What to choose for retirement planning - Equity Mutual Fund or Provident Fund?

Look beyond traditional instruments for retirement planning

Retirement is inescapable. Most of us prepare for this eventuality by investing in provident fund (PF). Considering rising lifestyle expenses, span of retirement and increasing nuclear structure of Indian households, investors should look beyond traditional products and consider investment avenues such as equity mutual funds over the long term to support their sunset years.​

First, the reasons for building a large retirement corpus:

Rising lifestyleexpenses – Household expenses, on average, have grown exponentially over the years. If we consider the rise in expenses by factoring in the Consumer Price Index inflation of 7.63%, a monthly expense of Rs 5,000 in 1990 (before liberalisation) would have grown to nearly Rs 34,000 in 2016. The same expense after 30 years grows to a staggering Rs 3.01 lakh per month. We will come back to this number a little later.

Span of retirement – The life expectancy of average Indian is over 68 yearsand with the improvement in health care and development of the country, it is expected to increase in the future. Further, many individuals do not conform to the standard connotation of retirement age of 60 years, preferring to retire earlier. Thus, the average span of retirement could be as high as 20 years – that is a lot of years to live off savings!

Nuclearisation of family – Indian households are becoming more nuclear by nature. The average number of people in a house has decreased to less than fivefrom over five a decade ago. This means that most retirees are expected to fend for themselves rather than finding support in a joint family structure.

Traditional instruments may not suffice for Retirement Planning

To reiterate, there is a need for garnering higher returns to live a comfortable retirement life. However, traditional products may not suffice as they may not offer real (inflation-adjusted) returns. For instance, the employee provident fund has historically returned ~8%on average. If we apply this rate of return to an investment of Rs 50,000 annually, with 10% annual increase in contribution, the total corpus grows to just Rs 2 crore. This corpus could last only about five years if we take the 3 lakh per month requirement at the end of 30 years.

While the Employees Provident Fund Organisation (EPFO) allowed equity investment in 2015 to give a push to the retirement corpus, up to a maximum permissible limit of 15%as per the last count, the contribution to equity might not be enough to make a considerable impact.

Consider equities Equity Funds to enlarge the retirement kitty corpus

Investors should look at supplementing traditional asset classes with higher risk-higher returns investment assets such as equity to generate a larger corpus. The reason is twofold – one, equity is a high return asset class, and second, the long investment horizon of retirement planning (around 30 years) reduces the short-term risk associated with equity. planning (around 30 years) reduces the short-term risk associated with equity. As seen from the table below, equity as represented by S&P BSE Sensex has given 16%* average returns in the 30-year rolling period with the risk associated reducing considerably in the long term.

Table: Risk / return characteristics of S&P BSE Sensex over short and long terms

• ​Average annual CPI since 1958
  
• WHO 2015 data
  
• Indian Census data, 2011
  
• Historically declared EPF interest rates
  
• Rs 2 crore grows at 6%, while the annual expense grows at 7.63%, the annual inflation rate.
  
• E​PFO, Labor Ministry

Consider equities to enlarge the retirement kitty

Investors should look at supplementing traditional asset classes with higher risk-higher returns investment assets such as equity to generate a larger corpus. The reason is twofold – one, equity is a high return asset class, and second, the long investment horizon of retirement planning (around 30 years) reduces the short-term risk associated with equity. As seen from the table below, equity as represented by S&P BSE Sensex has given 16%* average returns in the 30-year rolling period with the risk associated reducing considerably in the long term.

Table: Risk / return characteristics of S&P BSE Sensex over short and long terms

*As on January 31, 2017

If the same investor invests the same portion of money invested in PF into equity and gets the historical growth rate (16%), his / her corpus can grow to Rs 7.82 crore in 30 years. This coupled with the traditional asset class return of around Rs 2 crore, can give a decent buffer corpus to manage the sunset years.

Most investors, however, do not have the wherewithal to invest directly in equity. Mutual funds, on the other hand, offer one of the easiest ways for investors to participate in India's equity market. Investing in mutual funds also provides advantages of professional management and the SIP feature, which is ideal in the early stages of a career. SIP Investment can be stepped up as and when income, and as a result, savings, increases.​​

Chart: Benefits of equity mutual funds

Before investing, always consider your risk profile and examine the track record of the fund house offering the equity scheme before making an investment decision.

Disclaimer : Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content herein has been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. Investors should consult their financial advisers before taking any investment decision.

Mutual Fund investments are subject to market risks, read all scheme related document carefully.​