We’re looking at Stage 3 investor options – when you need to live off the returns from your investment corpus. Paramount imperatives are Safety, Return, Predictability and Tax-effectiveness; and then there’s a nice-to-have Liquidity consideration.
A lesser-known alternative to Fixed Deposits is the Fixed Maturity Plan (sometimes called the Fixed Term Plan) that mutual funds offer. Lots of people have the misconception that mutual funds are only about risky equity investing when nothing could be further from the truth.
FMPs share many of the characteristics of FDs with some additional nifty advantages.
Mutual fund houses offer FMPs at various intervals, so unlike an FD, you can’t just plop down the money whenever the fancy grabs you. However, these intervals are often as frequent as several times a week, and definitely several times a month. So, for all practical purposes they’re fairly easily available for investment all year around.
FMPs come in various flavours from as little as 60 days to 3 years and everything in between. However, the different durations are decided by the fund house based on what kind of investment opportunities are available – and the rates of return accordingly vary. The rules dictate that the FMP can only invest in instruments (called “paper”) that match the duration profile of the FMP itself. So, if the FMP says its duration is 368 days, then it can’t invest in paper that has a longer duration than 368 days. This protects you because it means that when the time comes to repay the FMP to you, the money is available because the underlying investment will also have matured. The only catch is that not all duration FMPs are available all the time. However, the usual 365+ days duration is the most popular and there are usually several offered each month (across the fund houses).
FMPs invest only in debt – bank paper, commercial paper, government securities and similar instruments – much the same things that banks themselves invest in. However, there are varying degrees of safety when it comes to debt, so if you’re really paranoid ensure that the FMP you’re investing in is only investing in AAA+ paper. In practical terms however, FMPs are one of the safest investment options available regardless of whether they’re investing in AAA+ paper or AA paper. Your money is safe.
Mutual funds are prohibited from promising a specific rate of return and this prohibition extends to all debt schemes too including FMPs. In reality, an FMP’s return is fairly predictable because it’s based on the return of its underlying investments. These are market-driven and closely correlate to the return available in the debt market for paper of the chosen duration and safety. Practically, this means that FMP returns are at least as much as FD interest rates and often a bit better.
Here’s where FMPs really shine thanks to some leeway in the tax laws. An FMP is a debt security under tax law which means that when it’s redeemed the investor’s gains are treated as capital gains, not interest. Now, if it’s a 365+ day FMP, the gain becomes a long-term capital gain and another bit of tax advantage steps in. The investor can opt to have the gain taxed at “20% with indexation”. Indexation is a bit of tax legerdemain which legitimately allows you to inflate your cost of purchase for tax purposes by indexing it via the inflation index (which is announced each year by the Tax Department). This means that in most years, you can bump up your cost of investment when calculating the tax due so that your FMP return shows much lower gains than you actually earned – often zero or negative gains. Which means no tax. This entirely legal and very handy when it comes to minimising your tax liability and it’s not available to you if you dumped all your money in FDs.
Inflation beater? Er…
Of course, a little reflection will show that if your FMP is showing a negative return when adjusted for inflation (as indexation does) then your investments are not beating inflation, which means that over time you’re going to start running out of income to meet your expenses. Unfortunately, this is true of all debt investments, which is why you need to continue saving and need to park a portion of your nest egg in risky equity, to at least give you the chance to beat inflation down the road.
In practical terms, unlike an FD, once you’re invested in an FMP you’re stuck with it till it matures – no loans against it and so on. You can opt for an FMP to pay you a periodic return but this is not predictable or definite as it would be for an FD. You’re better off choosing the cumulative option and taking home an enhanced lump sum when the FMP matures. You can game this a bit by staggering your FMP investment through the year so that, after a year, you have something maturing each month, which will provide a reasonably predictable cash flow.
FMPs tick all the boxes except liquidity and should be an essential part of every Stage 3 investor’s portfolio.