Income security in old age
This interview with Ajay Shah appeared in Intelligent Investor in June 1999.
Do people need to worry about their old age income security? Absolutely. It should be the predominant issue in all financial planning: to prepare for old age.
Why is it a big issue - most people will stop working at around 60 and have just a few years more to go? You are wrong on that "just a few years to go". I often meet people who think that "my father died at 60, so I am unlikely to go beyond 60". The plain fact is that improvements in nutrition and health have greatly elongated lifespan. Anyone who has avoided poverty in India - e.g. any reader of Intelligent Investor - should worry about living for 25 years beyond age 60. In this situation, to not plan for old age is very dangerous: you could be miserable for a quarter century if you get it wrong.
The entire point of being an intelligent investor all your life should be to setup things so that you can survive for a quarter century while being out of work - while paying the largest medical bills of your life. That's not going to be easy, and it does require special efforts.
In addition, we need not be fixated on the idea of "retiring at age 60". If people have enough wealth in hand, they might often be able to obtain more rewarding lifestyles by retiring, or atleast getting out of the classic 9-to-5 job, well before age 60. When individuals do a good job of planning out their old age, such choices become available.
Is the breakdown of the joint family an aspect of this? Absolutely. People today, who are taking care of their parents, should seriously worry that their children will not similarly take care of them. In every dimension: that of living arrangements, financial support, personal care when ill, companionship -- a working person today should worry about having enough money when retired so that all this can be obtained without any inputs from children. Further, the working person planning for old age has to worry about inflation over those last 25 years.
We can visualise children as a way through which old age support was assured in the olden days: people invested in their children and this took care of them in old age. Now, we need to shift these investments into financial instruments. I know, this sounds a little odd. But I did my Ph.D. thesis on this topic!
The status quo
Won't the normal PF deductions be adequate to take care of all this? Well, most people don't have any PF deductions. But for even those that do, the PF deductions do not constitute an adequate plan for old age. PF pays a poor rate of return, and PF is not setup to accumulate wealth (at many steps along the way, the money is too easy to withdraw and tends to get used up). The average person who leaves the PF system walks away with around Rs.25,000, which is pitifully inadequate for coping with 25 years. So you can't just endure the PF deductions and hope that your problems are taken care of -- they are not.
What about PPF? The way it is being used, PPF is not an investment plan. It is a tax shelter. People are going into it to get 12% tax free, and taking their money out after that. That doesn't add up to old age security. Either PPF should be scrapped, or it should be renamed "Public Tax Shelter Fund" so nobody mistakes it for old age saving!
Are the difficulties the fault of our PF system, and should we be working to remedy this? It is the fault of our PF system. Our existing pension systems are quite thoroughly ill--equipped to solve the problem of old age income security. Workers in India are forced to suffer a high deduction rate by world standards; yet they get nearly nothing out of it in terms of protection in old age. We as a country need to do radical surgery on these systems.
You are talking about a bigger corpus of wealth at age 60. But what people really want is a steady monthly pension until they die. How would that work? What you are describing is called "an annuity": it is a contract that pays you Rs.1 per month until you die. Such contracts are sold by "annuity providers", who would charge a fee for such a contract that depends on your age and death probabilities (this is a bit like life insurance).
So this should work in two distinct steps. First, people should save all their working life, and pile up as much wealth as they can. Then, at age 60, they would approach an annuity provider, and buy annuity contracts using this wealth. The more money they have, the larger the monthly pension that they would be able to get from the annuity provider.
This clarity refocuses upon the core problem that people should address themselves to while they are working: that of saving and earning high returns.
But we don't have a well functioning market for annuities in India right now. True, but insurance reforms should be able to cure that fairly rapidly.
What directions should pension reforms take? The Dave Committee, which is part of the Project OASIS being run by the Ministry of Social Justice, has worked on charting out future strategies for pension reforms in India. We should push the members of our parliament to ensure rapid adoption of this report as public policy.
But for each of us, as individuals, we cannot afford to wait and hope that things will become better; we need to plan for our old age in the knowledge that the PF system is a failure; that our forced PF contributions are not going to solve our problems.
Planning for old age, and the power of compounding
So what can an individual do? What is the secret of planning for income security in old age? There are exactly three secrets: (a) Save regularly, (b) Capture the power of compounding - don't disrupt compounding by premature liquidation, and (c) Get the highest possible rate of return.
