Dhana Sutra: The Art of Wealth Creation.

The Finance Minister’s (FM) budget announcement that an individual could potentially enjoy a deduction of 4.442 Lakhs made the middle class happily sit up & take notice. The happiness escalated into ecstasy when The Economic Times announced that the actual deductions were much higher than those promised by the FM, as per the list alongside. 

The deductions, seen in conjunction with the income between 0 to 2.5 lakh - that attracts zero tax – precludes an individual, with a salary approximating 10.15 lakhs, from paying taxes. There is however a catch. The deductions are contingent on investments in certain products, not all give an adequate return. That begs the question

What is an adequate return?

The following Dhana - Sutras attempt to answer the query.

     Rule 1: Nominal Rate = Real rate + Inflation Rate.

Rs 100/- saved today is expected to grow to cover at least inflation by the same time next year. The consumer price index (CPI) - a measure of inflation with the base year being 2001 - is listed alongside.

The inflation fig. between 2006 & 2014 was 9.1% while the corresponding fig for the period 2008-12 was 10%.  A rational investor should, therefore, reasonably expect a return of at least 9.1% & if the same is unavailable, then a tax benefit - devolved through govt. policy pronouncements  - should fill the gap. Needless to add, expected return changes with the times - for it is directly linked to the current inflation trends; when inflation drops the expected return drops accordingly.
 

Rule 2: Return is directly proportionate to the risk assumed.

Govt. securities - backed by a sovereign guarantee – carry a zero risk & hence offers the lowest interest rate, while betting - which carries the highest risk - rewards the investor with astronomical returns. A rational investor is, however, expected to avoid speculation & therefore, can reasonably expect a return in between the two extremes listed above. For achieving the objective the investor should evaluate the returns offered by each of the financial instruments - details of which are reproduced from The Economic Times Wealth issue of 8^th Mar 2015.

Some takeaways

•           A risk-averse investor goes for an EPF since the EPFO invests in high quality debt instruments. Withdrawal before retirement is not allowed under the scheme, except under some special circumstances like medical emergency, construction of a house or child’s marriage. Withdrawal of money before 5 years invites tax on the interest earned. The return of 8.75% offered is lower than the inflation rate of 9-10% & hence not fulfilling. EPF effectively offers a negative real rate of interest.
•        Self-employed personnel not covered by the EPF could invest in the PPF. Investment before the 5^th of a month earns interest for that month too. PPF is a long term investment with a 15 year term which can be extended in blocks of 5 years each. It offers limited flexibility with withdrawal & loan against PPF allowed post the 5^th year. However, here too, the return at 8.7% is much lower than the inflation rate.
•         Since both EPF & PPF are long term savings which the govt. can utilize for creating assets, GOI panders investors through a tax benefit that ensures that the actual return in higher, making it reasonably attractive. The principle invested, interest earned & amount post maturity are all exempt from tax under the Exempt, Exempt, Exempt (EEE) rule.  

Other Investment Options

The govt. offers tax benefits on investments in Equity Linked Saving schemes (ELSS), Life Insurance premiums, Unit Linked Insurance plans (ULIP), New Pension Plans (NPS) etc. too. Let us evaluate each one of them.

