Maximising returns

How can you maximise returns, while at the same time generating a regular income? Two steps may be involved in this:

Step 1: Choose your investments based on expected after-tax returns and not on the basis of the frequency of income distribution. If you are looking strictly for investments which generate monthly returns, you may have to forego attractive investments such as bond funds. Yet, mutual fund debt schemes should score over bank term deposits or monthly income plans of mutual funds, due to higher returns and better tax efficiency. Obviously, where instruments that generate monthly income also offer better after-tax returns such as post office monthly income scheme, go for them.

Step 2: To save on tax, try to ensure that income received as interest in any year, along with other sources of income, such as pension, should not exceed Rs 62,000. The rest of the income to be generated in a year should ideally take the form of tax-free dividend or long-term capital gains (which means holding on to the investment for over a year).

If pension or rent or business receipts bring in about Rs 5,000 a month, then it would be tough to reduce your annual receipts to less than Rs 62,000. This may be difficult to ensure in the first year. In year two, generating long-term capital gains by selling a portion of your holdings in mutual funds or shares would be an easy way of generating monthly income.

Why stocks?

More than generating regular income, beating inflation is a major problem for investors. Suppose you need Rs 5,000 as monthly income now and you also need it to rise with inflation, if you are going to invest only in debt instruments, then you will need a principal of at least Rs 15 lakh, assuming your investments generate real returns (returns adjusted for inflation) of 4 per cent. If real returns are lower at 2.5 per cent, as present conditions suggest, you will need as much as Rs 24 lakh.

Enter stocks. Without investing in stocks it may prove impossible in future to beat inflation. This is true even if you are between 50 and 60 years in age, as you may still live another 15 to 20 years. Beating inflation over such a long period may be impossible without relying on stocks. Studies on this subject suggest that stocks actually reduce risks compared to a portfolio that is fully invested in debt, with the minimum exposure to stocks at 20 per cent and the maximum going up to 40 per cent for younger investors.

However, few Indian investors would be comfortable with the prospect of maintaining a constant exposure to equities of 20 per cent in their portfolio. Such investors can practise fixed amount investing. If you have Rs 25 lakh, you can invest Rs 5 lakh in equity in the first year. If the value of equity rises to Rs 5.5 lakh at the end of year one, then sell the excess of Rs 50,000 and shift it to debt. If this value declines then you can either top up the allocation to equity or leave it unaltered. Over a longer period, you may have to revise the equity exposure based on the size of the portfolio. This will help you stay invested in equities and at the same time combat inflation to an extent.

Investment options

What are the investment options available for those seeking regular income? The two high yielding options are Varista Bima Yojana (VBY) and post office monthly income scheme (POMIS). The maximum sum that can be invested in VBY is about Rs 2,50,000 while in the POMIS it is about Rs 6,50,000. These high yielding options need to be exhausted first. However, Varista Bima Yojana is available for investment only for an investor who is 55 or more.

Another option that investors need to consider is a guaranteed return annuity. An annuity contract pays a certain sum till the end of your life. The benefit of investing in an annuity is that it will protect you from the vagaries of inflation or any depletion in your capital if you happen to live longer.

There is only one annuity contract available now — New Jeevan Akshay II from LIC. In this policy there are five options, one of them is annuity for life with return of purchase price on death. This appears to be an attractive option. The return on an annuity contract differs on the option chosen. For the option of annuity of life with return of purchase price, it could work out to about 6 per cent.

Debt funds

Thereafter, mutual funds are the most tax efficient choice. As of now, splitting your investments equally between floating rate debt schemes and normal debt schemes appears prudent. In the case of normal debt schemes, again diversifying investments into plain vanilla bond funds, long-term gilt funds and bond index funds may reward investors better.

Stocks

In the case of stocks, investors have the option of splitting the amount to be invested into dividend yielding stocks and growth stocks. Dividend yielding stocks generally provide dividend ranging between 4 and 5 per cent.

There are a number of dividend-yielding stocks to choose from. It has to be understood that in the case of dividend yielding stocks the risks may be low but the potential for capital appreciation may also be so. So, how much you put into dividend yielding stocks will depend on the investor risk preference. A conservative investor would put substantially more in dividend-yielding stocks. In the case of growth stocks, it would be much better to invest through diversified equity mutual funds. Managing growth stocks on your own may prove unwieldy.

Model portfolio

In the case of an investor who has less than Rs 10 lakh in hand, there are not many options — Rs 9 lakh in VBY and POMIS would be a simple and efficient option. The rest could be parked in dividend yielding stocks. A slightly complex portfolio arrangement is required only in the case of an investor who has more money.

Let us suppose an investor aged 55 or more has Rs 25 lakh on his hands. A sample portfolio for such a person could be Rs 9 lakh in POMIS and VBY, Rs 3 lakh in floating rate bond funds, Rs 1.5 lakh each in plain vanilla bond funds and long-term gilt funds, Rs 1 lakh in bond index fund, Rs 1 lakh in liquid fund and Rs 3 lakh in annuities. The remaining Rs 5 lakh could be split evenly between dividend yielding stocks and growth stocks. If the investor is aged 40, then the amount set aside for VBY can be added to the amount to be invested in annuities.

This arrangement would produce a sum of Rs 1,40,000 per annum as income (see accompanying table). For an investor aged 40, the annual income will be slightly lower at about Rs 1,32,000. The tax incidence would be minimal. In fact, it will be zero though tax returns will need to be filed. In the first year, regular receipts can be expected from VBY, POMIS and annuities only. This would be about Rs 7,500 per month. If this is less than the monthly needs then some amount may need to be drawn from the liquid funds. The liquid fund can be replenished with either tax-free dividends or by generating capital gains in year two. For an investor with Rs 10 lakh-25 lakh, the sum invested in VBY and POMIS can be maintained at Rs 9 lakh. The rest can be invested in varying proportions in bond funds, annuities and stocks.

Finally, no portfolio can be allowed to remain static. It has to be changed to accommodate changes in investment objectives, taxation, interest rates and inflation expectations. The portfolio needs to be evaluated at least once a year to deal with changes in any of the material factors. This may not completely insulate you from changing conditions.

However, you will be in a much better position to combat the challenges imposed by changing conditions compared to ad hoc investing based on which instrument offers you the highest monthly returns.

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