Compound interest is an uncanny thing, when applied with regular saving over the multi-decade horizons that working people today face. Let me try you. How much do you think you will end up with, if you saved up Rs.10 every day (the price of one cold drink) from age 25 to age 60, and kept investing in the safest of assets, government securities? The answer is astounding: it is Rs.2.9 lakh. You would come out at age 60 holding Rs.2.9 lakh, measured in 1999 rupees. Note that this number is in today's rupees, i.e. we are not bloating the figure by including future inflation.
Note also that we have to be very careful to harness the power of compounding: these savings should not be disrupted to buy a car or a marriage ceremony etc. The savings should be left intact, with continuous addition of Rs.10 per day, from age 25 to age 60.
What happens if the rates of return are better than government securities? Every small gain in terms of the rate of return pays off handsomely. I love to tell a story of the "Red Indians" (the native residents of the Americas). Around 400 years ago, they sold Manhattan Island (where New York is built) to the white men for a handful of trinkets and mirrors worth around $20. This sounds like a steal.
But if they had invested this $20 at just 5% interest for these past 400 years, they would be holding $6 trillion today, which would suffice to buy back most of New York! This is the power of compounding. Here, we see the extreme sensitivity to small changes in the rate of return: if we move up their rate of return from 5% to just 5.1%, they end up with $8.75 trillion! Over long time periods, every small gain in the rate of return matters much more than "common-sense" suggests. The long time-span magnifies small changes in the rate of return.
You are saying that it is wrong for people to just "put their money in the bank" and forget about it. Yes. I strongly agree with traditional wisdom on the subject of saving: one should save, and one should save regularly. But given this attitude of saving, one needs to be an intelligent investor in trying to obtain higher rates of return, since small changes in the rate of return make such a big difference to the outcome. I am disagreeing with traditional wisdom of merely piling up a bank balance. We can, and should, do much better.
What about inflation? Many old people have their entire financial calculations disrupted because of episodes of unexpected inflation. Over a twenty-five year timespan, some such episodes are almost sure to happen. Yes, inflation is a major risk in this enterprise. I have two comments here. If people buy bonds in pension planning, they should strongly favour (or absolutely require) inflation indexed bonds so that this one issue is out of the picture. Equities are relatively "inflation proof": if prices in India go up, then share prices tend to also go up. In many countries, there are experiences with "hyper-inflation" where bond-holders get wiped out while equity-holders come out mostly okay. Hence, one should only buy inflation indexed bonds and equities.
Obtaining higher returns using equities
What asset class gives the best rate of return? Equities.
What do you mean? Equities seem to bounce up and down. If someone had got into the market in late 1994, then the latest five years haven't been good. Equities do give this year to year volatility. One should not judge the properties of an asset class using short recent experiences.
On short horizons, things could go this way or that way. But over longer time periods, equities yield high rates of return. By the time an investment horizon is 8 years or so, Nifty wins over a 12% fixed income investment with a probability of over 90%, and this probability rises as the investment horizon rises.
This higher rate of return, as compared with government securities, is called the "equity premium": it is the premium paid by equities in return for making you uncomfortable with the day to day volatility. There is an equity premium in India as there is in every country of the world: it follows from basic economics that people who suffer the day to day volatility of the stock market should be paid a premium of a higher rate of return.
What is the long-run Indian experience with equities?The average rate of return on buying the stock market index in India, over the last twenty years, is around 19 to 20 percent per year. This figure refers to the total return in the hand of the investor, i.e. the sum of capital gains and dividends. However, be careful in interpreting this because it includes inflation. If we remove the average inflation rate of around 7% from this, we get around a long-run average rate of return on equities of around 12 to 13 percent per annum in real terms.
From a pension investment perspective, this is an extremely attractive asset. If you invested Rs.10 every day, from age 25 to age 60, into the equity index at 12% in real terms, you would end up with Rs.19.8 lakh at age 60 - this is an astounding 6.83 times better than being in government securities, which pay 4% net of inflation. This is astounding in absolute terms also: there is a very large number of people in India who can afford to save Rs.10 per day. If only they could buy a little Nifty every day, they would be in a position to come into a good stock of wealth at age 60.
This difference in returns is India's equity premium. The long-run average rate of return on equities is around eight percentage points ahead of the long-run average rate of return on government securities. This value (eight percentage points) is similar to that seen in many countries.