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• The average stock market returns are listed  alongside.BSE Sensex - started with an base index of 100 in1978-79 - gave a return of 17% by 2015 while NSE gave a return of 12% during the period 1995-2015. Equity, therefore, in the long run, can be expected to give an average return of 15%. Many of the Mutual Funds (MF), run by intelligent fund managers, can be expected to beat the market returns.
•         Investment in Equity Linked Saving schemes (ELSS) is recommended since it has the lowest lock in period of 3 years – unlike an EPF & PPF which blocks capital for a lifetime & 15 years respectively - & fulfills the equity requirement of the investment portfolio. Since dividends & withdrawal after 3 years for ELSS are tax free the actual return is higher than 15%.  Investors are advised to stagger investments through Systematic Investment Plan (SIP) since stock markets are volatile & any attempt to time the market would lead to failure.
•          Returns on a life insurance policy - a money back or endowment policy – at 5.5% is niggardly. Investors are better advised to buy a term policy instead which comes at a more reasonable cost. As an example LIC offers a 35 year term policy of Rs 10 Lakhs at Rs 3880/- per annum for an individual of age 30 years while an endowment policy for a similar profile comes for Rs 26810. Agents whose commissions are based as a % of premium secured would naturally be inclined to push for endowment plans.
•          ULIPs (Unit Linked Insurance plan) are sold as an investment cum insurance plans. Avoid them since they give returns in single digits. Instead, pick a MF (Mutual Fund) if the aim is investment & a term insurance plan for protection.
•          The FM has tried to make the NPS attractive with some announcements in the current budget. He has allowed an additional deduction of Rs 50000/- under sec 80CCD (1B) apart from increasing the benefit under sec 80C from 1 to 1.5 lakhs. The employer’s contributor is also tax deductible. Investors might not buy into NPS since exemption is restricted to the principle invested & interest earned alone while the final withdrawal is taxed, thereby falling under a EET ( Exempt, Exempt, Tax) rule unlike an EPF or PPF which allow for a EEE rule. To add to the agony, there is an additional rule that mandates an investment of 40% of the corpus into an annuity – which gives an abysmally low rate of interest- on maturity. This reduces the attractiveness further. NPS offers little flexibility since investments cannot be accessed till retirement. Unless the FM allows for the EEE rule & flexibility in withdrawals, NPS as it stands today shall not take off.
•          Health insurance depends on family size & age. For a family of 4 with parents at age 35 & 2 kids under 10 living in a metro, a “basic cover” of Rs 5 lakhs that comes with a premium of 10-12000/- shall suffice. For additional cover a “top up” can be added; a 10 lakh “top up” comes for under Rs 7000/-. For a family afflicted with a history of critical illnesses like diabetes, hypertension etc. a “benefits cover” should be added which also subsumes other ancillary expenses like food, travel etc.

Alternate Investments

In a country like India with low financial literacy, investments other than financial products have many takers; chief among them being real estate & gold. The returns derived from each of such asset classes is listed below

Gold:

Ten grams of gold was priced at Rs 18.75 in 1925 which has grown to Rs 26450 by 2015. But for the period 1925-45 when gold offered a 12.7% return, the growth during other periods has been in single digits; for the period 1925-2015 the return is 9.5%. Incidentally gold rates today at Rs 26450/- are equal to the 2011 levels.

Most of Indians have gold in the jewellery form which lends itself to wear & tear & hence depreciation. If you add the cost of security in the form of a locker then the return drops further. Therefore, be wary of stocking gold in a jewellery form; prefer gold exchange traded funds or coins/bars.

Assets behave differently during different time cycles. While the average return on gold has been 9.5%, gold bought in 1965 gave a return of 22.4% during the 1965-1975 decadal period. Likewise, gold bought in 1980 gave a return of 40% in one year. Therefore, gold should not be shunned; invest about 5-10% of the total savings in gold.

Real Estate:

Real estate is a difficult animal to predict since it is city specific.  Business cycles, have different impacts on residential property Vis a Vis commercial property. A fair estimate can however be made by studying the National Housing Bank’s (NHB) Residential Index (Residex) published for 26 cities every quarter since 2007.

Some Takeaways

•          The residential rates in Hyderabad & Kochi are, today, still less than their 2007 peaks.
•          Chennai has seen the highest growth. Rates in 2014 are 3.5 times their 2007 figs.
•          Between 2007 & 2014 only Faridabad, Ahmedabad, Chennai, Pune, Bhopal, Kolkata, Mumbai & Bhubaneshwar have returned double digit rates.
•          The common assumption that real estate can never fall nor give a negative return is, therefore, false. The hope of astronomical returns is not fully true either.
•          While some investors would flood the Chennai market - lured by high returns - there could be others who would bet that Kochi or Hyderabad - which have not seen a rise - would reach Chennai levels some-day & invest with the expectation of super normal returns.
•          For a normal rational investor, however, a self-occupied house which offers a deduction of 2 lakhs on interest is a recommended investment.

Conclusion

While fixed deposits & gold give an average return of about 9% & 9.5% respectively, real estate & equity give a higher return of about 15% - much higher than inflation.  An average Indian, keen to invest in a house, sinks a major chunk of his investable surplus into real estate. A portion is spent on gold to pander to the demands of his home minister. Post such investments & mandatory deductions, if any, he is generally left with a meagre surplus. A rational investor he shall be well served by investing the same in equity; engaging the services of experts -a Mutual Fund - is recommended.