Time to go to war

Vijay Venkatram, Managing Director, Wealth Forum

Return locked in for 25 years

The product is quite simple in itself, but what it can do for investors seems quite profound. The fund will buy into a couple of very long dated G-Secs (20-25 yrs maturity) where it hopes to lock in yields upwards of 8%, taking advantage of the current elevated levels. The fund will be more or less passively managed – in that it will continue to hold the same securities until maturity. Any fresh money that comes in, however large or small, will be deployed in exactly the same securities. What this “rolling down” strategy does, in simple terms, is that it gives fantastic visibility into very long term returns on the day of your investment itself. An investor who comes in now during the NFO can have visibility of 7.5% return for the next 25 years – provided he stays invested until maturity. Exits before maturity will of course be redeemed on the basis of marked-to-market prices of these securities. An investor coming in say after 2 years, say when yields have dropped down by 100%, will still get visibility of 6.5% for the next 23 years – and needs to take a call at that time whether he considers this a good rate to lock into for that period. Sunil Jhaveri – Mr. Bond – is quite excited about this roll down strategy which he believes has been underexploited by the MF industry. You can expect an article from him on WF on this aspect shortly.

A product that can take annuities head on

Lets focus for now on one point: an investor coming today has a visibility of 7.5% return net of expenses, for the next 25 years. When was the last time the MF industry was ever able to offer this kind of long term visibility on returns? Today, annuities and endowment plans are the only products that provide such long term visibility. Most other products offer visibility of no more than 5 years. The 8% senior citizen scheme introduced recently by the Government offers 10 year visibility on returns and is capped at Rs. 15 lakhs per senior citizen. PPF’s interest rates are subject to being reset from time to time – you don’t lock into a rate for the long term.

Today, LIC’s annuities with return of capital fetch you between 6.5% - 7% and the income is fully taxable. The Reliance product (and similar products that the industry will no doubt come up with), offers you a visibility of 7.5% pre tax, which translates to around 7% post tax based on current tax laws, if you choose to set up an SWP option to get regular monthly cash flows.

Interest rate risk is as big as inflation risk over a 25 year period

Balaji Rao, a trainer in Bengaluru, remarks that investors are being made aware of inflation risk but nobody is sensitizing them to long term interest rate risk. People who retired 15 years ago and locked in their capital at 12%+ for periods of 5-10 years, are living through the challenges of interest rate risk as they are now getting roughly half of the income they used to get from the same corpus, even as costs have spiralled due to inflation. When making retirement income plans for 20-25 years, we blissfully assume 6% - 8% returns on debt portfolios. What if 10 years down the road, Indian long term inflation settles in that 2% zone that the developed world is targeting and therefore interest rates collapse to sub 4% levels? One can argue that the real rate of return will still be in the same band, but the fact is that for retirees, their income will reduce by 50% when they go to renew their 5-10 year deposits and other savings schemes. It is here that long term visibility on returns becomes absolutely critical.

If you think that a sub 4% interest rate in India is fanciful, well, so would an average US saver have thought right through the 1980s – only to find that events over the next couple of decades reduced his interest income to a fraction of what it was.

If the need for long term visibility on interest rates is established – especially for people who are stepping into retired life – we then need to consider annuities vs products like Reliance Nivesh Lakshya. The MF product offers a superior pre tax return, a much superior post tax return (assuming tax laws remain the same), and importantly, offers liquidity should the investor need it at some stage. Unlike annuities where you can get back your principal ahead of maturity only if you can prove a critical illness or some such drastic circumstance, the MF product is an open ended fund.

Double edged sword

Bharat Phatak, Wealth Managers - Pune, who is quite excited about this product, however cautions about this open ended feature and the mark-to-market feature potentially acting as a double edged sword. A product with a 25 year maturity he says can have a duration of around 12-14 years. A 1% rise in interest rates would therefore mean a 12% - 14% depreciation in the NAV – which can be quite unsettling to some investors, particularly retirees who depend on it for their monthly cash flows. This in turn may prompt them to eject out and therefore cause a permanent loss of capital for themselves. In annuities, one doesn’t see what’s happening in terms of MTM on the underlying portfolio and one anyway does not have an exit option. So, one lives through blissfully unaware of interim volatility during the intervening 20+ years.

Salary extension for 15 years post retirement

Given however that this product is clearly superior to annuities, Bharat believes the responsibility lies with the advisor to help clients understand that MTM loss in such a product will not result in a permanent loss if one simply continues the SWP and stays invested until maturity. One simple way this can be done is to offer this product to investors who have 2-5 years to go before they retire. Lumpsums invested now will create a buffer over the next 2-5 years, after which you start the SWP, such that you optically tackle the prospect of temporary erosion of capital if interest rates rise. One can, Bharat suggests, go a step forward and offer this product as a retirement solution for a 50 year old. You can run the numbers – if you stay invested for 10 years without withdrawing and then commence an SWP for the remaining 15 years of the tenure of this product, the monthly amounts can be sizeable enough to appear as a salary extension for 15 more years post retirement!

25 year FMP

It all boils down to how advisors choose to tailor their solutions using products like this, which offer very long term return visibility. Hemant Rustagi, WiseInvest Advisors – Mumbai, says that it can be positioned like a 25 year FMP for conservative investors who want to build a corpus for very long term needs. You have caps on most small savings products like PPF, he says. When you want to invest larger amounts than these caps, this could be a good solution as the underlying is only G-Secs. While he continues to advocate equity as the best solution for 25 year horizon, he recognises that a very substantial amount of long term savings continue to go into debt. If that be the case, why not at least offer enhanced visibility on an attractive yield for that portion of the portfolio?

Use this tool wisely to create your own solutions

What distributors now have available is a genuinely long term fixed income product – which all of us know intuitively should have tremendous appeal in a conservative savings focused society like ours. What every distributor should do is to make the effort to understand the product, understand its advantages as well as challenges and craft solutions like Bharat and Hemant are doing, which build on the advantages and address the challenges. Do your homework, create effective solutions using products like the Reliance one, go to war against traditional long term savings products and win the huge retirement income space for yourselves and for the fund industry!

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