Tuesday, August 14, 2012

Waiting for pension reforms? Invest in mutual funds for better retirement planning :

A country's retirement system is usually supported by three pillars. The first is typically a state-run, universal basic pension system. The second is a mandatory occupational one for employees, while the last comprises a private, voluntary plan, such as individual retirement schemes.

India has around 90 million people above the age of 58 years, the retirement age for most Indians. Of these, nearly 7 million receive pension from various government entities. Hence, the first option covers these staffers and the very poor elderly through schemes like the National Social Assistance Programme ( NSAP).
The EPFO manages around Rs 3,70,000 crore for 45 million employees with the help of four fund management firms. This is India's second pillar, which covers only 12% of the employees who work in the organised sector, while the unorganised sector, which employs a massive 88% of the workers, has no formal retirement plans for staffers.

The last pillar is very small, limited to the Public Provident Fund (PPF), superannuation schemes and private pension plans run by two mutual funds, and some insurance companies. The PPF has a corpus of Rs 35,000 crore held by around 3 million Indians, while the pension plans manage around Rs 7,000 crore for 1.6 million investors. Hence, the financial situation for a majority of Indians in retirement is grim, with no state-sponsored social security system or standardised pension plan.

Till a couple of decades ago, the low post-retirement life expectancy and financial support from children and relatives meant that retirement planning was not given too much importance. Taking note of this, the government set up the Pension Fund Regulatory and Development Authority ( PFRDA) in 2003, and the New Pension System (NPS) was introduced in January 2004, starting with central government's new employees and was later extended to state government staff and private sector workers as well.

However, the broad pension reforms have been stuck due to various reasons. The pension plans by insurance companies are also hamstrung by issues of guaranteed returns. Given that the people above 58 years of age will reach the 200 million mark by 2030, it is critical that instead of waiting for legislative reforms or tax breaks, people should use the available tools for their retirement planning.

One such tool is mutual funds, which offer a wide range of products managed by professionals, transparent and published track records, diversified portfolios, liquidity and full disclosure under the watch of a strong regulator. Low investment size, widespread distribution and availability of low-cost products are other benefits that they offer.

The basic flaw in the investment allocation of Indians is that they lock their long-term funds in fixed return avenues, which give negative post-tax, inflation-adjusted returns. The low allocation to equity markets is reflected in the low 10 million demat accounts.

What has helped steady the overall balance for average Indians is their holding in real assets, largely real estate and gold, both of which have done well in the past few years. Despite a high 30% savings rate, the low allocation to equity-related assets indicates that India is largely a nation of savers. There is a need to make it a nation of investors.

However, if one analyses the investment pattern of the average Indian with that of the high net worth individuals, those with more than Rs 1 crore in financial assets, the difference is stark. This segment invests over 40% of their funds in equities and another 9 % in alternate assets, apart from high investments in real assets.

Little wonder then that the rich keep getting richer since they invest in the high return assets, which undoubtedly have a higher risk but give positive post-tax, post inflation returns. Add to this the magic of compounding and you can understand why the average Indian who holds fixed deposits is ravaged by rising prices, while the luxury segment seems to be largely unaffected and is actually showing growth that is greater than the nominal GDP growth. Take the example of the US, where pension reforms were initiated in the 1980s.

By the end of 2011, the US retirement market stood at a massive $17.9 trillion for 82 million citizens. Mutual funds accounted for $4.7 trillion or 26% of this amount, which in turn represented 40% of the entire mutual fund industry in the US. Retirement saving accounts comprised 48% of the long-term mutual funds across the industry. Interestingly, funds held in retirement accounts were 51% of the entire household's long-term mutual fund holdings.

The investment pattern was also revealing. As much as 54% or $2.53 trillion was invested in pure equity mutual funds, both in domestic and global stocks. Another 21% or $1 trillion was invested in hybrid funds, which invest in varying combinations of equities and bonds. The remaining 25% was in bond and liquid funds.

The US has seen a virtuous circle, with dynamic pension reforms leading to over 50 million households investing in mutual funds, which, in turn, invested in the stock market, leading to both market depth and entry of long-term funds in the market. Today, over 66% of households in the US have more than 50% of their savings in mutual funds.

This is in stark contrast to India, where a very small number of households invest in mutual funds and the total allocation of household savings to these is less than 5%.

With the increase in financial literacy and better marketing, the benefits of mutual funds can be brought to the attention of the under-invested Indians, who are clearly ill-prepared for retirement. This could start a virtuous circle of long-term funds coming into the capital markets, funding critical needs for infrastructure building and creating compounding assets that are tax-efficient and give returns that can beat inflation. Targeted retirement funds, with a set number of years and varying asset allocations that become conservative closer to the goal can make retirement planning simpler and the average Indian independent.

This would be a simple, actionable solution for which no further legislative support is needed. However, investor education and widespread distribution, along with dedicated, client-centric fund managers is essential.
Source : ET

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