is Rs 15,000 and growing at 10 per cent per annum- 8.5 per cent per annum. That's a lot of safe money in every employed person's kitty.
1.5 crore- now that's a nice whole number. This number is on the assumption of a starting salary of Rs 15,000 a month that grows at 10 per cent per year and this person works for 30 years without withdrawing from the EPF account. EPF is one of the best ways to target our retirement since the money is deducted before the salary comes into our hands. A little known fact is that if you maintain a EPF account for more than 10 years you become eligible for pension. A checklist to get the best out of your EPF:
# Max your contribution to 12 per cent of your basic salary plus dearness allowance.
# Don't encash your EPF account when you move jobs. Get a transfer.
# If you stay in the EPF for at least 10 years, you can get pension when you turn 58.
# Don't withdraw your pension scheme money even if you encash your EPF.
# Instead, get a scheme certificate, which you can give to your new employer and carry forward your pension account.
What if you've already build a substantial kitty of savings and are looking safe regular investments- these are the options you could look for regular investments:
# Post Office Monthly Income Scheme (MIS): Here each individual can invest upto 3 lakh rupees, not more and you are allowed a joint account with spouse that can take this upto 6 lakhs per annum and this 6 lakh invested gives back Rs 48,000 a year. That's 8 per cent per annum, interest payable monthly.
# For senior citizens there also Senior Citizen Bonds: Rs 15 lakh invested gives back Rs 1,35,000 a year. 9 per cent per annum is your returns and you get money back quarterly.
In ranking these investments, you will have to mix and match here. If you need regular money right away- you should look at the Senior Citizen Bond. If you have more than Rs 15 lakh, you can use the post office MIS.
But if you are able to defer this income need by 1 or 2 years, I would use the bank FD to get that over 11 per cent rate of interest and then use MIS and Senior citizen bonds to give me a regular return.
A checklist for you:
# Have you and your spouse maximised investment of 70,000 rupees each year in public Provident Fund ?
# We also recommended you should be Maxing your EPF or employee provident fund contribution to 12 per cent of your basic salary plus dearness allowance. Must talk to your company today and tell them to do that.
# Then we recommended that for 1 to 5 years lumpsum investments- with rates likely to come down we would recommend that you do put some of your surplus investments in those.
# There are also government backed investments like Post Office deposits and Kisan Vikas Patras which most of us tend to ignore simply because they are not available easily; only a select list of agents sell these products.
Source:ndtvprofit.com
Sunday, December 7, 2008
What is rights issue?
Raise additional capital
A rights issue is a way by which a listed company can raise additional capital. However , instead of going to the public, the company gives its existing shareholders the right to subscribe to newly issued shares in proportion to their existing holdings. For example, 1:4 rights issue means an existing investor can buy one extra share for every four shares already held by him/her. Usually the price at which the new shares are issued by way of rights issue is less than the prevailing market price of the stock, i.e. the shares are offered at a discount.
To raise fresh capital
Why does a company go for it?The basic idea is to raise fresh capital. A rights issue is not a common practise that a corporate organisation resorts to. Ideally, such an issue occurs when a company needs funds for corporate expansion or a large takeover. At the same time, however, companies also use rights issue to prevent themselves from being conked out. Since a rights issue results in higher equity base for the organisation, it also provides it with better leveraging opportunities. The company becomes more comfortable when it comes to raising debt in the future as its debt-to-equity ratio reduces.
A rights issue affects
What is the effect on the company and what if a shareholder does not exercise his right?A rights issue affects two important elements of a company — equity capital and market capitalisation. In case of a rights issue, since additional equity is raised, the issuing company’s equity base rises to the extent of the issue. The effect on m-cap depends on the perception of the market. In theory, every new issue has some kind of diluting effect and hence as a result of a fall in the market price in proportion to an increase in the number of shares, the market capitalisation remains unaffected. However, if the market sentiment believes that the funds are being raised for an extremely positive purpose then price of the stock may just rise resulting in an increase in the market capitalisation . If a shareholder does not want to exercise the right to buy additional shares then he/she can sell the right as the rights are usually tradable. Alternatively, investors can just let the rights issue lapse.
Investor be careful
What should an investor be careful about in case of a rights issue? An investor should be able to look beyond the discount offered. Rights issue are different from bonus issue as one is paying money to get additional shares and hence one should subscribe to it only if he/she is completely sure of the company’s performance. Also, one must not take up the rights if the share price has fallen below the subscription price as it may be cheaper to buy the shares in the open market.
