A retirement mutual fund assists in planning for your lifestyle once you cease earning a regular income. These funds typically invest in a combination of stocks and bonds, gradually transitioning towards lower-risk assets as retirement nears. They can provide a regular income stream for retirees and generally have no exit fees with low expense ratios. However, they may have a lock-in period of up to five years or until retirement.
In this article, we will explore what retirement mutual funds are, and whether they are a good option for retirement planning.
What are retirement mutual funds?
Retirement funds, also known as pension funds, are investment options that allow individuals to allocate a portion of their earnings towards retirement savings. These funds ensure a stable flow of income post-retirement, providing retirees with a regular annuity from their investments until they pass away.
Pension funds manage investments on the investor's behalf, and the income generated from these investments contributes to the overall interest in the fund pool. They offer a fixed benefit, unaffected by fluctuations in asset returns or market conditions.
Retirement mutual fund plans typically focus on low-risk assets such as government securities to secure consistent returns. Depending on the policy and the nature of the investments, pension funds can offer interest rates up to 11%, making them a preferable option for retirement planning compared to other alternatives.
How do retirement mutual funds work?
Retirement mutual funds operate by adjusting their investment strategy based on the investor’s age. Initially, they emphasise stocks for growth and gradually transition to bonds as retirement approaches. This age-based strategy ensures the portfolio aligns with the investor’s evolving risk tolerance and income requirements over time.
Key features include:
- Age-based strategy: The fund modifies its asset allocation according to the investor's age. Younger investors have a higher proportion of stocks to maximize growth potential, while older investors hold more bonds for stability.
- Automatic rebalancing: As retirement nears, the fund automatically reallocates investments from growth-oriented stocks to income-focused bonds and fixed-income assets.
- Early growth focus: Initially, the fund prioritizes stocks to capitalize on growth opportunities, benefiting from the longer timeframe to recover from market fluctuations.
- Risk reduction: Closer to retirement, the fund shifts towards bonds, which are safer and generate regular income, reducing investment risk.
- Aligned with risk tolerance: This adjustment mirrors the typical decrease in risk tolerance as investors age, ensuring the investment strategy matches their evolving financial needs and comfort level with risk.
- Simplified investment decisions: By automating asset allocation, these funds simplify investment management, particularly beneficial for less experienced investors.
- Long-term goal orientation: Retirement mutual funds are tailored for long-term investment, maintaining focus on achieving retirement goals throughout an investor's career.
Features of retirement mutual funds
Retirement/pension funds, such as pension plans and mutual fund retirement plans, offer features that distinguish them in the investment landscape:
- Less risky: These funds are characterised by lower risk levels compared to other investment options, making them particularly suitable for retirement planning. They typically invest in low-risk securities like government bonds to ensure consistent returns.
- Hybrid: Some mutual funds now offer hybrid pension plans, blending investments in both debt and equity markets. These plans often maintain a modest equity exposure, typically around 40-50%, alongside debt investments.
- Withdrawal conditions: Withdrawals from retirement funds are discouraged before the age of retirement, typically around 58 to 60 years. Investors may opt for either a lump-sum withdrawal or choose to receive monthly annuity income.
- Liquidity: Retirement funds generally offer lower liquidity due to charges and heavy exit loads for early withdrawals. Prospective investors should thoroughly understand these conditions before committing to a plan. Additionally, returns from these funds are taxable, potentially reducing their attractiveness.
- Lock-in period: Retirement mutual funds typically impose a lock-in period of five years, longer than the three-year lock-in period for Equity Linked Savings Scheme (ELSS) funds. Despite this, the extended lock-in period can benefit investors through the power of compounding, mitigating short-term market fluctuations. Holding investments for an extended duration can enhance stability and potential returns
Also read: How to Invest in ELSS Mutual Funds.
Advantages of retirement mutual funds
Retirement mutual funds offer several advantages that make them a viable option for retirement planning:
Flexibility: Investors can choose from different asset allocation strategies based on their risk tolerance.
Tax Benefits: Certain retirement funds offer tax deductions under Section 80C of the Income Tax Act, reducing the taxable income.
Less Risky: Debt-based retirement funds provide stability and lower risk compared to pure equity funds.
Long-Term Investing: Retirement funds encourage disciplined, long-term investing, which can lead to significant wealth accumulation.
Risks involved with retirement funds
- Exit load – Withdrawing your investment before the specified date in the scheme document may incur an exit load. This fee reduces your overall returns, making early withdrawals less beneficial.
