Why Union Budget 2017 Must Give the Nod to Target-Date Funds

In its February 2014 board meeting, market regulator SEBI alluded to “a long term product such as Mutual Fund Linked Retirement Plan (MFLRP)” as a part of its 'Long Term Policy for Mutual Funds in India'. Since then, some fund companies have launched their versions of retirement funds.

However, the regulator is yet to issue guidelines to pave the way for a defined MFLRP product. With Union Budget 2017 on the anvil, one hopes that the MFLRP segment is promulgated in the form of Target-Date Funds.

What are Target-Date Funds?

As the name suggests, target-date funds focus on a pre-set year of retirement. For instance, if you are 30 years of age, and intend to retire at the age of 60, then you will invest in a fund with a target date of 2047.

Target-Date funds are structured as fund-of-funds. They operate on the principle of asset allocation. In their initial years, target-date funds focus on wealth accumulation by largely investing in a combination of domestic and global equity funds. As the target-date approaches, the portfolio acquires a conservative bent with equity allocation being trimmed in favour of fixed income funds.

Simply put, a target-date fund can be a one-stop shop for accumulating a retirement kitty.

In the US, several billion dollars are invested in target-date funds. It certainly helps that target-date funds are often the default choice under defined contribution plans such as 401(K).

Retirement Planning and India

While awareness about retirement planning has grown over the last decade or so, it continues to be a bit of an alien concept for several Indians. Perhaps one can chalk it up to cultural factors. We have been a country of joint families wherein post-retirement, parents are provided for by their children. But thanks to a combination of factors such as growth of nuclear families, higher life expectancy, and cost of living, the need for retirement planning is real.

Successive governments have nudged citizens to independently provide for retirement as well: From opening up the National Pension System (NPS) for all citizens in 2009, enhancing its tax sops in Union Budget 2015, to launching the Atal Pension Yojana for those in the unorganised sector. The message is clear: Focus on retirement planning.

Tax Treatment and Benefits

The allure of tax benefits can be a strong motivator while making investment decisions. Let’s take the example of Equity Linked Savings Schemes (ELSS), a niche segment in the Indian mutual fund industry with assets of INR 501 bn (3% of industry assets) as on Dec 2016.

From Dec 2011 through Dec 2016, assets under ELSS have risen at an annualised rate of roughly 20%. That is no mean feat considering that the investments are subject to a three-year lock-in. To put things in perspective, over the same period, the broader category of other equity funds has grown by 25%.

So, what makes the niche ELSS category tick—tax benefits! Investments in ELSS are eligible for deductions under Section 80C of the Income Tax Act.

To enhance the appeal of target-date funds (and thereby facilitate retirement planning), it is pertinent that investments therein be made eligible for Section 80C deductions.

Another area which must be simultaneously addressed is the tax treatment of fund-of-funds. In India, fund-of-funds never took off. While the latter can be attributed to a variety of reasons, none is more significant than tax treatment.

Irrespective of their underlying investments (equity funds or fixed income funds), fund-of-funds are taxed akin to fixed income funds. Since the tax treatment for fixed income funds is more punitive (versus equity funds), fund-of-funds have been at a disadvantage.

Hence the need for regulatory intervention to ensure that target-date funds enjoy the same tax treatment as equity funds. And what better platform than the Union Budget to iron out these regulatory matters, and launch target-date funds on a strong footing.

How the Investor Wins

Presently while planning for retirement, investors can choose from NPS, small savings schemes (Public Provident Fund) and retirement plans of insurance companies. Target-date funds can effectively close the circle of retirement-focused avenues. 

The potential for ancillary benefits—inflow of long-term monies into mutual funds, greater influence of domestic institutional investors in markets, multiplier effect of higher consumption from retirees—is strong.

Hopefully, the Finance Minister will agree, and give the nod to target-date funds in Union Budget 2017.

Why Union Budget 2014-15 isn’t bad for the mutual fund industry

Union Budget 2014-15 has produced its share of diverse reactions. On Budget day, equity markets were at their volatile best. While bigwigs from opposition parties slammed the Budget, industry leaders hailed it. Diverging opinions notwithstanding, one area where consensus has emerged is that the mutual fund industry and investors have been done in by the Finance Minister (FM).