Source:Economictimes.com
A rights issue is a way by which a listed company can raise additional capital. However , instead of going to the public, the company gives its existing shareholders the right to subscribe to newly issued shares in proportion to their existing holdings. For example, 1:4 rights issue means an existing investor can buy one extra share for every four shares already held by him/her. Usually the price at which the new shares are issued by way of rights issue is less than the prevailing market price of the stock, i.e. the shares are offered at a discount.
To raise fresh capital
Why does a company go for it?The basic idea is to raise fresh capital. A rights issue is not a common practise that a corporate organisation resorts to. Ideally, such an issue occurs when a company needs funds for corporate expansion or a large takeover. At the same time, however, companies also use rights issue to prevent themselves from being conked out. Since a rights issue results in higher equity base for the organisation, it also provides it with better leveraging opportunities. The company becomes more comfortable when it comes to raising debt in the future as its debt-to-equity ratio reduces.
A rights issue affects
What is the effect on the company and what if a shareholder does not exercise his right?A rights issue affects two important elements of a company — equity capital and market capitalisation. In case of a rights issue, since additional equity is raised, the issuing company’s equity base rises to the extent of the issue. The effect on m-cap depends on the perception of the market. In theory, every new issue has some kind of diluting effect and hence as a result of a fall in the market price in proportion to an increase in the number of shares, the market capitalisation remains unaffected. However, if the market sentiment believes that the funds are being raised for an extremely positive purpose then price of the stock may just rise resulting in an increase in the market capitalisation . If a shareholder does not want to exercise the right to buy additional shares then he/she can sell the right as the rights are usually tradable. Alternatively, investors can just let the rights issue lapse.
Investor be careful
What should an investor be careful about in case of a rights issue? An investor should be able to look beyond the discount offered. Rights issue are different from bonus issue as one is paying money to get additional shares and hence one should subscribe to it only if he/she is completely sure of the company’s performance. Also, one must not take up the rights if the share price has fallen below the subscription price as it may be cheaper to buy the shares in the open market.
Source:Economictimes.com
Wednesday, December 3, 2008
Term Plan Better Now
Pure term policies have become more attractive than earlier due to lower premiums offered by some insurance companies
The premium that pure term plans charge is the lowest among life cover policies as they provide only life insurance for a specified number of years. Term plans don’t offer any returns as they focus only on providing life cover and have no savings element. If you outlive the policy, you will not get anything, but if you die during the term of the plan, your nominees will get the sum assured. So, if your aim is not to use insurance as an investment avenue, but to only protect your dependents from a financial crisis in case you die prematurely, pure term is the product as it will serve your need at the lowest cost.
WHAT TO LOOK FOR WHILE BUYING TERM INSURANCE
As term plans don’t have any surrender or maturity value, purchase decisions are often based on premium. However, choice should be guided by other factors too.
Paying term. Limited PPT, in which a higher premium is paid for only a few initial years of the plan, can be a better option than paying premium every year if you want a big cover and can afford high premiums over the first few years. While limited PPT lowers the total premium outflow, it also prevents the policyholder from benefiting from falls in the premium in the future. The PPT advantage is also diluted if the policyholder dies early.
Duration. Unlike endowment plans, premium of term plans rises as its duration increases. However, life is uncertain and you should ideally choose a plan that covers you for long. Term cover can be dropped easily once financial responsibilities are over. It does not make sense, for instance, if a 30-year-old person buys a term plan for just 25 years.
Maturity age. If you expect to have dependents till late in your life, look for term plans that have a high maturity age. Most term plans provide coverage till age 60 or 65 years.
Top-ups. Some plans allow hikes in cover at regular intervals without any financial or medical underwriting. Higher incremental premiums may be required as age advances, but they may still prove helpful in circumventing age-related health problems. These annual hikes are capped, but even small increases at regular intervals add up to a neat overall rise. For instance, if a cover of Rs 10 lakh is increased by 5 per cent every year, the total cover would become Rs 15 lakh in 10 years.
WHY BUY EARLY
The right time to buy term cover is when one finds someone financially dependent on oneself. Apart from low premium, there are other reasons for purchasing a pure term cover early in life.
Health issues.
