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Rediff.com  » Business » Why pension plans are better than mutual funds

Why pension plans are better than mutual funds

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June 27, 2006 16:26 IST

As financial planners, we regularly receive queries on how to go about planning for various life stages. Financial planning to take care of the post-retirement years is always an important activity for individuals.

With respect to retirement planning, we recently received a query from a client who wanted to know whether he would be better off investing in a pension plan offered by a life insurance company or investing in mutual funds. Given below is our analysis on the options available to the investor.

Let us look at the given set of variables first.

  • The client's age is 38 years and he would like to retire 22 years hence i.e. at the age of 60 years.

  • The client would like to invest an amount of Rs 1,000,000 (Rs 1 m) each year for three years. In total, he will invest an amount of Rs 3 m over 3 years.

  • The client has been suggested a single premium plan of Rs 1 m with additional 'top-ups' worth Rs 1 m p.a. (per annum) for the following two years. In all, the client would be paying Rs 3 m over the 3-yr period.

  • The client has a high-risk appetite and would like to remain invested in equities throughout the tenure of the pension plan.

  • The client has a well-diversified portfolio including mutual funds and stocks.

Based on the information, we have worked out a likely retirement solution for the investor.

Let us first take a look at how investments in the unit linked pension plan (ULPP) pan out.

Pension plan: Preparing for the future
Investment
amt (Rs)
One-time
charge (%)
Admn.
Charges (Rs)*
Fund Mngt
Charges (%)
Investment
Tenure (Yrs)
Net maturity
Value (Rs)
1,000,000 2.50 180 0.80 22 18,400,000
1,000,000 2.50 180 0.80 21
1,000,000 1.00 180 0.80 20
Administration charges are subject to 5.00% inflation per annum.

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%).

As can be seen from the table above, assuming a compounded growth rate (CAGR) of 10% p.a. over a 22-Yr tenure, the client's investments will grow to approximately Rs 18,400,000.

As against the ULPP given above, let us now analyse how investments in a mutual fund would have worked out over a similar tenure.

How do mutual funds fare?
Investment
amt (Rs)
Entry load
(%)
Fund Mngt
Charges (%)*
Investment
Tenure (Yrs)
Net maturity
Value (Rs)
1,000,000 2.25 2.00 22 15,240,000
1,000,000 2.25 2.00 21
1,000,000 2.25 2.00 20
FMC is assumed to be 2.00% for the first 5 years, 1.75% for the next 5 years and 1.50% the remaining tenure.

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.

In our view therefore, the client would be better off investing his money in the ULPP.

However, analysis on pension plans versus mutual funds would be considered myopic if deliberated only from the expenses point of view. There are some inherent advantages as well as disadvantages that both ULPP and mutual fund investments offer.

1. Maturity proceeds

The maturity payout differs for ULPP as compared to mutual funds. Only upto one-third of the maturity proceeds are allowed to be withdrawn under the pension plan; the remaining two-third amount has to be 'compulsorily' invested in an annuity from a life insurance company. The annuity helps generate an income stream for a time period as specified by the individual. Conversely, in an open-ended structure, equity funds allow the individual to withdraw the entire corpus whenever he wants.

2. Diversification

Mutual funds offer the benefit of diversification across various parameters like fund management style (aggressive vs. conservative) and investment strategy (e.g. large-cap orientation, mid-cap orientation, value style of fund management, growth style). This level of diversification is not possible with the ULPP under consideration. Also, in case an individual feels that a particular mutual fund has not lived upto expectations, then he can redeem his investments in that particular scheme and invest in another scheme that fits into his criteria (i.e. modify his portfolio). The same is not entirely possible with a ULPP- since the individual has already invested his entire 'available' savings into only one 'plan'.

3. Track record

Several equity funds have a track record to boast of. A good track record helps individuals identify mutual funds that have performed well across time horizons as well as market phases.

However, the same is not the case with unit linked insurance plans, which are a recent phenomenon. While some of them may have done well over the short time period that they have existed, we would like to evaluate their performance over a longer time frame of at least 5 years before giving a conclusive view.

So what is the bottom line? As can be seen from our calculations and analysis, the client is better off investing in the ULPP as opposed to equity funds; but of course one needs to keep in mind the inherent disadvantages of ULIPs as mentioned above.

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