Mutual funds withdrawals through SWPs are considered redemptions. The gains are treated as short-term capital gains and taxed at the applicable slab rates for the first three years and as long-term capital gains thereafter and taxed at 10% without indexation and at 20% with indexation. Your pension, however, will be treated as income and taxed at the applicable slab rate. The effective tax payable on capital gains (short and long term) tends to be lower than the tax payable on annuity or salary income.
Based on current income tax laws, income slabs and tax rates, an SWP in accrual debt mutual funds is likely to give you better after-tax cash flows, compared to a pension plan. So, the mutual fund route seems better than a pension plan.
Here is a brief note on pension plans and mutual funds to help you make an informed decision basis what suits you and your personal needs.
Investments in unit linked pension plan (ULPP)
If the client decides to buy the pension plan, then he would be paying Rs 1,000,000 in the first year. Since this is a single premium plan, one-time charges on the same are 2.50% (i.e. in the first year). In other words, Rs 25,000 would be deducted from the client’s single premium amount and the remaining amount (i.e. Rs 975,000) would be invested in the 100% equity ULPP option. This amount will remain invested for the entire 22-yr tenure.
The charges for any additional top-ups in the second year too would be to the tune of 2.50%. Similar to the first year, Rs 25,000 would be deducted from the second year’s top-up amount. So Rs 975,000 would be invested over 21 years.
One-time charges for any top-ups from the third year onwards fall to 1% for the year. Therefore, only Rs 10,000 (i.e. 1% of Rs 1,000,000) would be deducted and the remaining amount would be invested. The third year amount (Rs 990,000) will remain invested for a 20-yr period (i.e. time to maturity).
Fund management charges (FMC) for managing equities in the given ULPP are 0.80% p.a. Administration charges are assumed to be Rs 180 p.a. (increasing at an assumed inflation rate of 5.00%).
Investments in a mutual fund
Similar to a ULPP, the client would invest Rs 1,000,000 p.a. for 3 years in a mutual fund scheme. However, unlike a one-time initial charge associated with the ULPP above, mutual funds usually have an entry/exit load on their schemes. Assuming an entry load of 2.25% for each of his three annual investments (of Rs 1,000,000), the net amount invested would be drawn down by Rs 22,500 (i.e. 2.25% of Rs 1,000,000) each year for the initial three years.
We have also assumed a decreasing FMC on the mutual fund schemes- the assumption here is it would be 2.00% for the first 5 years, 1.75% for the next 5 years and 1.50% for the remaining period thereafter. The ‘decreasing FMC’ assumption is based on the fact that as the corpus for a mutual fund scheme grows over a period of time, economies of scale come into play. This helps the mutual fund spread its costs over a larger corpus, thereby reducing its overall cost of managing the fund.
As with the ULPP, assuming a 10% rate of growth over a 22-yr period, the mutual fund investments would have grown to approximately Rs 15,240,000. The corpus generated by ULPP is higher than the mutual fund corpus by Rs 3,160,000 (i.e. 20.73%).
The reason why ULPP scores over mutual funds is because of a low FMC. The FMC on the ULPP under review is 0.80% throughout the tenure as compared to the mutual fund FMC, which is in the 1.50%-2.00% range. Over the long term, FMC makes a significant impact by reducing the corpus available for investments. In other words, lower the FMC, higher the investible surplus and vice-versa.
Retirement / Pension Plans and Mutual Funds
When life insurance companies mention retirement plans and pension plans, they are referring to bundled products that offer the combined benefits of insurance and investment.
- Deferred pension plan – This type of pension plan has two phases – the accumulation phase and the distribution phase.
- Accumulation Phase – In the first phase of the plan, you are required to pay premiums and the money accumulates through the tenure of the plan period – and a retirement corpuses built up. When the tenure of the pension plan ends, the accumulated money is used for buying an annuity. If at the accumulation stage you have invested in a pension plan from an insurance company, then it is compulsory to invest at least one-third of the amount received from this instrument in an annuity at the time of retirement.
- Distribution Phase – Once this period is over, that is when your policy matures you can begin withdrawing money from the retirement corpus for monthly expenses. This is the distribution phase.
