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Wednesday, April 26, 2017

How to meet long term fixed income goals

For most people, investing is about identifying undervalued investments(stocks, real estate etc) and entering. The areas of position sizing, entry price, portfolio allocation and exit criteria is hardly considered. Additionally,dynamic portfolio allocation, wealth preservation and tax efficient withdrawal are essential parts of a wealth management strategy but due to behavioural finance quirks, are not optimized. Hence, one has the challenge of purchasing different products for different needs, and these products often have different providers, time horizons, design frameworks and regulators, thus leading to cognitive overload by the poor individual investor who has to juggle term plans, FDs, liquid funds, pension funds, equities and insurance. What if one could maximize post tax investment returns, without sacrificing portfolio rebalancing flexibility and liquidity needs?
Let’s consider the case of Mr Akash, aged 30 years,earning Rs 50,00,000 net salary per year, who is in the maximum tax bracket of 30%. He wishes to retire early at the age of 50, but would like to fund some commitments such as children's education, marriages etc. Considering his overall financial position and goals, his financial planner suggests an allocation of 2% of annual income, to fixed income. Now, fixed deposits would lock in the rate for maximum 5-7 years, but exposes him to reinvestment risks. Unlike institutional investors, he cannot purchase a 30 year GSec bond which would give him that locked in return. And even if he directly purchased it, his post tax returns would fall below 4%. His goal is to lock in long term interest rates, but also ensure the investment continues even in the event of death, or inability to pay the annual contributions due to accidental disability, critical illness etc.Also, having seen how some friend's dependents had not been able to effectively utilize the lump-sum maturity payouts, he wishes to stagger the maturity payouts so that in the unfortunate event of death, his family will get the money in instalments and hopefully spend the money prudently. And if he is still alive then as expected, his other investments permit him the luxury of staggering these proceeds. 
Any bank product would not give him protection against inability to pay premiums, nor does it give him any 'upside' compared to merely purchasing a long term bond fund. Hence,desiring guaranteed returns over a long horizon with tax benefits, Mr Akash decides to check the Edelweiss Tokio Life GCAP plan on the advise of his planner. 
The following table shows the IRR obtained basis quote for 30 year male who pays Rs 1lakh/ year for a 10 year premium paying term, and who gets the maturity benefit at the end of year 20.The quotation is sourced from https://www.edelweisstokio.in/product/planned-future/gcap as of 28 Mar 2017, and might be subject to change. 




Post Tax yield
5.68%
Year
Discount Factor
Cash Flows
PV
Remark

1
                       1.00
          (100,000)
        (100,000)
Premium at start of year

2
                       0.95
          (100,000)
          (94,624)


3
                       0.90
          (100,000)
          (89,538)


4
                       0.85
          (100,000)
          (84,725)


5
                       0.80
          (100,000)
          (80,170)


6
                       0.76
          (100,000)
          (75,860)


7
                       0.72
          (100,000)
          (71,782)


8
                       0.68
          (100,000)
          (67,924)


9
                       0.64
          (100,000)
          (64,272)


10
                       0.61
          (100,000)
          (60,817)


20
                       0.33
         2,384,564
          789,716
Maturity benefit at end of year



Total NPV->
                       2


Comments:




This includes insurance benefit(Since product offered by an insurance company)







Looking at the calculation, Akash's first reaction is that it is too good to be true. When a pension plan itself offers only 4%-5%(he knows this having recently taken one for his parent's EPF proceeds), how can the yield be so high? And that too post tax and with insurance? Is there some catch here? The planner tells him that in insurance, due to the persistency issue( people do not pay their premiums despite signing up for it), insurance companies give loyalty additions for just sticking to your contractual terms. Also, the high number of people who do not continue their policies, and the asset liability management of insurance companies, helps them manage the liquidity and solvency risks associated with this plan, and enables them to offer such a high guaranteed return. Since the plan  is eligible for 80C benefits on contribution, and 10(10D) benefits on maturity proceeds, Akash can be assured that his maturity proceeds are tax free(being a HNI he has long ago exhausted his 80C benefits with EPF etc), and that his wealth is enhanced equivalent to pre tax 5.68/70% or 8.061%per year, with the insurance sweetener. While he might pay some slight extra for the riders on premium waiver etc, he realizes that is well worth his piece of mind, and allowing him to solve his fixed income needs with one single product. 
. So with this, Akash decides to sign up for this. He also realizes that the financial product innovation is such that insurance companies can now often beat banks and mutual funds at their own game, and that one needs to be open to new ideas, instead of blindly abhorring all insurance companies due to their past sins.