- Volatility – Mutual funds, especially equity funds, are subject to market volatility. Debt funds are relatively less volatile, so selecting the right portfolio balance is crucial when investing.
- Expense ratio – Fund houses charge a management fee, known as the expense ratio, which can lower your actual returns. This fee is deducted from your overall investment returns.
- Lack of control – Retirement mutual funds are managed by professional fund managers and are subject to market fluctuations. Investors have no direct control over the funds until they withdraw them.
- Over-diversification – Over-diversifying your portfolio or failing to find the optimal asset mix can limit your returns. For instance, if your portfolio is debt-heavy and the equity market performs well, your gains may be lower.
- Illiquidity – Certain retirement funds restrict withdrawals until you reach retirement age. This could be problematic if you need access to funds for an emergency.
Types of retirement mutual funds in India
Retirement mutual funds come in different types to cater to the diverse needs and risk profiles of investors:
- Equity funds:
- Equity-based retirement funds primarily invest in stocks and equities. They offer the potential for higher returns but also come with higher volatility.
- These funds are suitable for investors with a higher risk tolerance and a longer investment horizon.
Also read: What are equity funds
- Debt funds:
- These funds primarily invest in fixed-income securities like government and corporate bonds.
- Suitable for investors with a low-risk appetite looking for stable returns.
Also read: What is a debt mutual fund
- Hybrid funds:
- Hybrid retirement funds invest in a mix of equity and debt instruments.
- They aim to strike a balance between capital appreciation and income generation.
Also read: What are hybrid mutual funds
Importance of retirement funds
Retirement funds are crucial for ensuring financial stability and security once you cease earning a regular income. They provide the necessary resources to cover living expenses and maintain your standard of living throughout retirement.
- Retirement planning: Effective planning involves building a substantial retirement fund to support your needs and objectives during retirement.
- Retirement mutual fund: A key component of retirement planning that offers a balanced investment approach to growing and preserving wealth.
Purpose of a retirement fund
The main purpose of a retirement mutual fund is to provide long term capital appreciation to meet retirement goals. These funds enable investors to:
- Accumulate a corpus over their working years through systematic investments.
- Enjoy the power of compounding by staying invested for the long term.
- Create an income source to maintain their lifestyle post-retirement.
What should be the mode of investing?
Investors can choose between two modes of investing in Retirement Mutual Funds:
1. One-time investment
- A one-time investment, also known as a lumpsum investment, involves investing a significant amount of money at once into a Retirement Mutual Fund.
- This mode of investment is suitable for individuals who have a substantial corpus of savings or a windfall amount, such as an inheritance or a bonus, that they want to invest for their retirement.
- It provides the advantage of potentially benefiting from market conditions at the time of investment. If the market is favourable, the entire lump-sum amount can be invested, potentially leading to immediate capital appreciation.
- However, it comes with higher risk because the entire investment is exposed to market fluctuations at once. If the market experiences a downturn shortly after the investment, it could impact the overall returns.
2. Systematic Investment Plan (SIP)
- A Systematic Investment Plan (SIP) is a mode of investing where investors contribute regular, smaller amounts of money at predefined intervals (typically monthly).
- SIPs are designed to promote disciplined and consistent investing over time. Investors commit to contributing a fixed sum regularly, regardless of market conditions.
- This mode of investment is convenient for most investors because it allows them to start investing with a smaller initial amount and gradually increase their investments over time.
- SIPs reduce the impact of market volatility as investments are spread out over time. When the market is down, investors buy more units with the same amount, and when the market is up, they buy fewer units.
- SIPs are an effective way to harness the power of rupee cost averaging, which means buying more units when prices are low and fewer units when prices are high, potentially reducing the overall average cost of investment.
Taxability of retirement funds
Retirement funds stand out as tax-efficient investment choices, offering a potential tax deduction of up to Rs. 1.5 lakh annually under Section 80CCC of the Income Tax Act. However, once the annuity starts, the accrued income is subject to taxation based on your prevailing tax slab. While premature withdrawals from retirement funds can be challenging, they come with specific tax implications:
1. Equity retirement fund
- Withdrawal within 1 year: Short-Term Capital Gains (STCG) tax of 15% + cess + surcharge.
- Withdrawal after 1 year: Long-Term Capital Gains (LTCG) taxed at 10%.
2. Debt retirement fund
- Withdrawal within 3 years: Taxed as per your income tax slab for FY 2024-25.
- Withdrawal after 3 years: Taxed at 20% post indexation.
These tax considerations add to the overall appeal of retirement funds for tax-conscious investors.
Who should invest in retirement mutual funds?
