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Sourcing Fixed Income

When tragedy strikes the head of the household, steps must be taken to ensure and safeguard the family income

The untimely death of the family bread-winner puts other members in a financially insecure position. Here’s a look at how a fixed income can be earned for the others to live in peace.

Abhijit Jadhav, after his father’s demise, wanted to address all the issues regarding his mother’s finances.

The start was positive, as the money received from her husband’s Provident Fund account would serve as the bedrock on which her future financial security could be based.

She now has Rs 22 lakh in bank fixed deposits (FDs) and another Rs 50,000 in savings accounts to meet emergencies. Her monthly expenses are Rs 9,000, while bank FDs provide her with Rs 19,000 per month in interest. A certain part of these FDs have earned interest at 10 per cent and the remaining at nine per cent. The FDs mature in June 2012. Back in 2007, investments were made in Magnum Taxgain fund for tax-saving purposes, which is now valued at Rs 50,000. She also has medical insurance of Rs 1 lakh.

There are some upcoming expenses that have to be met from this portfolio – the last installment of his sister’s tuition fee (Rs 30,000) and his own marriage in 2010 (Rs 80,000).

There is some worry regarding the falling interest rate scenario -- FDs might not be renewed at the same rates. He wants the portfolio to provide a similar monthly income over the years that will help fight inflation.

Abhijit also wants to know if monthly income plans can help and whether there are other instruments that can help in any way.

Observations

(1) The portfolio is mainly built up of fixed income investments.
The problem: Income that will accrue from these instruments will fail to keep pace with inflation and increasing prices over the years.

(2) Medical insurance of Rs 1 lakh looks insufficient.
The problem: Medical needs might turn out to be more than what she is insured for.

(3) Investment in a mutual fund was made as a lump-sum.
The problem: When you invest a lump-sum in equities, the investment becomes vulnerable to sudden market movements. But when investments are made methodically, via the systematic investment plan (SIP), units are purchased at all market levels, averaging out the rupee cost per unit. The present fund investment is down by about 30 per cent (considering reinvestment of dividends). Had Rs 10,000 been invested every month from April 2007 to January 2008, this investment would have been down just about 10 per cent today.

(4) Income from bank FDs that exceeds the exempt limit of Rs 1.90 lakh will be taxable.
The problem: Presently, annual tax works out to be more than Rs 3,500 per annum. Paying tax can be avoided by investing in instruments specified by Value Research.

The Proposal

(1) Invest in balanced funds.
Balanced funds invest about 65 per cent of their assets in equity and the rest in debt instruments. With 30 per cent of the portfolio in balanced funds, you will have about 20 per cent of the portfolio in equities which will help you fight inflation.
How? Target a 30 per cent allocation to balanced funds. Start with investing the extra income from FDs (Rs 10,000 per month) in balanced funds. Once the FDs mature, start investing systematically in balanced funds to attain the portfolio allocation. Choose from HDFC Prudence, Magnum Balanced, DSPBR Balanced and Canara Robeco Balance. Regularly rebalance to ensure that the allocation to balanced funds does not move away from the planned allocation.

(2) Save on income-tax
Investments in equities can also be tweaked to achieve the additional goal of tax-saving.
How? You can invest in tax-saving funds (ELSS) to the extent of the taxable income. Do this by way of either investing the spare income, if any, or shifting from the balanced fund to the ELSS. Magnum Taxgain, HDFC Taxsaver, Sundaram BNP Paribas Tax Saver are good picks. But avoid investments in Public Provident Fund and National Savings Certificate as they involve a longer lock-in (15 years and 6 years respectively) as compared to ELSS (3 years). This will be a compromise on liquidity.

(3) Increase medical insurance limit
You should increase the sum assured to about Rs 3 lakh to meet any medical emergencies.

Can the goal be achieved?
Earning a return of 10 per cent per annum, the portfolio can help meet her needs for a sum of Rs 9,000 per month, which can later be increased at about 6 to 7 per cent per annum as prices rise. Income from fixed income investments (forming 70 per cent of portfolio) will stay constant over the years. When this income falls short, withdrawals from the balanced funds can be made. These withdrawals will be tax-free after one year.

Can monthly income plans (MIPs) help when interest rates fall?
In any market situation, performance of a mutual fund depends on the fund manager’s decisions. MIP schemes keep more than 80 per cent of their assets in fixed instruments. The rest is invested in equities which help them generate more returns than pure debt funds in a rising market. But being a mutual fund, neither the principal nor the returns are assured.

The dividends that the scheme will distribute will be taxed at 14.28 per cent. This can be a tax efficient option when the interest from the fixed income portfolio falls under the 20 per cent or 30 per cent tax slab and about 20 per cent of your fixed income portfolio can be invested in MIPs.

Any other instruments that can help?
For generating fixed income, you can also look at Post Office monthly income scheme, which will pay interest at 8 per cent per annum, taxable in the hands of the account holder.

Some other options that can be looked at are National Savings Certificate, Public Provident Fund, and Kisan Vikas Patra. While interest from NSC and KVP will be taxable, that from PPF will be tax-free.