In Dread Of Another Cut

Updated: Aug 31 2003, 05:30am hrs
Fixed income seekers are caught between devil and the deep blue sea with yet another round of cuts in deposit rates on the anvil. The recent rate cut is a case in point where debt markets have been, for long, expecting a slash in repo rate. RBI, too, on its part surprised the market by reducing the repo rate by as much as 50 basis points. While this fired up debt markets pushing up bond prices to a new high and yields to a new low, the ground has been prepared for yet another slash in deposit rates.

Risk-averse investors who may now be scratching their heads will have a daunting task to find attractive fixed income products. More bad news could be in store for them. The yield on 10-year benchmark government security is currently hovering around 5.25 per cent and the yield remained below 6 per cent for most part of the current fiscal so far. As the Union Budget 2003-04 linked the coupon on small saving instruments to market-linked rates, there could be a sharp reduction in small saving rates.

It goes without saying that the sharp fall in inflation, especially since financial year 1999, has proved to be a boon for fixed income investors. The inflation-adjusted return on the fixed-income products has been on the rise. Although coupon on these products has been falling, inflation rate which measures the rate of change in prices of goods and services has been declining on a much faster pace, giving a big push to the real rate of returns. Importantly, investors always run the risk of not realising the benefit of lower inflation rates. For instance, if they spend the income earned on these products in future when the inflation level is high, they could face an erosion in their purchasing power.

Nevertheless, in a low-interest rate regime, when most of the assured return saving products are rendered unattractive, income earners could find solace in employees provident fund (EPF).

Srinivasan, a young business executive in a private company, earns Rs 10,000 per month and is hardly able to save money for his future. He is just about managing to make his ends meet. So, where is the scope for saving, he asks.

His boss, Raghavan, gets a much larger monthly package of Rs 50,000. However, he too is not able to put any money aside for the future. His alibi, increasing expenses as I have a family to maintain. To top it, most of the time he ends up overspending.

This is the story of most of the households. Its not that people do not realise the importance of savings, but their current needs often take precedence over their long-term financial goals.

For such people, EPF could come in handy. For those disciplined savers, too, investment in EPF could bring in rich dividends. In fact, the falling rate of interest has made EPF as one of the most attractive fixed income products. While one may complain about the low level of liquidity in EPF, the high coupon on this instrument is luring. EPF is currently providing a coupon of 9 per cent plus 0.5 per cent as bonus. Says Rajiv Bajaj, managing director, Bajaj Capital, an investment advisory and distributor firm: EPF is a bonanza for investors as the coupon rate of 9 per cent plus 0.5 per cent is very attractive. People should utilise this opportunity before the rates go down. Such rates may not even last for long.

Asked about the possibility of a cut in EPF rates, Central Provident Fund Commissioner Ajai Singh says, The Government, in consultation with our board of trustees, determines the interest rate on EPF. The recommendations are made on the basis of our projected earnings. Thus we cannot say whether the rates would be reduced in the next year.

There has been a growing realisation among investors about EPFs attractiveness. While the mandatory contribution towards EPF is 12 per cent of basic wages, dearness allowance, cash value of food concession and retaining allowance, investors can go in for additional investment. A lot of people have been going beyond the mandatory EPF investment limit of 12 per cent of their salary. Our own employees have exhausted the maximum EPF investment limit, Mr Bajaj says.

Such high coupon rate on EPF cannot be sustained for long as the provident fund managers may not be able to earn the assured level of returns when the yield on debt papers has hit a rock-bottom. The coupon on EPF will ultimately become market-linked. In fact, all provident fund money will be managed by pension fund managers. Existing asset management companies can also become pension fund managers but they have to apply for a separate license, Mr Bajaj says.

The Product
An EPF fund account is maintained with the Employees Provident Fund Organisation (EPFO), a social security organisation which functions under the overall superintendence of the policies framed by the Central Board of Trustees, a tripartite body headed by the Union Minister for Labour as chairman. The body also has representation from both the employers and the employees.

