When we draw up our long-term financial plans, we make multiple assumptions. To calculate the cost of living, we blithely assume that the inflation rate will average 7 or 8 per cent for the next 20 or 30 years. To estimate the corpus at the end of that period, we assume debt returns at 8 per cent and add on a 'risk premium' to get equity returns of 12 to 15 per cent.
But history tells us that any or all of those assumptions can easily go wrong. The inflation assumption, for instance, is derived from the inflation rates we have experienced in recent years. Inflation rates have averaged 8-10 per cent in the last seven years, but the range of monthly consumer-price inflation in India over the last 20 years has been anything between 0 per cent and 19.7 per cent.
The assumption that 'safe' debt instruments will pay 8 per cent is also based on recent trends. But RBI data show that short-term interest rates in India's call-money market were as high as 17.7 per cent at one point (1995-96) and fell as low as 3.2 per cent in another (2009-10).
As for equities, it is the nature of the beast to deliver highly volatile year-to-year returns. But just for the record, BSE Sensex returns in the last 20 years have actually fallen short of the 12-15 per cent range, delivering an 11 per cent CAGR. Why should the next 20 years be any different?
If plans go awry
Yes, none of us will bemoan the fact if inflation rates over the next 20 years plunge to 2-3 per cent or if debt and equity returns overshoot our estimates. That will leave us rich beyond our wildest dreams.
But what if the opposite happens? What if inflation breaks all previous records or debt and equity returns plummet sharply below our assumptions? Our carefully made financial plans will then go badly awry.
Yet there are some financial goals in our lives that we absolutely cannot afford to leave to chance. A corpus to ensure basic education for our children, our plans to buy one residential home or our need to ensure basic living expenses post retirement are not goals that we can flexibly afford to skip.
While debt instruments such as bank deposits, five-year NSC, corporate fixed deposits or NCDs can help us get halfway to these goals, all such instruments carry re-investment risk. If interest rates in the economy plunge into an abyss over the long term, we will be forced to accept lower and lower returns every time we re-invest the maturity proceeds.
Hunt for predictability
Our long-term portfolios, therefore, do need a bedrock of really long-term investments that can deliver an absolutely predictable return, not subject to market forces. But the menu of such instruments in India is rapidly shrinking. Those that are available require you to make sacrifices on returns, liquidity or tax efficiency.
Retail investors seeking predictability often turn to traditional products from insurance firms - the ubiquitous endowment and money-back plans. These plans are sub-optimal on costs (upfront commissions can be as high as 35-40 per cent), liquidity (surrender charges can range from 10 to 70 per cent) as well as returns (4-5 per cent, if not even less).
Scoring on predictability
There are, however, other products that are worth considering for predictable return seekers. They offer better returns than traditional insurance plans, while scoring better on liquidity or tax efficiency.
While insurance agents will seldom recommend them, immediate-annuity plans are reasonable options for investors looking for utterly certain long-term income for perpetuity (until they die). Today, an upfront investment of ₹1 lakh by a 40-year old in LIC's Jeevan Akshay VI (an immediate-annuity plan) can help him earn an annual income of ₹7,510 until he dies (assuming he is looking only for income and not return of capital). If he lives to 80, that's an internal rate of return of 7 per cent. This is not an impressive return on the face of it (those returns are pre-tax), but the longer you live, the better your effective returns will be.
By allowing you to lock into today's rates for perpetuity, immediate-annuity plans also shield you from the risk of falling rates for a lifetime. Just imagine a worst-case scenario where interest rates in India, like those in the Western world, head to 2-3 per cent or, god forbid, negative territory over the long term. With this annuity plan, your income would stay protected.
Immediate-annuity products are good for investors looking to ensure a minimum level of income, come what may, for themselves or their spouses. But they may not beat inflation during one's retirement years and score low on liquidity. Once you sign up, there's no option to stop an annuity plan mid-way or seek a refund of your upfront amount.
Tax-free bonds
There is an even better opportunity offered by the current crop of tax-free bonds. Issued mostly by AAA- or AA-rated entities, such as NHAI, IRFC, HUDCO, recent tranches of these bonds have offered returns of 7.5-7.7 per cent for tenures of ten to 20 years.
Given that these entities have a good credit rating and offer completely tax-free returns, this is about the best return you can get on a safe, long-term debt investment. There's some liquidity element too, with these bonds freely traded on the stock exchanges (though not in large volumes). However, the flip side of tax-free bonds is that there is a very limited supply of them. They need to be notified in the annual budget each year. They are also open for subscription for very few days at a time. Recent tranches of tax-free bonds have been so popular that they have been fully subscribed within hours of the offer opening. Nevertheless, given that they score on returns, taxation and liquidity, you should maximise your investments in 20-year bonds to earn predictable income.
What about the tried-and-tested Public Provident Fund? Well, while the interest rates on the PPF are absolutely mouth-watering (8.7 per cent this fiscal) and tax-free to boot, the problem with the PPF is that these rates of interest are liable to be reset each year. The current government is even talking of resetting rates every quarter, in tune with gilt yields. This would prevent PPF investors from locking into the currently high rates for the long term. The maximum investment cap of ₹1.5 lakh a year can also act as a constraint.
The certainty of returns seldom comes with the ability to beat inflation. Therefore, it is best to lock into the above instruments either when we are at the very top or close to the peak of an interest-rate cycle, which we are now. So if you have money saved up, or have made a windfall gain, make hay while the sun's still shining.
This article was originally published on March 03, 2016.
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