Though investment brochures often scream attractive returns, the reality is a little different. The sad truth of many retail financial products is: what you see is not what you get. Cost manifests itself in many ways to eat into your returns. Here are the three faces of the monster that you need to recognise to decode the return.
The most visible face of the monster is in product costs. Typically, charges can be levied in two ways: one, a fixed sum; two, a percentage of the corpus or the value of the investment at the end of each year.
Fixed costs take out a certain pre-decided number from the corpus each time you invest. To understand this cost, let’s look at the National Pension System (NPS) that until recently levied a distribution cost of Rs 20 for every investment made. Fixed costs fall heavily on small investments, so a distribution cost of Rs 20 translated into 0.02% of R1 lakh investment, but 0.2% of Rs 10,000. This anomaly has now been removed and the costs in NPS are 0.25% of the investment amount.
Costs defined in percentage terms can be levied in two ways. One, a straight deduction from the amount you invest and two, a deduction from the accumulated corpus or fund value. To illustrate a cost of 1% of the amount invested would mean that every year when you invest Rs 1 lakh, the product will keep Rs 1,000 and invest the remaining Rs 99,000. But if the cost is a percentage of the fund value you will need to pay a little more. Let’s assume the fund grows at 10%. So at the end of the year a R1 lakh investment will become Rs 1.10 lakh. A 1% cost of the fund value here would mean the company would keep Rs 1,100 or Rs 100 more in costs. Over a 10-year period, the first scenario will return Rs 88,952 more.
Costs drag your net return down and the best way to find out what you get post-cost is to ask the agent or bank how much is the net rate of return of a product, even in an illustration.
“If costs are not displayed or you find it hard to understand how they will affect your investment, just ask for the absolute amount that you will get on maturity, and then calculate the net return of the product,” said Veer Sardesai, a Pune-based financial planner. On the excel sheet, the IRR (internal rate of return) function can give you the exact rate of return. If you are not excel savvy, just google a compounded annual growth rate calculator and key in the details. It is the net return that you should concern yourself with.
This is the next big bite out of your return. Luckily for long-term products, including Public Provident Fund, insurance-cum-investment plans, equity-linked savings scheme and Employees’ Provident Fund are EEE (exempt-exempt-exempt) in nature. The contributions, accumulations and maturity proceeds are tax-free.
But for products that get taxed on maturity, you need to look at post-tax returns. For instance, the maturity proceeds from a fixed deposit are taxable and hence even an attractive rate of 10% may lose its sheen after you factor in the tax that you need to pay. For an individual falling in the 30.9% tax bracket, a 10% return gets reduced to a net return of 6.91% after income tax. Taking the example that sucked out 1% cost on corpus every year and gave a net return of 8.90% will further come down to 6.15% for the 30.9% tax bracket and 7.98% for the 10.3% tax bracket.
It slowly reduces the value of your investment. The most attractive of returns can deflate if they are not inflation proof. In other words, your investment will still be buying you less if the rate of return is less than the rate of inflation. For instance, if you earn a net return of say 6% and inflation is at 6%, then the value of your investment would still be equal to the value of your money when you started because even as your money would have grown by 6%, the cost of consumables would have gone up by 6%.
Your real rate of return or inflation-adjusted return needs to be positive to make any meaningful gains. In the example above, a post-tax return of 6.15% will come down further to 0.15%, assuming long-term inflation tends to be 6%.It is after factoring in these costs that you can arrive at the effective rate of return of the product. Knowledge of what that return really means could be a game changer and recognition of various embedded costs can bridge the gap between the advertised rate and the truth underneath.