Options for low-income households

A defining characteristic of the finances of low-income households is the irregularity and seasonality of cash-flows, and the generally small surplus. Yields from agriculture and livestock — the main occupations in rural households — vary depending on such factors as water availability, seasonality and disease incidence.

As households have to manage expenses with unpredictable income streams, they need to save when there is surplus, so they can cover the deficit over the rest of the year.

There are conflicting demands on this small surplus, making liquidity management crucial for low-earning households. The mechanisms currently available for them include savings, at home or in no-frills bank accounts, and short-term borrowings from microfinance institutions, self-help groups or informal sources.

There is clearly a need to improve access to liquidity management mechanisms that are convenient and inflation-protected. Innovations such as reducing minimum investment sizes in money market mutual funds and making them available through easily reachable distribution channels can increase access to such products significantly. In addition to short-term liquidity management, low-income households also have goals such as the wedding or education of a daughter or son (in the medium-term) or maintaining a certain standard of living post the productive years of the bread-winner's life (long-term).

Meeting these lumpy goal-related expenses calls for an appropriate investment strategy. The household must have an appropriate portfolio of investments that should provide long-term positive real returns and capital protection.

No inflation protection

Key challenges in the investment strategies of low-income households include concentration in a few physical assets such as agricultural land and gold; high degree of correlation in returns from assets and human capital; and inadequate inflation protection.

A low-income household in rural India typically has assets and income sources — land and livestock — concentrated in the local economy. Human capital, which is essentially the income-generating capacity of members of the household, is often the principal asset owned. Usually, the source of income for the household is agriculture-based, or small retail in the local area. Clearly, these are assets exposed to local episodes, such as floods, and this correlation will hurt them in bad times. During floods, the wage labour availability and income from agriculture is impacted, along with a decline in the value of agricultural land — thus, the household suffers a double whammy. This is conceptually similar to the flaw in a software company employee investing all her surplus in the stocks of that company.

A basic principle of sound investing is to diversify as much risk as possible, by investing in various asset classes, whose returns are uncorrelated with each other. There is thus a clear need for such households to reduce exposure in the local economy and invest in financial assets that are not linked with the local economy. Investment products must be customised to enable such households to manage unpredictable and erratic cash-flows. In its absence, several low-income households choose to invest in gold, which is held over the medium to long term.

From a return perspective, a better investment avenue for the household would be an index fund (that replicates the movements of an index in a specified financial market), which yields higher return than gold, even over longer periods. Investments in equity through index funds, over longer periods, can generate long-term positive real returns with low volatility and lower costs.

Pension products

Old-age security is particularly crucial for low-income households. A wage labourer is unlikely to find work opportunities after the age of 50 or so. Managing household expenses, planned and unplanned, for the rest of his life is a daunting challenge. There is a need to design products to specifically meet this objective. A successful product design in this category is the NPS-Lite — pension product specifically designed for low-income households in the informal sector — launched by the Pension Fund Regulatory and Development Authority (PFRDA).

A defined contribution plan, it allows small transaction sizes with no lower limit to deposit in the account. Withdrawals are allowed only when the customer crosses 50, thus encouraging long-term savings. The scheme also considers change of location due to new employment or residence, and ensures portability of accounts.

At the back end, the fund is managed by mainstream asset management companies, which invest in the debt and equity markets. The asset allocation balances growth and safety objectives appropriately. The choice of the fund manager rests with the customer; and cost of servicing is low for service providers.

Complexity

However, providing households access to the right products is only half the job done. These products may not be effective, or may even expose households to further risks, if the customer is intimidated by the complexity of the product and hence chooses not to access them.

The mere existence of 3,000 mutual funds under various schemes can be daunting for a person to choose from. Therefore, there is clear need for a client-facing entity which highlights the risks associated with these investments and provides sound advice to customers on optimum allocation of assets in their portfolio. This is critical from the perspective of the customer placing trust in the service provider since he or she is taking a risk by investing money with the entity concerned. The service provider must be held liable for appropriate product guidance so that there is no scope for mis-sale.

(The author is with IFMR Rural Finance. >blfeedback@thehindu.co.in )

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