In the first part of this post, “Why you should get serious about retirement planning and start investing in mutual funds”, we had discussed that without serious thought and planning from an early stage of your career, retirement planning can become a daunting challenge later in life. Simply saving a portion of your income may not be sufficient for creating a sufficiently large investment corpus. In life we have multiple goals like home purchase, children’s higher education, children’s marriage etc. In an inflationary environment, meeting multiple financial goals from regular savings can be a challenge. In the first post we saw an example where, despite saving for retirement from the age of 30, you would deplete your retirement corpus by the age of 70. Clearly therefore, saving is not enough; your savings need to generate sufficient returns for you to achieve financial independence.
Read why smart asset allocation is crucial in retirement planning
Investments and power of compounding
Money loses its value over time. Wealth is created when money grows at a rate faster than the inflation rate. You need to invest your savings to create wealth. How does investment create wealth?
Money invested earns profits or returns; profits re-invested earn more profits. This is known as power of compounding. Power of compounding is simply profits earned on profits; interest earned on interest. Rs 1 Lakh invested in an asset earning 10% returns will grow to Rs 1.33 Lakhs in 3 years; Rs 1 Lakh invested in the same asset will grow to Rs 6.72 Lakhs in 20 years. You can see that in the latter case, the profit itself is much more than the investment. Now if you remain invested for 30 years, your money will grow to Rs 17.5 Lakhs. It is the profit on profit which earns returns for you. Therefore, time is the most important factor in investments.
How mutual funds help you in retirement planning?
Start retirement planning early in your career: Mutual funds enable you to start investing with savings of just Rs 1,000. You do not need to wait to have a sufficiently large income to start investing in mutual funds. In other words, you can start investing in mutual funds from an early stage in your career. By starting early, you give yourself more time to achieve your financial goals. We saw that time is the most important factor in investment because of the power of compounding. By starting early you can exploit the maximum potential of the power of compounding and create wealth.
Read: why should you get serious about retirement planning early in your career
Take the right amount of risk at various life-stages: Regular Advisorkhoj readers know that risk and return are related. The more risk you take, the higher is your potential returns. When you are young, you can take more risks because you have more time on your side to recover from an impact of investment cycles.
Equity is the ideal asset class to suit the risk profiles of young investors. Rs 1 Lakh invested in Nifty 100, which is the index of large cap stocks, would have grown to Rs 14 Lakhs in the last 15 years at a CAGR of 18%. The same amount invested in Fixed Deposits and Gold would have grown to Rs 2.85 Lakhs and Rs 5.25 Lakhs respectively, over the same period of time. Mutual funds enable young investors to invest in equity with a small capital outlay or from their regular savings. Over a long investment horizon, investors can create substantial wealth by investing in equities.
Did you know what to analyze and ignore while selecting equity mutual funds
Risk Diversification: WhenI began my career 23 years back and had some savings in my bank account, my family advised me to put the money in fixed deposit and buy life insurance endowment policy. They asked me to stay away from the stock market. My father had invested in stocks in the 80s and saw prices of his stocks crash when the market tanked in the early 90s. Naturally, he was very apprehensive about stocks. Unfortunately, there was little awareness of mutual funds in the 90s. It was 5 years later, when I was studying in business school, that I realized the importance of risk diversification in equity investments.
There are two kinds of risks in equity investments – systematic risk or market risk and unsystematic risk or stock specific risk. Unsystematic risk can be reduced to a great extent by investing in diversified portfolio of stocks across different industry sectors. This is how mutual funds work. Investing in mutual funds is a much less risky way of investing in equities compared to buying stocks directly in the stock market. Therefore, mutual funds are ideal investment options for new / inexperienced investors.
Learn more about what are equity mutual funds in India and their types
Leverage the expertise and experience of fund managers: Mutual funds not only help you achieve risk diversification, it can also help you get better than market returns because mutual funds are managed by experienced professionals. Most investors do not have the expertise of selecting stocks or can even devote sufficient time to understanding stocks and other asset classes. Fund managers are professional with the requisite expertise and experience; they are tasked with the responsibility of beating market returns. The excess return generated by the fund manager is known as alpha. In the context of a long term secular growth market like India, if a fund manager is able to deliver 1 – 2% alpha, investors can create substantial wealth over long investment tenors. Long term track record of some of the top performing mutual fund schemes bear testimony to the alphas created by mutual funds.
Systematic Investment Plans: Mutual funds enable you to invest for your long term goals from your regular monthly savings through Systematic Investment Plans (SIP). You can start your SIP with an investment of just Rs 1,000. The power of SIP over long investment tenors is almost magical. With Rs 3,000 monthly SIP over 30 years, you will be able to accumulate a corpus of more than Rs 1 Crores. As your income increases, you should increase your SIP amount and the result over a long investment horizon will be outstanding. The table below shows the amount of corpus created over various investment tenors for different monthly SIP amounts (figures in Rs Lakhs) assuming a 12% rate of return on investment.
Mutual Fund Systematic Investment Plans (SIPs) is one of the most powerful tools in your financial planning arsenal. SIPs take advantage of market volatility through Rupee Cost Averaging and over long investment tenors can create substantial wealth for you. It is also highly convenient. With a one-time bank mandate, money will get debited every month (or any other frequency) from your savings bank account and get invested in a mutual fund scheme of your choice for as long as you want. You can start SIPs for each financial goal (children’s higher education, marriage, retirement planning etc). This will help you remain disciplined towards each goal and achieve all of them, without compromising any one of them in favour of another.
Example of SIP – Growth of Rs 10,000 monthly SIP in the last 10 years
Tax Efficiency: Most investors, especially new investors, ignore the effect of taxes on their returns. When you put your money in a bank FD, the bank will deduct TDS before crediting interest to you. However, your actual tax liability may likely be higher in the case of bank FDs. Bank FD interest is taxed as per the income tax rate of the investor. You will have to add the interest to your taxable income in your income tax return and pay taxes accordingly. Bank FD is just one example where investors need to consider the effect of taxes.
Mutual funds are among the most tax efficient investment options in India. In the case of equity funds, capital gains (profits) on withdrawals made before 12 months from the date of investment will be taxed at the rate of 15%. Capital gains on withdrawals in equity funds made after 1 year from the date of investment is tax free up to a limit of Rs 1 Lakh; capital gains in excess of Rs 1 Lakh for equity fund investments held for more than a year will be taxed at 10%.
Capital gains on withdrawals in debt mutual funds made before 3 years from the date of investment will be taxed as per the income tax rate of the investor. Capital gains on withdrawals in debt mutual funds made after 3 years from the date of investment will be taxed at 20% after allowing for indexation benefits. Indexation benefits can lessen the tax obligation of the investors considerably. For individual tax consequences, investors are requested to consult their tax advisors.
We suggest the following articles to read on taxes –
How mutual fund capital loss tax credits works
What are ELSS mutual Funds and their benefits
Mutual Fund capital loss: Tax implications
In this two part post we discussed why retirement planning is a very important priority for investors. Given the magnitude and complexity of the challenge in a dynamic economic and work environment, investors should start saving from retirement from an early stage of their careers. As discussed in this post, saving is not enough; you should invest your savings wisely in order to achieve your financial goals.
We also discussed why mutual funds are the best investment options for your retirement planning. Mutual fund investment is not rocket science; these investments are simple to understand and execute. However, if you have questions about how mutual funds will be helpful for your specific requirements and your financial situation, you should discuss with a financial advisor. Your financial advisor will be able to clarify your doubts, guide you through the investment process and also help you monitor your investments.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.