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Suresh Krishnamurthy

The Budget may have made equity investments worthwhile, but also consider PPF, which is a potent investment capable of delivering `equity-like' returns in the later years.

THE Budget has made equity investments more worthwhile. If you are, however, planning to overload your portfolio with equities, you may need to reconsider.

This is because the Public Provident Fund is a potent investment capable of delivering `equity-like' returns in the later years. It is essential to invest substantially more in PPF when it approaches maturity. That can significantly enhance the returns to an investor.

PPF's return characteristics: The Public Provident Fund is an option with an investment horizon of 15 years. Each year, investors are required to invest at least Rs 100 in PPF to keep the account alive. It cumulates interest at the rate of 8 per cent per annum.

For an investment made in the first year, the after-tax return works out to 9.6 per cent. For the entire 15 years, the after-tax return works out to 10.5 per cent. This is for an investor in the 20 per cent tax bracket.

These two numbers, however, hide a remarkable aspect of the return characteristics of PPF — that returns made in subsequent years keep rising.

For the initial year return of 9.6 per cent to grow to 10.5 per cent, the returns on investment made in each subsequent year have to increase, and they do. This is a mathematical necessity. The return for an investment made in Year 2 increases to 9.7 per cent, to 10.4 per cent by Year 5, to 12.9 per cent by Year 10 and to a phenomenal 35 per cent for the investment made in the final year. The return pattern is even more spectacular for an investor in the 30 per cent tax bracket. For this investor, the returns rise to a whopping 54.3 per cent in the final year.

This rising return profile of PPF is no illusion. This is mainly because of the effect created by the declining lock-in period. An investment made in the initial year fetches a tax saving of 30 per cent and is locked in for 15 years.

Investment made in the final year fetches the same tax saving of 30 per cent but is locked in only for one year, leading to excessive skew in returns generated by investments made in subsequent years. This return characteristic thus needs to be exploited.

Invest more in final years: Once this return pattern is established it is not difficult to figure out that you have to step up allocations to provident fund in the later years. Specifically, in the last five years, allocation to PPF could be as high as 100 per cent. This is because after-tax return of more than 12 per cent would be difficult for equities to match. More so for investors in the 30 per cent tax bracket; for them, PPF returns more than 15 per cent per annum for investments made in the last five years.

This return profile is equally applicable for Employee Provident Fund. As such, salaried taxpayers on the verge of retirement should contribute more to the EPF. That too would enhance returns. As EPF now fetches 9.5 per cent compared to 8 per cent that PPF would earn, the effect would be even greater.

Optimal allocation: If you think equities would fetch 15 per cent per annum, then the optimal asset allocation plan would be to overload equities in the initial years and overload PPF in the later years.

For instance, consider the following plans:

Plan 1: Invest Rs 50,000 each in PPF and Equities for 15 years. At the end of 15 years, the total wealth works out to Rs 42 lakh. The yield-to-maturity after-tax savings works out to 14.6 per cent.

Plan 2: Invest Rs 99,000 in equities and Rs 1,000 in PPF in the first five years; Rs 50,000 each in equities and PPF in the subsequent five years; In the final five years, invest Rs 99,000 in PPF and Rs 1,000 in equities. At the end of 15 years, the total wealth works out to Rs 50 lakh. The yield to maturity works out to 16.5 per cent.

No doubt, the assumption of a steady 15 per cent annual return on equities has skewed the results. Equity returns are volatile and you may be forced to invest more in equities precisely in the last five years because valuations are attractive. As such, this asset allocation plan is not ironclad and may need to be judged in accordance with expected returns from equities.

These two plans, however, highlight the returns that could accrue by investing in equities early and in debt later. That is also in tune with the investment literature, which suggests that you invest in equities when you are young and in debt when you are older. The Finance Minister deserves compliments for making such sensible asset allocation possible.

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