You should consider retirement mutual funds if you:
- Have a long-term investment horizon: Retirement savings benefit greatly from time in the market. If you have several years, ideally 10 or more, until retirement, you can ride out market fluctuations and potentially achieve good returns with retirement mutual funds.
- Aim for steady growth: Retirement mutual funds typically invest in a mix of assets, including stocks and bonds. This diversification helps balance potential growth with some stability, suitable for long-term retirement goals.
- Lack the time or expertise for active management: Retirement mutual funds are professionally managed, so you do not need to constantly research and adjust your investments. This is ideal if you are busy or do not feel comfortable actively picking stocks.
- Want discipline and convenience: Systematic Investment Plans (SIPs) allow regular contributions to retirement funds, promoting consistent saving and leveraging rupee-cost averaging. This can be a great way to build your retirement corpus steadily.
How to invest in a retirement fund?
Investing in a retirement fund is simple and can be done either directly through an Asset Management Company (AMC) or via reliable platforms like Bajaj Finserv.
- Register and complete the KYC process to verify your identity.
- Select a mutual fund that aligns with your retirement goals.
- Invest your desired amount and regularly monitor the fund's performance to ensure it meets your expectations.
Why should you invest in a retirement fund?
There are several advantages to investing in a pension fund. These include:
- Long-term saving: These plans are designed for long-term savings, regardless of whether an investor opts for monthly payouts or a lump sum disbursement. Retirement funds generate an income stream that can even be further invested.
- Flexibility: An investor can choose to receive either a lump sum payment or a monthly annuity depending on their financial requirements and plans. It is even possible to opt for a deferred annuity plan to secure a larger sum for post-retirement.
- Offers insurance: Most pension policies provide life insurance cover, protecting the insured from any financial loss in the event of their demise before retirement. They also allow the investor to withdraw a lump sum amount in case of a medical emergency. This can prove beneficial for covering long-term healthcare costs and is an important feature of pension funds.
- Protection against inflation: Investing in pension plans is a favoured method of protecting one's assets against inflation. Most retirement plans offer some form of compensation for inflation, often disbursing one-third of the accumulated sum after retirement and utilising the remaining two-thirds as a monthly annuity for the investor.
- Risk-free investment: Mutual fund retirement plans are among the safest avenues of investment as they have an extremely low-risk profile. Investors also have the option to invest their money in government securities for a guaranteed return or to invest in debt and equity to earn higher returns. The risk is suitably balanced with the prospect of return and an individual's risk appetite.
Factors you should know before investing in mutual funds for retirement in 2024
Before you invest in retirement mutual funds:
- Align your goals: Clearly define your retirement goals. Matching your investment horizon and risk tolerance with a fund's objective keeps you disciplined and motivated throughout your saving journey.
- Invest for the long haul: Retirement plans benefit from a long investment timeframe. Ideally, aim to invest for at least five years or more. This allows you to weather market ups and downs and potentially achieve good returns with equity-based retirement mutual funds.
- Understand risk and reward: Unlike fixed-income options, mutual funds don't guarantee returns. However, historically, equity mutual funds have provided higher returns compared to traditional plans. The key is to be patient and focus on the long term, avoiding short-term market worries.
- Assess your risk tolerance: Mutual funds can invest in a mix of debt and equity. The proportion of each determines the fund's volatility. Carefully analyse the fund's portfolio to ensure it aligns with your risk comfort level.
- Look beyond basic returns: While returns are important, consider these key financial ratios to evaluate a retirement mutual fund:
- Alpha: Measures a fund's performance against its benchmark. A positive alpha indicates the fund has outperformed the benchmark.
- Standard Deviation: Shows how much the fund's returns deviate from the average, essentially its volatility. Higher standard deviation indicates higher risk.
- Beta: Measures a fund's sensitivity to market movements. A beta less than one suggests the fund is less volatile than the market, while a beta greater than one indicates higher sensitivity.
- Portfolio Turnover Ratio: Measures trading activity within the fund. A low portfolio turnover ratio suggests lower transaction costs and capital gains taxes.
- Sharpe Ratio: Analyses risk-adjusted returns. A high Sharpe Ratio indicates the fund delivers strong returns relative to the risk taken.
Conclusion
Retirement mutual funds can be a valuable addition to one's retirement planning strategy. They offer the benefits of diversification, professional management, and tax advantages. However, the suitability of a retirement fund depends on individual financial goals, risk tolerance, and investment horizon. It is advisable carefully assess various options before making an informed decision on including retirement mutual funds in your retirement planning portfolio.