The EPF scheme gets contributions both from employer and employee. Employers covered under the scheme have been made responsible to deduct their employees contribution, add their own contribution to it and deposit the same with the EPFO.

Currently, barring some exceptions, a compulsory 12 per cent of their pay is deducted at the source of income and the employer adds an equal amount. Interest rate on EPF is fixed by the Government in consultation with the board of trustees of the EPFO. According to Mr Singh, The current situation is that the board of trustees have recommended an interest rate of 9 per cent and a bonus of 0.5 per cent. However, the 9.5 per cent returns are subject to the approval by the Government.

While the liquidity is low, withdrawals are allowed in case the investor wants the funds for buying or constructing a house, marriage, education, accident or disease and in certain special cases. Most of the time, it will be the option of the employees to make the withdrawal on refundable or non-refundable basis. Nevertheless, withdrawal from EPF is a time-consuming process.

The Returns
Indians have been used to high rate of interests on assured return saving instruments. For many years till June 2000, the EPF investors were getting an assured return of 12 per cent. Between June 2000 and March 2001, it was at 11 per cent, after which the rate was cut to 9.5 per cent.

However, in the 1990s, the country also had a higher rate of inflation. As a result, the real rate of return on this product has been rising (see table). In fact, in the year 1998, the rate of inflation was over 13 per cent and as a result, the real rate of return on EPF was negative! With the decline in the inflation rate to 4-5 per cent during past few years, the real returns from EPF scheme has increased to 5-7 per cent even after the rate cut in the recent times.

A Case For EPF
An assurance from the Government and its tax-free nature, added to high returns make the EPF investment very attractive. The amount contributed by the employee towards EPF is eligible for a deduction under Section 88 of the Income Tax Act. Depending on the total taxable income, 15 per cent or 20 per cent of the EPF contribution subject to a maximum limit of Rs 70,000 is deducted from an investors tax liability.

Investment experts suggest that investors should use EPF as a substitute of other small saving products if the product is meeting their other investment requirements apart from returns. Additional investments in EPF are allowed upto a maximum of Rs 70,000 in a year for taking the Section 88 benefit. The employer, however, is not required to contribute an equal amount in the case of additional investments.

Besides, it is also very easy to make such investments. An employee only needs to inform his employer and a higher amount gets deducted from his salary and deposited to the EPF account. According to Mr Singh, The major attractiveness of the EPF scheme is that it offers tax-free assured returns and also has a pension scheme. Besides, the savings are protected against attachment by a court of law.

Comparative Analysis
The 9.5 per cent rate of return on EPF is attractive when compared with the earnings on other assured return schemes offered by the post office, the Reserve Bank of India, the Government and other agencies. This is especially after the recent cut in interest rates on small saving instruments which have been cut to 8 per cent.

Compared with Public Provident Fund (PPF), EPF is still attractive. While the rate of interest on PPF has been cut to 8 per cent, EPFs coupon is higher by 150 basis points. Both enjoy same kind of tax benefits.

But EPFs poor liquidity makes it difficult for anyone to put all the savings in this illiquid product, specially at a younger age when the need for liquidity is higher as income is low and the savings base is relatively small. So, while EPF may be ideal for a young executive to provide for his retirement, it may not take care of his short-term or medium-term needs. One has to maintain certain level of liquidity depending on the investor needs.

In India, most of the investments are made for saving taxes. Post Office Savings Bank offers National Savings Certificate (NSC) which accounts for a large chunk of such investments, thanks to the Section 88 benefits and Section 80 L benefit. The interest rate on these products has been cut to 8 per cent, which is way below EPF rates.

However, remember that the rates on EPF may not last forever and even a seemingly small cut of 0.5 per cent may make a big dent in your retirement kitty by setting it back by couples of lakhs. So make hay while the sun shines.