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The Way Ahead

Government employees should treat their pay arrears as savings & use these strategies to invest the same

A couple of weeks back I wrote about the pay arrears that government employees will be getting soon. As I pointed out, windfalls tend to get spent. I think that at the back of one’s mind, one feels that this is something that I wasn’t expecting and isn’t part of what I was saving anyway. Psychologically, we feel comfortable about spending this bonanza. This is a normal human response and has been observed in studies on behavioural finance. The trouble is that these arrears are not really a windfall--at best they are a payment for money that you’ve already spent. Therefore, they should be treated as savings. Since that last article pointed out what not to do with the pay arrears, this time let’s focus on what one’s savings strategy should be.

The most important aspect of the savings strategy should be that it should be simple enough for you to understand and plan yourself. It should also be based on transparent, low-cost and low-commission products like bank deposits, small savings schemes and mutual funds. Obfuscated, high-commission products like the ULIPs should obviously be avoided. This isn’t always easy to do because these products have the most high-pressure advertising and the most persistent salesmen. But this is precisely because a higher part of your money goes into paying commissions to the salesmen.

The basic trade-off which decides a savings strategy are between risk and return and the basic variable which decides the savings strategy is the number of years left for one’s retirement. The main decision that has to be taken is how much of the money should go into equity and how much into safer but low return fixed income avenues. I would recommend three different strategies--one for those with more than ten years to go for retirement, one for those with between ten and five years to retirement and one for those with less than five years to for retirement.

The youngest category should invest almost all into equity with about ten per cent in fixed income avenues. In the middle category, the share of equity-based investments should come down to around 65 per cent while for the oldest group, equity should be dropped down to just about 40 per cent. The actual investments could be bank and post office deposits as well as debt funds for fixed income and diversified equity mutual funds for the equity part.

I’m sure many people will think that 40 per cent equity is too high for the oldest group. The generally-accepted idea here is that equity is risky and therefore should be minimised rapidly as one gets close to retirement. While this is true in principle, the world of investments is a quantitative one where the question ‘what’ is meaningless without an accompanying ‘how much’. In the long run, the greatest threat that your savings face is inflation and no matter what the short-term volatility of equity, it is the only hedge against inflation. No fixed income instrument ever provides a significant margin above the real inflation rate. There are times (as they are now) when fixed income actually loses you real money. The post-retirement time horizon is actually quite long and you’ll need equity on your side to fight the battle against inflation.