Rajeev Agarwal is 30 years old and is married to Aarti who is 29. They have a daughter who is two years old. Rajeev is an engineer employed with a multinational firm and his annual salary is Rs 15 lakhs. Aarti is a housewife. They save 2 lakhs a year. They have 2 lakhs in an ICICI savings account for liquidity to meet any emergency needs and 3 lakhs invested in the ICICI Prudential Balanced Advantage Fund Growth. Their goals are to save for a home, their retirement and daughter’s education and marriage. Their risk tolerance is average for both of them.
Analysis and Recommendations
Rajiv and Aarti have a relatively simple portfolio. Their liquid savings amount of 200,000 is 40% of their portfolio. Their annual expenditures are 11,00,000 so their liquid savings are 2.2 months of expenditure. Looking through the balanced fund which has 66.66 % equity and rest debt.
What we’re going to do first is to identify the Easy Wins that we think they can make with respect to their portfolio.
- They have 3 lakhs in the ICICI Prudential Balanced Advantage Fund growth. This is a regular fund which has a much higher fee than the direct fund equivalent. This fund has an expense ratio of 1.53%. The direct version of this fund has an expense ratio of 0.91%. The portfolio for both classes are the same. By switching to the direct fund, they are going to save 0.62% per annum or Rs 1860 per annum, till they hold it.
- Their liquid reserves are currently in a savings account earning 3%. They can instead keep their liquid savings in a liquid fund. The ICICI Prudential Liquid Fund as of July 31, 2023 had assets with a yield to maturity of 6.91 and the direct class has a fee of 0.21%. We therefore currently expect to earn about 6.71% . The maturity of the holdings of this fund are very short at 53 days so we do not expect any significant gains or losses from changes in interest rates. For now, the return is expected to be 6.5% and this will go up or down in future as interest rates go up or down. This means that they are going to have an additional income of Rs 7,420 per annum on their current balances of 200,000. Bank deposits are insured up to 5 lakhs per depositor, so their savings account is fully insured. The liquid fund invests in highly related short term instruments so the credit risk is low though it exists. However we believe that this is a switch worth making because this risk is very small and the cushion of incremental yield and return at 3.5% per annum is very high in relation to potential credit losses. You can access the money in a savings account on any day. For the liquid fund, you will have to put in a redemption and the money will be available the next day so the liquidity is almost as good.
Other Observations
Their choice of balanced fund comes with an exit load of 1% if they sell more than 30% of their holdings in less than a year. The fees in the balanced fund are also very high. Even after switching to the direct class, they will still be paying 0.91% per annum. They should consider substitutes with lower fees and without loads.
Asset Allocation
If we look through the holdings of the balanced fund which has 66.6% in equity and the balance in fixed income, their asset allocation has a 40% exposure to equity and a 60% allocation to fixed income. The real driver of reasonably diversified portfolio’s returns is the amount of equity exposure. If you take more equity exposure and equity markets do well, you will make more money. If equity markets do badly, you will lose more money.
Advisors have limited ability to forecast markets well and this is a decision clients should think about carefully, understand as best they can and get to a level of comfort with. Unlike easy wins there is expected reward but it comes with a potential downside if equity markets do poorly. Rajeev and Aarti have said that they have average risk tolerance. However if you look at their equity allocation, it is quite low for their age at 40%. Rajeev and Aarti are young. Most of their capital is their human capital embodied in their earnings capacity. They can stand the risk of losses in their equity investments with the expectation that increasing their equity exposure will increase their returns and portfolio value over time. Our recommendation for them given their average risk tolerance is 75%.
Investment Recommendations
With a higher target allocation to equities, our recommendation is
- Switch savings account balances of 200,000 to Prudential Liquid Fund Direct Growth
- Sell their Prudential Balanced Fund
- Reinvest the 300,000 as follows:
- 50,000 in the Tier 1 National Pension Scheme( and repeat annually).
- Put 75% in the scheme Tier 1 Equity and 25% in Tier 1 Govt Securities.
- Pick State Bank of India as the investment provider
- 2,50,000 in the SBI Nifty Index ETF Direct Class
- 50,000 in the Tier 1 National Pension Scheme( and repeat annually).
Logic for the NPS
The earnings within the NPS are not going to generate any tax liability during the investment period. Any reallocations within funds also will not trigger any taxes. On withdrawal, 60% can be taken as a lump sum and will not generate any taxes. 40% has to be taken as an annuity. It is good to have an annuity for a portion of your assets since it will last for your life and will hedge the risk that you live a very long life and run out of retirement income. After retirement, your income level is going to be much lower and the effective tax rate will also be quite low. The fees at the NPS are about 0.10% and are much lower than the 1.53% they are currently paying on the balanced fund. They are also much lower than the 0.91% you can reduce the fees to by switching into a direct fund. We have picked State Bank of India as the investment advisor as it is the largest investment manager on the NPS platform.
Rationale for the SBI Nifty Index ETF Direct Class
The SBI Nifty Index is the largest ETF in India. It gives you exposure to the Nifty Fifty which is the 50 largest companies in India. This covers the largest companies in India and the ones most likely to benefit from the projected growth of the economy and the consumer. The fees are very low at 0.04% for the direct class in comparison with about 1% for the average large capitalization equity fund.
We would have been open to recommending an even broader index based like the Nifty 500. However these are very small in comparison to the Nifty 50 ETF and we have decided to guide to the SBI Nifty ETF Direct Class.
Another option that could have been considered is to put all the funds into the NPS scheme. The tax advantages are better but the downside is that the funds are not available until retirement and the couple may want to access the funds for a down payment on a house or for other purposes. One could use the NPS Tier II instead as that allows for early withdrawals as well. This would be a very good alternative as well and the portfolio here is actively managed and broader than the Nifty Fifty Index. The fees are a little higher than the index but they are very low at under 0.10%.