The health status of the person buying a term plan goes a long way in deciding the premium and even whether the policy would be issued to him at all. There are stringent medical tests and processes before a policy is issued. In some cases, extra premium is charged if the health reports do not fall within the insurer’s underwriting limits.
Saving the surplus.
Buy a term plan with adequate coverage to keep worries away. Once your life is protected, it will be possible for you to deploy your savings more efficiently. It will help if you choose the right instruments with the aim of creating wealth over the long term.
MORE TO COME
Premium is largely a function of mortality rate (number of deaths per thousand), the insurer’s expenses and interest rates. The mortality rate being used by all insurers is based on the 1994-96 mortality tables. Fall in mortality rate due to higher life expectancy will push premiums further down. Insurers can afford to charge less if policyholders pay premiums for longer periods on account of increase in average longevity. A recent US report records this. According to Insurance Information Institute, a US trade group, term cover premiums have fallen by 50 per cent over the past decade in the US. The reason cited for this is change in the mortality tables due to rise in life expectancy.
Though a similar situation is likely to develop in India too, you should not wait till it does to buy a term plan. When that happens, you can decrease your overall cost by buying more.
Note : This article is an extraction from another site.
The premium that pure term plans charge is the lowest among life cover policies as they provide only life insurance for a specified number of years. Term plans don’t offer any returns as they focus only on providing life cover and have no savings element. If you outlive the policy, you will not get anything, but if you die during the term of the plan, your nominees will get the sum assured. So, if your aim is not to use insurance as an investment avenue, but to only protect your dependents from a financial crisis in case you die prematurely, pure term is the product as it will serve your need at the lowest cost.
WHAT TO LOOK FOR WHILE BUYING TERM INSURANCE
As term plans don’t have any surrender or maturity value, purchase decisions are often based on premium. However, choice should be guided by other factors too.
Paying term. Limited PPT, in which a higher premium is paid for only a few initial years of the plan, can be a better option than paying premium every year if you want a big cover and can afford high premiums over the first few years. While limited PPT lowers the total premium outflow, it also prevents the policyholder from benefiting from falls in the premium in the future. The PPT advantage is also diluted if the policyholder dies early.
Duration. Unlike endowment plans, premium of term plans rises as its duration increases. However, life is uncertain and you should ideally choose a plan that covers you for long. Term cover can be dropped easily once financial responsibilities are over. It does not make sense, for instance, if a 30-year-old person buys a term plan for just 25 years.
Maturity age. If you expect to have dependents till late in your life, look for term plans that have a high maturity age. Most term plans provide coverage till age 60 or 65 years.
Top-ups. Some plans allow hikes in cover at regular intervals without any financial or medical underwriting. Higher incremental premiums may be required as age advances, but they may still prove helpful in circumventing age-related health problems. These annual hikes are capped, but even small increases at regular intervals add up to a neat overall rise. For instance, if a cover of Rs 10 lakh is increased by 5 per cent every year, the total cover would become Rs 15 lakh in 10 years.
WHY BUY EARLY
The right time to buy term cover is when one finds someone financially dependent on oneself. Apart from low premium, there are other reasons for purchasing a pure term cover early in life.
Health issues.
The health status of the person buying a term plan goes a long way in deciding the premium and even whether the policy would be issued to him at all. There are stringent medical tests and processes before a policy is issued. In some cases, extra premium is charged if the health reports do not fall within the insurer’s underwriting limits.
Saving the surplus.
Buy a term plan with adequate coverage to keep worries away. Once your life is protected, it will be possible for you to deploy your savings more efficiently. It will help if you choose the right instruments with the aim of creating wealth over the long term.
MORE TO COME
Premium is largely a function of mortality rate (number of deaths per thousand), the insurer’s expenses and interest rates. The mortality rate being used by all insurers is based on the 1994-96 mortality tables. Fall in mortality rate due to higher life expectancy will push premiums further down. Insurers can afford to charge less if policyholders pay premiums for longer periods on account of increase in average longevity. A recent US report records this. According to Insurance Information Institute, a US trade group, term cover premiums have fallen by 50 per cent over the past decade in the US. The reason cited for this is change in the mortality tables due to rise in life expectancy.
Though a similar situation is likely to develop in India too, you should not wait till it does to buy a term plan. When that happens, you can decrease your overall cost by buying more.
Note : This article is an extraction from another site.
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