The minimum assured return scheme (MARS), the pension regulator’s version of a scheme aimed at delivering minimum assured returns, is expected to be based on floating rates pegged to 10-year government security. The scheme, spurred by the need to provide an alternative to entirely market-driven performance in the organised retirement sector, will take pension reforms to the next level.
Assured returns will attract a new set of subscribers to the National Pension System (NPS), which stand at the very centre of reforms initiated by the Pension Fund Regulatory and Development Authority (PFRDA) in recent days. The MARS variant, likely to draw serious long-term allocations to the system, will encourage a relatively more conservative section to save for retirement.
In this context, an insight into the concept of floating rates is expected to help subscribers. To be reset periodically, such rates will be a critical driver for all. A number of elements may work in their favour, or against, depending on the circumstances. Retirement planning, to say the least, needs to take cognisance of such factors.
Simply put, the 10-year government securities (G-secs) serve as a crucial barometer for the fixed-income segment to which investors usually refer to in the debt market. It serves as a benchmark for major borrowing rates, with variations in its yield giving serious repercussions for investments.
It must be noted that the price of G-secs will fluctuate, depending on conditions in the secondary market where demand and supply dynamics determine the trends. Price is impacted by the level and variations in interest rates. A range of macro factors come into play here. Inflation expectations and the level of liquidity in the system obviously make it to the list. G-sec watchers keep an eye on policy developments in India—specifically, the Reserve Bank of India’s (RBI) action with regard to key rates—and trends emerging from overseas bonds markets.
Retirement-minded investors must take two facts into account.
- The price of a security, for instance, a bond, captures the current value of all its future cash flows. The yield to maturity (YTM) is the rate used to discount the cash flows.
- Yield and price are inversely related.
Keeping these factors in view, it must be understood that when yield increases, bond price decreases. And when yield declines, the price of the bond advances. Any investor who has purchased a bond and holds it in the portfolio can earn regular interest payments (a factor of its coupon rate). They can also expect capital gains on sale or on maturity.
Will MARS Beat Inflation?
Subscribers need to have a clear idea of the scenario to start with. As every retiree will know, inflation will eat into their savings. An enormous chunk of the retired population in India, and in other parts of the world, is currently in financial distress because of their inability to tolerate inflationary conditions.
Of late, prices have eased, according to data released by RBI. Regarding the somewhat moderate commodity prices, this may be seen as a purely incidental phenomenon. Nevertheless, all potential subscribers should realise the longer term impact of changing prices and their role in the retirement strategies.
Inflation sensitivity is a crucial element here. It can be argued that higher inflation will not really be an important factor for a defined contribution (DC) scheme because the outcome of the DC-oriented retirement programme is not known beforehand. In other words, its benefit is not defined. Thus, there is unlikely to be a big impact for those who intend to fund such a scheme directly. The actual implication—and a severe one too—comes later for subscribers whose active income streams dry up (while purchasing power diminishes) after retirement.
When a DC scheme functions as planned, a younger subscriber may gain from a longer time horizon at their disposal. Such an individual may also benefit when earnings—typically, salary and bonus—increases in line with the inflation index.
But an older subscriber who is nearer superannuation is not so comfortably placed. For them, time is running out, their expenses are mounting, and such a situation will lead to the inevitable question: “What if my retirement corpus runs out of steam before my demise?” Such a poser may be seen in the context of longevity risk that many face at present.
Inflation-adjusted annuity payments may hold the key to pension stability in future. In the present circumstances, an individual is normally expected to buy one or more annuity plans to serve him during retirement. For such a participant, the idea of deferred annuity carries a lot of promises, the impact of which will be stronger if adjustments can be effected in the quantum of annuity payments.
It should, however, be noted that most annuity plans are conservative in nature. Their payouts generally do not vary. Yet those who invest in these products sold by insurance companies do so while keeping in mind their future financial commitments. The latter may well rise, leaving them in a sorry state. Thus, in the face of changing pricelines, adjusted payments are welcome.
RBI’s policy initiatives will also be critical here. If interest rates rise, there will be a negative effect on the bond prices. Thus, long-dated fixed-income options will not be so useful in later years. At any rate, interest rate risks rise when time horizons are stretched. In such cases, experts will advise to switch to equity. On the other hand, if interest rates are prompted to turn softer, fixed-income plans are likely to produce smarter results. A reverse of sorts, perhaps a partial switch from equity to debt, may then be suggested. It should all depend on the individual’s ability to bear risk.
This means that an average retiree must keep a close watch on the latest interest rate policies of the central bank. The latter’s outlook on inflation must also be monitored to the extent possible. Thus, the retiree’s strategy may have to be modified when sudden life-stage changes take place.
It is generally believed that long-term DC schemes sometimes come with an in-built challenge. It is not easy for such schemes to provide superior returns in addition to being a constant hedge against advancing prices. Here, the issue of liquidity assumes significance.
This scenario may become evident in India if yields on G-secs remain on the lower side. It remains to be seen how the concept of minimum assured returns works out in a large and complex country like ours.
By Nilanjan Dey, Director, Wishlist Capital