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    How ignoring this factor can erode your wealth in the long term

    Synopsis

    Most investors know about the power of compounding and how time can help multiply your wealth. However, if your investments do not beat inflation, you can end up with a lot of money but still, be poor.

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    Don’t get misled by the return of premium offers.
    The features of some life insurance policies can take your breath away. The return of premium term plans give back the entire premium paid if the policyholder survives the full term. Just think about it. You can get an insurance cover of Rs 2-3 crore for 20-30 years and if you survive the term, the company will give back every rupee you paid as premium. Such a great offer! Or is it? Here's the catch, the money you will get back after 20-30 years would have lost a lot of its value by then.

    Over 25 years, even a modest 5% inflation reduces the value of Rs 1 lakh to less than Rs 30,000 (see graphic). If inflation is higher at 7%, the value would drop to below Rs 20,000. So, while the amount may seem big today, the inflationadjusted value of what you get back will not be substantial.

    How much will Rs 1 crore be worth in 25 years?
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    This week’s cover story looks at how time affects your money. Most investors know about the power of compounding and how time can help multiply your wealth. But time can also erode your wealth if the growth rate is below the inflation level. “Absolute returns can be quite misleading. If your investments do not beat inflation, you can end up with a lot of money but still be poor,” says Dhirendra Kumar, CEO of Value Research. Life insurance companies use absolute returns very effectively by highlighting the huge maturity amounts of traditional endowment policies. One of the options of the newly launched Child’s Future Assured Plan from Aditya Birla Sun Life Insurance requires a buyer to put in Rs 1 lakh per year for 10 years and promises to pay Rs 21.65 lakh on maturity after 20 years.

    To the lay person the proposition of Rs 10 lakh growing to Rs 21.65 lakh might appear very lucrative. But a careful study shows that the returns from the insurance savings plan are just a little over 5%. If we assume 5% inflation, the purchasing power of the Rs 21.65 lakh maturity corpus after 20 years will be only Rs 8.2 lakh (see graphic).

    Traditional plans highlight large maturity values
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    Insurance companies defend these numbers, pointing out that overall interest rates are down. “At a time when the 10-year government bond is offering a yield of around 5.8%, a tax-free return of 5% is not at all bad,” says Anil Kumar Singh, Chief Actuarial Officer of Aditya Birla Sun Life Insurance. He also points out that these plans also have a life insurance component. “It is not a typical investment product but an insurance plan that offers a death benefit in case something untoward happens to the policyholder,” he says.
    But the argument that insurance gives tax free returns should be taken with a pinch of salt. Tax rules allow investors to adjust the cost of an asset to the inflation during the holding period. Also known as inflation indexation, this is done by dividing the invested amount by the cost inflation number of the year of purchase, and then multiplying the answer with the cost inflation number of the year of sale. In other words, if your money has not grown at the same pace as inflation, it will anyway escape tax if you claim indexation benefit.

    Not enough insurance
    However, the insurance offered by traditional plans is far too low to be of any consequence. Typically, financial planners recommend that an individual should have an insurance cover of at least 7-8 times his annual income and also cover any big-ticket outstanding loans. This means a person earning Rs 1 lakh a month should ideally have a cover of Rs 80-90 lakh. The only way to buy such a large cover is through a pure protection term plan. A traditional plan would require a premium of almost Rs 8-9 lakh per year, which is impossible for someone earning Rs 12 lakh a year. On the other hand, a term cover of Rs 1 crore for a 30-year old will cost just Rs 10,000-12,000 a year.

    Another way that insurance plans lure buyers is by dangling the bonus carrot. Traditional participating plans add bonuses to the policy corpus every year. This bonus amount is not guaranteed and depends on the performance of the company and the investment. It is represented as a percentage of the sum assured. So, if a company declares a 4% bonus, a policy with a cover of Rs 10 lakh will add Rs 40,000 to the corpus.
    That may sound like a big deal, but there’s a catch. While this bonus does get added to the policy corpus, it is given out along with the maturity amount at the end of the policy term and does not earn any return till then. So, even 5% inflation will pare the Rs 40,000 bonus declared in the first year to barely Rs 11,500 in 25 years.