If you begin investing when you are 30 years old, with a plan to retire at 50, and assuming you live for another 30 years after retirement (till the age of 80), then the accumulation phase will last 20 years while the distribution phase will span 30.
Note that in most retirement plans, the age at which you will start receiving a pension (called the vesting age), is typically in the 40-70 years age bracket. As your targeted retirement age is 50, you are well covered in this respect. The period when a person gets a pension is also known as the annuity phase.
- Immediate annuity plan – In this retirement plan, the investor can pay lump-sum, instead of contributing over the years and can start receiving income immediately. The frequency of payments received can be monthly, quarterly, half-yearly or annually.
There are many annuity plans on offer in the market, and their variants: e.g., the steady monthly income, the increasing monthly income etc; choose one based on your preferences, financial requirements and premium payment capacity. However, remember that while an income source for life is guaranteed, it is a lump-sum one-time investment, whether one chooses immediate income or deferred income.
- Mutual fund retirement plans–In a mutual fund retirement plan, you can opt for a systematic withdrawal system and you do not have to buy an annuity. This provides you with liquidity to meet your immediate cash flow requirements.
SIP, or the Systematic Investment Plan, is a scheme to invest a fixed amount regularly at a specific frequency, say quarterly or monthly. It ensures that you invest a fixed amount regularly and reward you with long-term financial gains, the potential for which is immense.
It is flexible in terms of termination or modifying amount, which ensures easy cash flow: the plan can be terminated when you want after submitting a written request. In a month’s time, the SIP will be discontinued. (Note: One can increase or decrease the sum being invested by ending the existing and starting a new one; this offers protection from market volatility.
Advantages of pension plans
- Ensures uninterrupted income after retirement – The biggest advantage with pension plans with deferred annuity is that it ensures uninterrupted income after retirement; in other words, it provides you with the security that you will receive a pension every month for the rest of your life. You can also set the frequency of payouts – monthly, quarterly, yearly, as per your requirements.
- You do not have to think of making an investment at the time of your retirement – This is a big plus because a fresh investment with X amount of money 20-30 years later may not fetch the same interest it would have earned now. In fact, you may have to invest more money to get the same amount of pension.
Short-term instruments such as the Post Office Monthly Income Scheme (POMIS) carry reinvestment risk (of lowered interest rates), but an annuity guarantees you the same rate of payout for life. And unlike the POMIS or Senior Citizens Savings Scheme (SCSS), there is no cap on annuities.
Disadvantages of pension plans
- Money is locked in till maturity – You cannot make withdrawals during emergencies or if you want to switch to another investment avenue midway. The National Pension Scheme (NPS) allows a maximum withdrawal up to 60% of the corpus at the age of retirement and the rest must be invested to buy the annuity.
- Moreover, some amount of the maturity amounts is taxable, which actually makes it less attractive for investment.
- Payouts are given with simple interest calculations – while all the small savings schemes like PPF, EPF etc. gives you the facility of compounding the money. Thus, the interest rate of any pension plan is very low – at about 6%-7% – too little to even beat the inflation rate. On the other hand, small savings schemes like PPF will give you a better return.
Advantages of mutual funds
- With this long-term investment, you can ride out short-term fluctuations – The advantage of equity funds is that as you are investing for the long term, you could ride out the short-termfluctuations and earn higher returns.
- Helps save taxes – Opting for an ELSS (Equity Linked Savings Scheme) Mutual Fund will also help save tax under 80C and also enable growth. It is advisable to avoid MFs that invest only in large caps, as returns are low (about 10% annually); as the investments are for a long-termand for retirement goals. It is advisable to choose a mix of large caps as well as midcaps (where returns are better at 14%).
Since these schemes are expected to pool savings for retirement, you have the flexibility to lock-in the money till your retirement or redeem it before that.
Disadvantages of mutual funds
- Do not offer death benefits and your nominee gets only the market value of the fund – Moreover, equity funds are volatile in the short term and sometimes the risk may not be worth the returns – especially as the investment goal is not profit but is part of your retirement planning.
- Stiff exit loads for early redemptions – Mutual fund houses have lined up stiff exit loads for early redemptions to limit people from exiting before retirement. Make sure to check out the exit penalties if you do opt for mutual funds.
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