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How to choose debt instruments for retirement?

Posted on 29 Jul 2021 • Updated on: 02 Feb 2023
Author: Sayan Sircar

Tags: Retirement ; Choosing Investments ; Pension

12 mins read
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This post describes suitable debt instruments for both pre and post-retirement investing: Provident fund, PPF, Sukanya Samriddhi, FD/RD, NCD, pension plans, RBI bonds, post office and SCSS.

Debt investment for retirement

📚 Topics covered:

Introduction
Choosing debt instruments in the accumulation (pre-retirement) stage
Choosing debt instruments in the withdrawal (post-retirement) stage

Introduction

This article builds on the debt selection framework discussed in this post to focus on the retirement portfolio specifically. To recap, a debt fund has a single purpose in a portfolio: reduce the overall risk and provide a small return. The purpose of having debt as a part of the general asset allocation of a goal is to stabilise the portfolio risk. It is extremely risky for DIY investors to chase returns from debt in their overall portfolio since debt funds can crash drastically like this.

As the Indian economy matures, interest rates will keep falling, impacting the steady returns of savings schemes (Fixed deposits, provident fund, senior citizen savings schemes, annuities, Sukanya Samriddhi Yojana) KVP, NSC etc.) as well as bonds and debt mutual funds. While inflation is also expected to fall over time, debt usually gives a lower return than inflation at any time. Therefore, the investor needs to accept this as a fact of life and build a portfolio with suitable asset allocation to both reach the target retirement corpus and then beat inflation post retirement.

We deal with choosing suitable debt instruments for both planning retirement and those entering / already in retirement.

Inflation: the impact on your goals and how to choose assets that beat it

Choosing debt instruments in the accumulation (pre-retirement) stage

Choosing a Debt mutual fund

Debt mutual funds

As discussed in this post, we choose mutual funds using these criteria:

Category of fund: overnight, liquid, ultra-short, low duration or money market funds only with Macaulay duration <= one year (alternatively modified duration <= one year)
Credit quality of portfolio: mix of SOV/AAA/A1+/Cash only
Gilt funds can be considered if you can understand what drives NAVs and how to profit from the volatility. Recent returns of debt funds do not predict future returns in any way.

Small savings: Provident fund and Sukanya Samriddhi

Provident funds (PPF, EPF and VPF) are typical products chosen for retirement. They have guaranteed returns and no taxes on maturity. However, there are two considerations:

Lock-in until maturity: EPF is locked in until retirement, while PPF has a 15-year lock-in (21 years for Sukanya). VPF can be withdrawn under certain circumstances. However, given the general lack of liquidity prevents rebalancing from PF to other assets when the time comes (for example, rebalancing after a 30% fall in equity markets). There needs to be sufficient liquid debt assets to rebalance in both directions as per market movements. This is why everyone should not maximise their contribution to PPF, VPF and Sukanya without evaluating the asset allocation for retirement.
Falling interest rates: while the interest rate is guaranteed, the recent trend for all of these schemes is downward, requiring you to lower the return expectation from this asset class when building your model. A good practice will be to set the long-term debt return expectation the same as the current short-term one to build in a margin of safety

Fixed / Recurring deposits

While bank deposits give you predictable returns, there are two things you need to keep in mind

these are taxed at the highest tax slab of the investor. Many people try to circumvent this problem by investing in the name of senior citizens in the family who are in lower tax brackets. However, income clubbing rules may apply, or the senior citizen will also end up paying tax. Generally, FDs in the name of senior citizens have a slightly higher interest rate
while all banks have a ₹ five lakhs DICGC guarantee for bank failure, this should not be the criteria in choosing a bank since there is a defined limit in getting this ₹ five lakhs in case the bank fails. RBI defines SBI/ICICI/HDFC as too-big-to-fail or Systematically Important (SIFI), and investors should stick to them during retirement.

This post discusses FD vs mutual funds in more detail.

Non convertible debentures

NCDs are very attractive to yield-chasing investors, given offers as high as 10% (as of July 2021), which doubles the investment in around seven years. There is no free lunch. However, to offer such high returns, these NCDs have AA or similarly low credit rating with a higher risk of default than lower-yielding AAA-rated investments. Only investors with very high risk-taking ability (not risk-taking willingness) should choose such NCDs with the understanding that an NCD default (like DHFL) should not derail their retirement. The proceeds are taxable at the marginal tax rate on maturity.

