Sunday, February 5, 2012

Problems with the NPS (National Pension System), India

The Indian Govt launched the National Pension System with high hopes and much fanfare. Unfortunately, despite several positives, it has not taken off as expected. Some blame it on the lack of incentive for intermediaries (agents, financial institutions etc) to sell the scheme. While true to a certain extent, why do you really need an incentive for higher offtake if it was so good for the public? True that agents will sell it more if they get better commissions, but at the same time it is also true that many (if not most) agents will mis-sell any product which gives them higher commissions, whether good for the investor or not.

There are several other pension products in India and none of them seem to be doing too well. May be they are doing a bit better than NPS due to the mis-selling being done by agents. Here I look at the most basic flaw or shortcoming of pension products in India including NPS.

"On attaining the Normal Retirement Age (NRA) of 60 years – You will be required to compulsorily
annuitize at least 40% of your pension wealth and the remaining 60% can be withdrawn as a lump
sum or in a phased manner; in case, you opt for a phased withdrawal"

Not just that, "Withdraw any time before 60 years of age– In such case, you will have to compulsorily annuitize 80% of your accumulated pension wealth"

Basically what Govt is telling us is that they kind of control our choice on what we want to do with our money on retirement. There are 2 basic flaws as I see it:

1. If a person is sensible enough to invest in a pension scheme, he would be sensible enough to know what to do with the money he receives on retirement. Govt. really has no business dictating what to do with the our hard earned money on which we have already paid tax. It's high time Govt start treating citizens of the country as adults. If we are mature enough to elect Govt to take decisions for the country, we are mature enough to take decisions for ourselves.

2. We may still be able to tolerate Govt limiting our options on what to do with our money if Govt provided us any sensible options. The only option Govt provides is to take Annuity. We don't know what kind of annuity options will be available to us when we retire. But at least today the annuity options available in market are probably the worst investment options.

Let's take a look at the annuity options in market today. There are 2 broad kinds of annuities available in the market today:
a) Annuity without the return of capital
With this, one receives the pension till one is alive. After that, the money is gone!! Stupid enough. It might work well in western societies where most people live their lives independently of their children. This probably won't work well in India, where people expect that their children benefit out of their savings when they are no longer there.
E.g. For a corpus of Rs 10,00,000 (i.e. 10 lakh), the pension may be around Rs 7500-8000 per month till the person lives. Once the person dies, the amount of 10 lakh is gone!! If a person dies 5 years after retirement, he/his heirs would have effectively received only Rs 4,50,000 out of the Rs 10,00,000 he invested.

b) Annuity with the return of capital
This probably is more suited to Indian needs as such plans return your original capital to the legal heir or the nominee. But there is a catch - the annuity amount (pension) given is very pathetic. E.g. For a corpus of Rs 10,00,000 (i.e. 10 lakh), the pension may be around Rs 6000-6500 per month. So, even though it returns the capital, it provides substantially lower returns than the annuity with return of capital.

Then there are other variations of the above 2 basic kinds of annuities, but the common theme across all of those is the meager returns they offer.

Compare the returns from annuities in market today with the Monthly income plans (MIP) available in the market today. With a lump sum of Rs 10,00,000, you can get a monthly income of around Rs 7500 per month and return of capital at the end of the tenure which is typically 5 years. Post office has some of the best schemes for senior citizens.

Note that the examples used above are based on current rates in the market. The pension/monthly income offered by such schemes changes with interest rates in the market, this is similar to how rates on fixed deposits change with interest rates in the market. Once you book a FD, the rate is fixed for the tenure of the FD. Same with annuities or MIPs.

One risk with monthly income plans is that when you get back your money after the tenure, you need to invest it again at that time to get regular income. And the interest rates at that time may not be the same. So you do have a risk with MIPs which is not there with annuities. As with annuities the rate is fixed (the pension amount if fixed) when you buy the annuity. But that has an even bigger catch:

The same interest rate risk is present in a much bigger way with NPS. Who knows what the interest rates will be like when you retire? You will be forced to buy annuity at that point of time even though it may not be a good time to buy annuity, if the prevailing interest rates are low.

Instead if Govt gives us our money back, we could choose whether to buy an annuity or MIP or some other investment. Or if we want to defer buying an annuity for some time.

Sunday, January 29, 2012

Bank FD or Infrastructure bonds

Some people ask the question whether to go for Bank FD or Infrastructure bonds. Really there is no need for comparison of Bank FD with Infrastructure bonds.

The reason is simple: The amount of investment which qualifies for Sec 80 rebate is normally Rs 1,00,000 (includes PF, PPF, ELSS i.e. tax saving mutual fund, NSC, 5 year bank FD etc). If you plan to invest only upto Rs 1,00,000, just go for the investment which gives you better return. So in that case, if SBI FD is offering 9.25%, it is better than an infrastructure bond offering 8.7%. Both have a lock in period of 5 years. The interest from both is taxable. Whichever offers better rate of interest, go for it. The bank FD is compounded quarterly which is an additional benefit.

