Investors often need to find the balance between risk and higher incomes from their assets. For conservative investors, bank term deposits and post office Government small savings schemes were the traditional investment choices since these investments assured capital safety. However, in an inflationary environment, the returns on these investments are not sufficient to meet the income needs of investors in the long term. With interest rates going down by more 200 basis points in the last 2 years or so many investors, especially retirees, are exploring alternative low risk investment options which can provide higher incomes compared to the traditional fixed income investments.
Risk and return relationship is one of the most fundamental theories in finance. It is not possible to get higher returns unless you are ready to take some risk. Many investors look at risk as a binary variable, like a lottery ticket where you either lose money or make some money. In the world of mutual funds, however, there are multiple risk grades, e.g. low risk, moderate risk, high risk etc. The probabilities of making a loss are different for different risk grades.
Why do we have different risk grades? Different asset classes have different risk attributes. Fixed income or debt is the lowest risk asset class, but also gives lower returns than other asset classes. Equity on the other hand is the highest risk asset class, but historically has given the highest returns compared to all other asset classes. Mutual funds which invest in debt, equity or a combination of both (hybrid), offer a wide variety of solutions to a variety of investment needs, risk capacities and investment tenures. Debt or income funds can meet income needs of investors with low risk. Equity funds on the other hand are suitable for investors looking for capital appreciation in the long term, but these funds can be volatile in the short term.
Hybrid funds which invest in both equity and debt securities, can provide both income and capital appreciation to investors. Hybrid funds can be equity oriented (equity allocation is more than 50%) or debt oriented (debt allocation is more than 50%). Equity oriented hybrid funds are suitable for moderate to moderately aggressive risk capacities while debt oriented hybrid funds are suitable for moderately conservative to conservative risk capacities. As such, debt oriented hybrid funds can be suitable for conservative investors who are looking for higher incomes.
Monthly Income Plans (MIPs) are debt oriented hybrid mutual fund scheme where debt allocation can range from 75 to 95% and the equity allocation can range from 5 to 25%. The primary objective of Monthly Income Plan (MIP) is to provide regular income to investors along with some capital appreciation over a sufficiently long investment horizon. 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 while the equity portion provides a kicker to returns over a sufficiently long investment horizon and can help investors beat inflation.
Though the name “monthly income plan” suggests that investors will receive monthly payments from these funds, it is important for investors to note that, there is no assurance of regular monthly income as mutual funds are subject to market risks. However, there is a difference between assurance and likelihood; top performing monthly income plans have paid regular monthly dividends over the last few years. However, during prolonged bear markets, there have been instances of monthly income plans not being able to pay regular monthly dividends. Bear markets do not last forever and therefore cash inflow disruptions in mutual fund monthly income plans are only temporary. In order to tide over the cash flow disruption you need to have other sources of cash-flows. It is almost impossible to predict when a bear market will strike. Therefore, it is always prudent in financial planning to have emergency funds invested in money market mutual funds like liquid or ultra-short term debt funds to meet six to twelve months of expenses.
Though mutual fund Monthly Income Plans are subject to market risk, the high debt component reduces the risk of capital loss considerably. The volatilities of Monthly Income Plans are considerably lower than equity funds. Instances of investors making a loss in Monthly Income Plans with a two to three years or more investment horizon is extremely rare. Historical data shows that, mutual fund monthly income plans can give significantly superior returns compared to traditional fixed income products like bank FDs and post office small savings schemes. Top performing debt funds have given 9 to 10% annualized returns over the last 10 years.
Further, mutual fund Monthly Income Plans enjoy considerable tax advantage over traditional risk free fixed income investments, e.g. Bank Fixed Deposits, Post Office Monthly Income Scheme etc, for investors in the higher tax brackets. While Bank Fixed Deposit and Post Office Monthly Income Scheme interest are taxed at the income tax rate of the investor, long term capital gains (investment holding period of at least 3 years) of mutual fund monthly income scheme are taxed at 20% after allowing for indexation benefits. The indexation benefit reduces the capital gains tax obligation for investors substantially over 3+ year investment tenure. However, investors should note that while Monthly Income Plan dividends are tax free in the hands of the investors, the Asset Management Company (AMC) has to pay dividend distribution tax (DDT) of 28.84% before distributing dividends to investors. The DDT paid by the AMC impacts the dividend yields of Monthly Income Plans.
Systematic Withdrawal Plan (SWP) can be a smart and tax efficient option of getting income from MIPs over long investment horizons. Withdrawals made after 3 years from the date of the investment will be subject to long term capital gains tax, i.e. 20% after indexation. Mutual fund Monthly Income Plans do not have any cap on investment, unlike Post Office Monthly Income Scheme, where the maximum investment amount is Rs 4.5 lakhs. While Bank Fixed Deposits and Post Office Monthly Income Schemes charge penalty for premature withdrawals, investors can redeem units of mutual fund Monthly Income Plans without any penalty after the exit load period (usually 12 months). However, to get the most from your SWP, your withdrawal rate should be lower than the average annual returns from these funds.
For moderately conservative to conservative investors with long investment horizon, the risk return trade-off in monthly income plans is quite favourable. Investors should be prepared to remain invested for a period of at least 3 years, so that, they can get the benefits of equity price appreciation and also the tax advantage, while earning stable income during the investment period
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.