Proposals pertaining to long-term capital gains on non-equity oriented funds (read debt mutual funds) and dividend distribution tax (DDT) are being seen as spoilers. To be fair, a higher tax liability does hurt and negative reactions aren’t surprising. But to suggest that these provisions will spell doom for the mutual fund industry is far-fetched. Debt fund segments such as liquid funds and fixed maturity plans (FMPs) which account for a significant size (roughly 41% as of June 2014*) of industry assets are likely to be most affected by the aforementioned provisions. The theory doing the rounds is that the stringent tax provisions will result in investors shunning these segments in favour of bank fixed deposits.

What critics need to consider is—was the tax arbitrage (versus avenues such as bank fixed deposits) their only draw? To my mind, debt funds operate on the premise of offering market-linked returns and high liquidity at low risk. Critics will argue that higher tax will result in lower post-tax returns. That’s where the mutual fund industry needs to step up to the plate. To begin with, fund houses can make debt funds inexpensive by lowering costs. Then, there’s scope for paying more attention to the investment management function.

For instance, it is an open secret that most FMPs operate on an auto-pilot mode with minimal intervention from portfolio managers. To be fair to portfolio managers, given the large number of FMPs that a typical fund house launches, there isn’t any alternative but to treat them as mass-produced commodities. But a modified approach, wherein the number of FMP launches is rationalized, managers invest more time and effort, coupled with competitive costs, will keep the segment competitive even in the new regime. It would be safe to assume that better returns will translate into investor interest and asset flows

A constant rhetoric from fund houses is that individual investors should use liquid funds (roughly 22% of industry assets as of June 2014*) as an alternative to savings bank accounts. However, it is an indisputable fact that liquid funds continue to be a domain for corporate and institutional investors (as of March 2014, 88% of assets in liquid funds were held by corporates and institutions*). Why the skewed holding pattern? It’s simple: corporates and institutions represent a ready clientele which will bring in big monies, so fund houses are happy to cater to them.  

Conversely, tapping into retail monies is an arduous task. To begin with, retail investors will have to be educated and sold the idea of investing in liquid funds. Also a smaller ticket size means that fund houses will have to reach out to a large number of retail investors. But is it realistically possible for fund houses to become more retail-oriented? Yes, it is, and here’s how: fund houses will help their own cause by making sensible and honest use of the mandated investor education monies rather than plastering cities with surrogate advertisements under the garb of investor education. In the long-term, fund houses must reduce their unhealthy reliance on corporates for assets.

Speaking of long-term, here’s something to cheer about. Most seem to have overlooked that the limit for tax-saving under Section 80C has been enhanced to Rs 150,000. Equity Linked Savings Schemes (ELSS) from mutual funds are eligible for tax sops under Section 80C. The interesting bit is that these are equity funds (on which fund houses typically make more money versus debt funds); additionally the investments are subject to a 3-year lock-in from the investment date (read sticky long-term money). For cynics who believe that ELSS will become a thing of the past when the long-awaited direct tax code arrives, wait and watch! All recommendations of the erstwhile FM may not find place in the new direct tax code.

The Budget highlights mention “uniform tax treatment for pension fund and mutual fund linked retirement plan”. In a February 2014 press release, market regulator SEBI alluded to the mutual fund linked retirement plan. It would be safe to assume that guidelines for such products will be issued shortly and that mutual funds will be able to attract retail long-term monies from such products too. Comparable tax treatment with similar products from the insurance industry only further sweetens the deal.

To my mind, the Budget has done enough to facilitate flow of long-term monies into mutual funds. The onus to make most of the opportunity on hand lies with the mutual fund industry.

On a related but distinct note, five years ago, around the same time, SEBI abolished entry loads on mutual funds. Even then naysayers had predicted that the mutual fund industry was doomed. Guess what, it’s still up and running. Likewise even now, it would be best to take those predictions of penal tax provisions seriously hurting the industry with a pinch of salt.

* Data sourced from www.amfiindia.com