Arbitrage funds

Arbitrage funds are hybrid mutual funds that try to profit from pricing discrepancies in the equity cash and futures markets. They have equity-like taxation (10% tax over 1 lakh of LTCG), which makes them reasonably popular for short holding periods. There are two things that investors need to keep in mind:

Short-term returns can fluctuate a lot depending on the arbitrage opportunities in the market. You should check this before investing
SEBI allows 35% of the fund portfolio in debt instruments that require the usual debt fund due diligence

Target maturity debt funds

This is a recent offering in the debt mutual fund space that “mature” like an FD on a particular date but allow new investments via lump sum and SIP (or exits) anytime before maturity. These funds typically have the maturity year in their name and invest in RBI / Government bonds or bonds issued by state governments and generally do not have a default, i.e. credit risk. These funds hold the bonds until maturity (chosen to be the same time as the fund maturity) and offer a roll-down holding strategy. Investors need to keep in mind that:

The goal horizon should be just after the maturity date and not more than a few months away for better tax efficiency and lower reinvestment risk
Low liquidity of the underlying bonds can impact returns in case there are significant in or outflows in the fund
each investment in the fund is expected to get the yield to maturity (YTM) since the bonds are held to maturity though that may not always be true due to the above point
any premature exits will have unpredictable returns, including losses since the fund NAV can be volatile (due to interest rate risk) if the maturity date is far away

Read more on this topic here: Who should invest in target maturity debt funds?

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Also read
Union Budget 2024: Should you invest more in NPS now in the new tax regime?

Choosing debt instruments in the withdrawal (post-retirement) stage

Apart from all the instruments mentioned above, there are a few additional ones suitable for the retirement phase when

there is no income
taxes are lower
risk-taking ability is lower

Annuities / pension plans

Pensions offer a fixed payment throughout the life of the investor with a few caveats

the returns are taxable in most cases
the payouts are fixed and do not beat inflation (there is a product offering 3% increment yearly, but the starting yield is lower)
you do not get the money back ever in case you change your mind
there are two options: higher payouts today by choosing not to get any money back on death or slightly lower payouts now to ensure the nominee gets the investment amount back on death

This concept is covered in more detail in this article.

RBI / Government Bonds

This is a new facility via the NSE goBID platform or the new RBI retail direct scheme where retail investors can directly buy RBI, i.e. government bonds for up to two crores. This allows sovereign guaranteed coupon payments every six months and gets the principal, i.e. face value of the bond, back after maturity. This replicates a pension plan with the option of getting a part of the bond purchase amount on maturity.

Investors should know that:

it is difficult to exit this investment since there is only a minimal secondary market for these bonds (depending on which platform you purchase them from)
the interest payments are taxable at slab rates and are not inflation-indexed. Investors in the pre-retirement phase should reconsider investing in these bonds since a part of their investment is lost to tax
bonds can be both short or long-dated (10-40 years or more) and should be matched with the goal duration or the duration for which income is needed
when buying the bond, you will most likely pay a price higher than the face value of the bond, but unlike annuity plans, there is no 18% GST

This same discussion applies to RBI Floating rate bonds as well, which mature after seven years.

More details: How to use the RBI Retail Direct Scheme to get guaranteed income?

Post Office schemes

There are a few schemes with minimal risk that you can consider:

Senior Citizen Savings Scheme (SCSS): Investors over the age of 60 are eligible to invest upto ₹ 30 lakhs with a quarterly payout of interest (8.2% today) that is taxable. The scheme matures in 5 years, and the investment is eligible for an 80C tax deduction. You must invest within a month of receiving retirement benefits from the employer and is available from the post office as well as banks
Post Office Monthly Income Scheme (POMIS): This is a 5-year scheme offering 7.4% currently (TDS not applicable) that you can open singly (up to ₹ 9 lakhs) or jointly (up to 18 lakhs) that offers monthly taxable income
Post Office deposit: This is a standard FD like that from any other bank. RD facility is also there
National Savings Certificates (NSC): This offers 7.7% compounded annually with a cumulative payout on maturity in 5 years. There is no limit on the investment amount, and the maturity amount is taxable
Kisan Vikas Patra (KVP): This scheme offers to double the investor’s money as per the applicable interest rate. If the rate is 7.5%, your money will double in 115 months

The latest (as on 30-Sep-2024) rates are:

Instrument	Rates of interest from 01-Oct-2024 to 31-Dec-2024
Saving Deposit	4.0%
1 Year Time Deposit	6.9%
2 Year Time Deposit	7.0%
3 Year Time Deposit	7.1%
5 Year Time Deposit	7.5%
5 Year Recurring Deposit	6.7%
Senior Citizen Savings Scheme (SCSS)	8.2%
Monthly Income Account Scheme (MIS)	7.4%
National Savings Certificate (NSC)	7.7%
Public Provident Fund (PPF) scheme	7.1%
Kisan Vikas Patra (KVP)	7.5% (will mature in 115 months)
Sukanya Samriddhi Account (SSA)	8.2%

Source:: https://dea.gov.in/budgetdivision/interest-rates

Footnote: dividends from stocks

Investing in dividend-paying stocks is a common strategy for generating income in retirement. This is mentioned under the “debt investment” category as a footnote because if chosen well, dividends offer a reasonably stable income stream and can be considered by understanding the impact of adding such stocks to the retirement portfolio. However, due to taxation at the marginal rate, dividend-paying stocks should not be a part of the portfolio during the accumulation phase.

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