    Illusion of enormity
    The illusion of enormity also works in the highly recommended term plans. Though experts say that term plans are by far the best form of life insurance, a lot of people don’t like the idea of not getting anything back. So life insurance companies have developed term plan variants that charge a higher premium than the regular plan but return the entire premium on maturity. It is nothing but a clever ploy to make pure protection term insurance more attractive to buyers.
    This arrangement appears very convenient till you do the math. We found that if the additional sum earned even a modest 5% returns, the corpus would be bigger than what insurance companies return to the policyholder (see graphic). “The insurance company simply takes money from the buyer, invests it at 4-5% and then gives it back to him at the end of the term,” says Rohit Shah, Founder and CEO of Getting You Rich.

    Financial illusion
    Don’t get misled by the return of premium offers
    This is how much a 30-year-old male will pay for a cover of Rs 1 crore for 30 years
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    Investing to beat inflation
    If you are investing for a very short term of 1-2 years, returns don’t matter that much. But experts insist that other investments, especially long-term savings, must be able to beat inflation. Otherwise your money is just losing value with every passing day.

    Investors saving for long-term goals such as their children’s education and marriage and their own retirement should remember that a 100% debt based portfolio will never be able to beat inflation. Consumer inflation averaged around 4.5% last year but may go up now due to the disruption caused by the lockdown. “If investors are aiming to beat inflation, they have no choice but to have some exposure to equities,” says Deepti Goel, Associate Partner, Alpha Capital. “It is the only asset class that has consistently beaten inflation in the long term.”

    The first rule is not to let your money idle in a savings bank account. Don’t be misguided by the attractive 5-6% being offered on the balance by some banks. Your money must grow faster than that to retain its purchasing power.

    Time correction in property
    Nowhere does the time factor work as quietly and ruthlessly as in real estate investments. There was a time when real estate investments were completely safe and yielded attractive returns. But things have changed dramatically in the past decade. The past 2-3 years have been especially painful, with many markets even seeing a drop in prices.

    Covid-19 has only added to the pain. Magicbricks data shows that real estate prices in major metros witnessed a 2-9% decline in April 2020 (see page 8). As the pandemic spreads, buyers are expecting prices to fall further. A Magicbricks survey conducted last month shows that 31% expect a discount of more than 25% while 27% expect prices to fall by 20-25%. Even if prices don’t fall, real estate is going through what is termed as ‘time correction’. Though prices remain stagnant, there is an inflation adjusted fall in value.

    What does this mean for investments in real estate? Investing in real estate may not be a very good idea if you are using a loan for the purchase. It is clear that real estate prices are not going to rise very fast in the coming years. Our calculations show that one cannot expect more than 7.5% returns from the investment in the best circumstances. We have made some very optimistic assumptions in our calculations (7% compounded growth in property prices every year, Rs 20,000 rent per month from fifth year and growing by Rs 2,000 every year).

    The reality may not be that smooth and there can be delays in construction and handing over possession. Despite the rolling out of the Real Estate Regulation Act, real estate projects may get delayed due to the shortage of migrant workers post Covid. According to a report by Anarock Consultants, projects that were scheduled to be completed by 2020-end face a high risk of delays since many construction labourers are migrants. “Construction activities are set to be delayed with many developers and contractors facing shortage of labour and a more pronounced liquidity crisis,” the report observed.

    Real estate investments can be tricky too
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    Lost and forgotten investments
    Time also works against you in case you have lost or forgotten about some investments or they are locked in legal disputes. Take the case of the six Franklin Templeton debt funds that were wound up in April. The fund house has already got roughly Rs 2,800 crore from debtors and expects another Rs 3,200 crore by September. But the money lying in these funds will not be handed to the investors till the legal process is settled. If the payments get delayed, the returns for the investors will further deteriorate. Likewise, customers of Yes Bank and PMC Bank suffered when the RBI placed curbs on withdrawals.

    A lot of investments are still not digitised and investors only have documentary evidence of shares, bonds and deposits. If these documents get misplaced, it can take several months if not years to obtain duplicates and access the money. Vikash Jain, Cofounder of Share Samadhan points out that though the terms vary for different instruments, post office investments stop giving interest after the investment matures.
    ( Originally published on Jul 13, 2020 )

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    (Your legal guide on estate planning, inheritance, will and more.)

    Download The Economic Times News App to get Daily Market Updates & Live Business News.

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