Capital appreciation and income are two primary investment goals. Mutual funds provide a multitude of investment solutions for both these objectives for different risk profiles. However, in India mutual funds are mostly associated with capital appreciation. A retail investor’s faith in mutual funds for wealth creation has been well-rewarded, with good equity mutual funds giving multiple times returns over a sufficiently long investment period.
The main purpose of investing, for many investors, is capital appreciation or wealth creation; investing for regular income is not an important consideration for majority of investors, except senior citizens. Most mutual fund investors in India belong to the salaried class and they depend almost entirely on their salary for meeting their regular expenses. Be that as it may, monthly income, whether from salary or investments, is the most important financial need for all of us.
Let us take a typical salaried person in his mid to late thirties or early forties in the upper middle income group. Consider his regular monthly expenses – home loan EMIs, fees for school going children, utility bills, fuel bills, grocery bills, salaries of household staff etc. Most of these expenses are fixed expenses and you simply cannot wish them away. Let us now ask the very uncomfortable question. What if he does not get his salary next month? He may have enough balance in his savings account to take care of his monthly expenses for a few months.
Eventually he would have run out of liquidity and have started redeeming his investments (fixed deposits, mutual funds, etc.) If unfortunately the market crashes at the same time (bad luck often strikes on multiple fronts), then he will be selling his mutual funds at a low price or even at a loss. He could find a new job, but until then his investments may have depleted considerably and it may take the investor a very long time to return to comfortable levels of savings/ investments, not to mention the severe mental stress, the investor and his family had to go through.
Safeguarding from loss of income
How can investors safeguard themselves from such a situation? In the developed countries like USA, Canada, UK etc. there are general insurance products which can provide income replacement if the insured loses his or her job, but unfortunately at present there are no unemployment insurance products in India. Investors should therefore, look for investment solutions for regular income. Fixed deposits paying monthly interest and Post Office Monthly Income Schemes were traditional investment choices for income in India. However, interest rates of these traditional fixed income products have fallen over the last 2 years and as such these products may not be able to generate sufficient income for your needs. Investors need to look at alternate income investing solutions and mutual funds provide such a solution to investors.
Before we discuss income investing solutions, it is important to understand that income producing assets are low or moderately low risk assets and therefore, investors should not expect very high returns from these investments. Further, since the income yield is not very high, it may take a considerable amount of assets to generate sufficient income to replace your monthly salary. But investing in income producing assets is a step towards financial independence. If your investment income can meet, say 20% of your fixed monthly expenses, pressure on your other assets will be considerably lesser during periods of no salaries.
Who should invest in income generating assets?
There is a misconception that only retired people should invest in income generating assets. Even if you are working, you should invest in income generating assets. You should ask yourself, how much flexibility you have in expenses – a very large part of the expenses of most families are inflexible. Such families should therefore, invest in income generating assets. You should look at your financial liabilities like home loans, car loans etc. You should also look at your family obligations – school going children, dependent parents etc. The higher your financial liabilities and other obligations are, the more you should invest in income generating assets.
Mutual fund income solutions
Mutual Fund Monthly Income Plans are excellent investment choices for investors looking for income and also some capital appreciation over a sufficiently long investment period. Monthly Income Plans are debt oriented hybrid mutual fund schemes where debt allocation can range from 75 to 95% and the equity allocation can range from 5 to 25%. You can choose between lower and higher equity allocations based on your risk appetite. For example, younger investors can opt for higher equity exposure, while older investors canopt for lower equity exposure.
The primary objective of Monthly Income Plans is to provide regular income to investors along with some capital appreciation over a sufficiently long investment tenure. The capital appreciation can help investors beat inflation in the long term. The debt component of Monthly Income Plans lowers the volatility, provides stability and generates income for investors. The equity portion provides a kicker to returns over a sufficiently long investment horizon and can help investors beat inflation.
Both Growth and Dividend options are available in Monthly Income Plans. Unless you have immediate income needs, you should invest in the Growth option so that you can benefit from compounding. When you need income from your investments, you can switch from Growth to Dividend and start receiving regular monthly payouts. Investors should understand that, though Monthly Income Plans aim to payout regular dividends to investors, mutual fund dividends are not assured.
Difference between Monthly Income Plans and Balanced Funds paying monthly dividends
Both Monthly Income Plans and Balanced Funds of many AMCs are paying monthly dividends for the last few years. The monthly dividend payout rates of Balanced Funds have been a few percentage points higher than that of Monthly Income Plans. However, you should understand that the risk profiles of these two types of mutual funds are very different. Balanced funds have at least 65% exposure to equities and the rest in fixed income. Monthly Income Plans, on the other hand, have only 5 to 25% exposure to equities. Lower equity exposure makes Monthly Income Plans much less volatile compared to Balanced Funds.
Let us also understand how Monthly Income Plans and Balanced Funds pay regular dividends. Monthly Income Plans ideally aim to pay dividends from income accrued by investments, e.g. interest earned from debt securities. Balanced Funds on the other hand are paying monthly dividends from their accumulated profits earned through portfolio churning, i.e. buying and selling stocks and bonds. Over the years, the older Balanced Funds have paid out only a portion of their profits as dividends, keeping the rest of the profits in reserve to be paid out on rainy days. But you should understand that Balanced Funds are more affected by stock market volatility and their ability to pay dividends has market dependency. Monthly Income Plans, on the other hand, get their income primarily from debt securities and therefore, provide much greater income stability.
One of the main reasons of higher dividend payout rates by Balanced Funds is because of the tax advantage these funds enjoy over Monthly Income Plans. Balanced Funds are taxed as equity funds and dividends paid out will be taxed at 10% by way of dividend distribution tax (DDT). Dividends paid by Monthly Income Plans, which are treated as debt funds, are subject to DDT of 28.8%. These rates are exclusive of surcharge and health and education cess.
Capital Gains Tax in Monthly Income Plans
Short term capital gains (investment holding period of less than 3 years) in Monthly Income Plans are taxed as per the income tax rate of the investor; long term capital gains (investment holding period of less than 3 years) are taxed at 20% after indexation. Indexation benefits can reduce the effective tax rate of the investors substantially.
Long term capital gains tax advantage makes Systematic Withdrawal Plan (SWP) in Monthly Income Plans more tax efficient than monthly dividends. However, the SWP rate should not be more than the long term average rate of return of the fund; otherwise you may end up depleting your investment and this will defeat the purpose of income investing. Top performing Monthly Income Plans have given nearly double digit returns over the past 5 to 10 years, but in our view you should limit your withdrawal to 8% per annum. Once your corpus grows, you can then increase your withdrawal rate.
Your portfolio should comprise of both growth assets (for capital appreciation) and income generating assets. Growth assets will create wealth for you, while income generating assets will provide stability in difficult times. Monthly Income Plans are excellent income generating assets for long term investors. You can invest in Monthly Income Plans either as a lump sum or using Systematic Investment Plans (SIP).
We advocate SIP as a disciplined investing mode for salaried investors. Over a sufficiently long period of time, through SIPs, you can accumulate a sufficiently large asset base, which can take care of a large part of your income needs. Investors should consult with their financial advisors if Monthly Income Plans are suitable for their investment needs.