The only advantage infrastructure bonds have over bank FDs is when you plan to invest more than Rs. 1,00,000 in the financial year. The infrastructure bonds provide you tax saving on Rs 20,000 over and above the 1,00,000 limit. So, if you make a total investment of Rs 1,20,000 including at least 20,000 in infrastructure bonds, you will get tax benefit on complete 1,20,000. But if your investments do not include infrastructure bonds, you will get tax rebate only on 1,00,000.

Example 1:
Ram makes the following investments:
1. PF  - Rs 40,000 (Employee contribution only)
2. PPF - Rs 20,000
3. Tax saving mutual fund - Rs 40,000
4. NSC - Rs 20,000
Total = Rs 1,20,000.
However, all these instruments come under the 1,00,000 limit, so Ram will get tax benefit on Rs 1,00,000 under section 80.

Example 2:
Shyam makes the following investments:
1. PF  - Rs 40,000 (Employee contribution only)
2. PPF - Rs 20,000
3. Tax saving mutual fund - Rs 20,000
4. 5 year bank FD - Rs 30,000
5. Infrastructure bonds - Rs 20,000
Total = Rs 1,30,000.
The first 4 instruments come under the 1,00,000 limit, so Shyam will get tax benefit on Rs 1,00,000 for first 4 investments + Rs 20,000 benefit for infrastructure bonds. So he will get tax benefit on a total of Rs 1,20,000.

Another point to note is that the maximum benefit above 1,00,000 with infrastructure bonds can be only upto Rs 20,000. So if you have already invested 1,00,000 in other instruments and your purpose is only tax-saving, then you should only invest a maximum of Rs 20,000 in infrastructure bonds.

Tuesday, January 10, 2012

Should you invest in Tax-saving Infrastructure bonds

First of all, a word of caution about the "realized" return the companies or agents tell you. Most of them exaggerate the returns because they assume that you fall in 30% tax bracket when you are investing and you fall in 0% tax bracket when you receive the interest and so they don't factor in the tax on annual interest received. Obviously if you are in 30% tax bracket this year, it is highly unlikely that you will be in 0% tax bracket next year.

Let's look at the real "realized" returns. We will consider that if you are in 10% income tax bracket today, you will be in the same tax bracket in the coming years. The real returns are higher than the interest rates because you save tax under section 80 CCF on investments upto Rs 20,000 in infrastructure bonds.

Here is a list of some of the current infrastructure bonds in market (2012 Infrastructure bonds), which can help you save tax for the current FY 2011-12. (Last date mentioned are for current tranches) (Last date: Feb 25, 2012) (Last date: Feb 11, 2012) (Last date: Feb 10, 2012)

Let's look at the real returns from the IDFC bonds.

This is the return table IDFC has provided (for investments upto Rs 20,000):

This is the real "realized" return (for investments upto Rs 20,000):

As we can see, the returns are not as high as claimed by IDFC and some of the advisors/agents. However, the real returns are still good compared to several other investment options.

Couple of points to note are:

1. infrastructure bonds provide the tax exemption over and above the 1 lakh limit which other instruments like PF, PPF, NSC etc provide in Sec 80.

2. It is better to use the buyback option provided at the end of 5 years compared to holding the bonds till maturity.

Though we took the specific example of IDFC bonds, but the same is applicable for infrastructure bonds by L&T and REC as well.

Can police sue a thief for not informing about theft?

The question is very simple - can police sue a thief saying that the thief should have informed us before commiting the theft. Since the thief did not inform us when and in what way he is going to do the theft, we were not able to catch him!!

I won't be surprised if this sounds stupid to say the least. But this is what the supposedly educated people do:

Yes, the auditor PriceWaterHouseCoopers who is supposed to find any wrong-doings and audit the accounts is suing Ramalinga Raju, the (erstwhile) CEO of Satyam for hiding the wrong-doings from the auditors and mis-representing documents. Well, isn't that the reason what the auditors are appointed for - to catch such misdeeds. What do the auditors get paid for - to accept whatever management says?

Why would a globally renowned auditor like PWC not independently verify things like bank balance and rely on the forged documents given by the management? Is it to say that we catch only one kind of frauds and not others? The auditors are required and entrusted to catch any form of fraud - whether accounting scandals, mis-reporting, forgery of accounts, whatever. In essence everthing, that's why they should to be able to state that the financial statements published by the company are true statement of accounts.

There are opinions which say that the auditors were hand-in-glove with the Satyam management in the fraud. Well, no one knows. Either they were, or they were incompetent.

It would be interesting to see the court opinion on this kind of lawsuits.