Retirement planning has rarely been actively practiced in the Indian context. The system of joint families is partly responsible for the same. Retirees were provided for by their children and family members, thereby eliminating the need to plan for one's retired life.
For others who didn't have the luxury of falling back on their family, savings schemes like EPF (Employees' Provident Fund) and PPF (Public Provident Fund), emerged as the default choices. Attractive returns offered by these schemes ensured that a sizeable corpus was available on retirement.
As a result most individuals never felt the need to give retirement planning a serious thought. In the changing scenario, however, such a passive attitude towards retirement planning may become untenable.
The usual suspects
Before discussing the new investment environment, let us examine the schemes under question. EPF is a statutory contribution deducted from employees' salaries. The amount deducted is matched by the employer with an equal contribution.
Employees' contribution to EPF is eligible for deduction under Section 80C of the Income Tax Act and at present earns a tax-free return of 8.50%. PPF on the other hand, falls in the category of small savings schemes and is open for investors across categories. Investments up to Rs 70,000 per annum are eligible for deduction under Section 80C.
The scheme runs over a 15-year time frame and currently offers returns at 8.00%. Interest earnings from both EPF and PPF are tax-free on maturity.
With such attractive options available, do investors even need to bother exploring alternative avenues? We think so and rationalisation in the aforementioned schemes should be credited as the primary reason.
Returns on schemes like EPF and PPF are divorced from market rates; factors other than economics often play a vital role in their determination.
At the time of writing this report, the 10-year benchmark GOI paper yielded a return of 7.11%. In simple words, if you were to invest in the given instrument and hold it till maturity, it would deliver a taxable return of 7.11%. EPF and PPF offer higher returns and that too tax-free!
This is indicative of the disparity in market-linked returns vis-à-vis those offered by EPF and PPF. As a result their feasibility and sustainability over longer time frames (for which they are intended) needs to be questioned.
Rationalisation in progress
Authorities on their part have initiated a host of measures to rationalise schemes like EPF and PPF, and align their returns with market rates. In January 2000, EPF offered a return of 11.00%; similarly investments in PPF yielded a return of 12.00%. At present PPF investments earn a return of 8.00%. The recommended rate on EPF deposits has recently been reduced from 9.50% to 8.50% for the year 2005-06.
Interest rates on EPF and PPF are reset every year; as a result, investors' returns are assured but not fixed. An investor, who invests in PPF at 8.00% now, might earn just 6.00% a few years hence. This is distinct from avenues like National Savings Certificate (NSC), wherein the earnings rate is locked at the time of making investment.
The investor in NSC continues to earn returns at the stipulated rate (irrespective of any subsequent changes in the rate) throughout the tenure of investment.
Tax sops on these investments have also added to their allure. However the same could be short-lived. The finance minister while presenting the Budget 2005-06 had proposed adopting the EET method of taxation for tax-saving instruments instead of the EEE method.
Under the EEE (exempt-exempt-exempt) method, contributions to specified schemes are exempt from tax, accumulation (earnings on investment) is exempt from tax and similarly the withdrawals/benefits from the schemes are exempt as well.
Conversely, under the EET (exempt-exempt-taxed) method, while contributions and accumulations are exempt, the withdrawals/benefits would be taxed. A committee has been set up to work out a roadmap for moving towards the EET system and to examine the instruments that would qualify for the new regime.
If EPF and PPF were to be brought under the EET regime, investors' retirement corpuses can shrink on account of the tax liability. This in turn might make their retirement plans go awry.
Another possibility that needs to be considered is the emergence of a dichotomous structure in savings schemes. For example, investors in lower income brackets might continue to receive returns at attractive and 'divorced-from-market' rates, while a new toned down structure could be introduced for those in higher income brackets.
A precedent of small investors' interests being safeguarded in the aforementioned manner does exist in the Indian context.
For example, in the bailout package for US-64 investors, those with less than 5,000 units were given the option of liquidating their investments at a higher net asset value (NAV) as opposed to those with larger holdings.
We believe the rationalisation process in schemes like EPF and PPF is irreversible and the returns delivered by these schemes will only become more aligned with market rates going forward.
What should you do?
Firstly, investors should factor in a scenario wherein schemes like EPF and PPF might be inadequate to provide for their retirement needs. This in turn necessitates that investors explore alternate avenues like mutual funds and pension plans for building a retirement corpus.
Mutual funds invest in both equity and debt instruments, and are available in a number of variants; this makes mutual funds a feasible avenue for investors across risk profiles.
For those who are habituated to conventional assured return schemes, the transition to market-linked instruments like mutual funds can be a tough one. However given that 'free lunches' like EPF and PPF might soon be a thing of the past (at least for some, if not for all), investors on their part would do well to gear up for new investment scenario.
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