Equity investment using index funds
Why do you talk about the equity index here? What about people making portfolios out of individual stocks, trying to pick stocks that will do well in the future, etc.? The surest argument that economists can offer in favour of equity investment is the equity premium -- that when you are willing to bear the day to day fluctuations of Nifty, you are compensated by obtaining higher returns (on average). To directly harness the equity premium, all you need to do is to buy the equity index and passively hold on. This is what an index fund does.
Now an active fund manager can try to obtain higher returns by actively trading in the stock market. There are many question marks whether this actually works:
- Will the investor be able to choose the right fund manager?
- Will the fund manager successfully and reliably pick the winning stocks or sectors? Will the fund manager be able to consistently do this over multi-decade horizons?
- Will his fees and costs be small enough compared to the gains?
- Will the extra risk that the fund manager introduces be worth it?
- Will the investor be able to assure himself that the actions of the manager are in the investors' best interests? Will the investor be able to effectively monitor the actions of the fund manager over these multi-decade horizons?
As of today, it is not clear that active management is a particularly good idea. In contrast, the argument leading from the existence of the equity premium to its operational implementation using index funds, is simple and direct. If you believe that investing in equities is a bright idea owing to the evidence about the equity premium, then index funds are a direct implementation of this idea.
Most people are not knowledgeable about the stock market and would like most to not have to take trouble in finding out. The index fund is an ideal, hassle-free, "fire and forget" strategy for investment multi-decade horizons. Such people would keep accumulating savings, and putting them into an index fund as the years go by. They would never need to learn about individual stocks, they would never need to see an NSE trading screen, or open a depository account, etc.
For all these reasons, the Dave Committee has recommended (a) that provident funds in India should commence investing in equities, however (b) all their equity investment should only be implemented through index funds on either the NSE-50 (Nifty) index or on the BSE-100 index.
So you are recommending that all of us buy index funds? Are good index fund alternatives available in India? Yes, I am saying that in the long time-horizons that are faced in planning for retirement, systematically buying equities, using index funds, is a very good idea. IDBI Mutual Fund has just launched an index fund on Nifty. So one good index fund alternative exists.
Suppose a person is knowledgeable about the equity market. In your terminology, suppose she does know about individual stocks (thanks to Intelligent Investor!), she has seen the NSE trading screen and has a depository account, etc. In that case, is it okay for her to steadily save money every month and keep building up her equity portfolio? Yes, provided a few guidelines are adhered to. (a) She should diversify with a passion, avoiding concentrations in any few stocks (she should benchmark her degree of diversification against that of Nifty). (b) She should have a strong accent on Nifty and Nifty junior stocks. (c) And finally, she should be very cautious about not wasting money in trading too much. This means a combination of being aware of trading costs of all sorts and optimising them, and it also means trading as little as possible. If these three conditions are met, then she should pretty much fully capture the equity premium, and possibly do even better if her personal stock picking is successful.
You said that every little improvement in returns is worth taking trouble to obtain, on multi-decade horizons. What if I want even better returns than 12% or so in real terms? It can be done, using simple strategies that involve index futures, at the price of even greater day to day volatility than Nifty. But we don't yet have index futures in India. This is a failure of public policy in India: even though NSE had built up all the capabilities to launch index futures trading as much as three years ago, regulatory and legal hurdles have blocked NSE.
You should pray that NSE's index futures market starts quickly, and come back and ask me this question when that happens!
Don't we need index futures to build index funds? No, it is possible to run index funds without having index futures. However, access to index futures does substantially improve the functioning of index funds. So the onset of index futures trading will help pension investments by making index funds more attractive.
What if I want equity rates of return but can't stomach the volatility of Nifty? You want to have your cake and eat it too. The only way to go below Nifty levels of volatility, while preserving Nifty levels of return, is by diversifying across index funds of multiple countries. This gives a risk reduction by diversification. However, currently India forbids citizens from buying foreign assets. So we can't do this until the onset of capital account convertibility. You should come back and ask me this question when we get this freedom!
So what does all this summarise to for us as individuals and as a country? For us as individuals, the message is simple: worry about living for a quarter century when you retire; save regularly; buy Nifty every month while you are young.
For us as a country, we urgently need reforms on many fronts. We need insurance reforms so that people can buy annuities. We need index futures markets. We need capital account convertibility. Finally, we need pension reforms.
All this is the subject of four committee reports in recent years -- the committees headed by R. N. Malhotra (Insurance), L. C. Gupta (Index futures), S. S. Tarapore (Capital Account Convertibility) and S. A. Dave (Pensions). We need to get down to implementing these four reports.
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