Shortcomings of Mutual Funds Monthly Income Plans
When it comes to investing in financial instruments for earning the extra bucks we always want, majority of us look up at Mutual Funds because they are less riskier that standalone stock and commodities trading. Still, they are subject to market risks. Since not all of us are risk lovers, we often tend to look areas of investments that offer a steady income stream month after month. The question is, ‘Is there any such investment option?’
A simple and truly heartbreaking answer to this question is ‘NO’. We often come across Mutual Fund schemes known as Monthly Income Plans. They promise to offer a monthly income stream in form of dividend earnings. But, will they always work as they promise? That is what we intend to find out in this article titled shortcoming of MF Monthly Income Plans. However, before we head for the shortcomings, let us take a look Monthly Income Plan variations that exist.
Monthly Income Plans that offer growth
What really happens here is that whatever profits are earned during the investment duration are eventually invested back in the plan. Hence, there is no real payout. At the end of the investment period, i.e. when the plan matures, the whole of earning is paid out at once. There is one benefit of these growth-oriented plans – since the profits are all reinvested, the profits grow at a higher rate. On the bad side however, the eventual payout may be taxed.
Monthly Income Plans that offer dividend earnings
In the other version, the profits are paid out at regular intervals instead of reinvesting those profits. The frequency at which these dividends are paid out depend on the frequency chosen by the investor. The allowed frequencies are per month, per quarter, once every six months and once every year.
Okay now that we have checked out the variations of Monthly Income Plans, let us take a quick look at the shortcomings of these plans.
- Income is not guaranteed: Have you ever taken the pain of reading the fine prints of a Mutual Fund document? There you will find ‘investments are subject to market risks’. This means that in case you make a loss, you will not earn money. Here is how it all works: Mutual Funds are allowed to pay out dividends only and only when there are profits or surplus. Let us take a quick look at an example. Let us assume that the MF invested in a Monthly Income Plan with a Net Asset Value (abbreviated as NAV) INR 30. Now, if the markets are good, the NAV can increase to say, INR 35. So, there will be a surplus of INR 5. Dividends can be paid out only on this surplus. In case the market takes a bad swing and the NAV drops to INR 25, there will be a deficit or loss. In this case, there will be no dividend payout. This happens quite frequently. In case you go through the historical data of MF Monthly Income Plans starting 2010 September, you will notice that 50% of these MF players failed to pay out monthly dividends to the investors. So, the probability of you earning dividends is 0.5.
- Monthly Income Plans are subject to significant risks:This is how Mutual Fund investments are broken down: 70% goes into debt instruments and 30% goes in equities market. Equity market is extremely volatile in nature. This is where the possibilities of losses are very high. Also, in case of debt instruments (such as government bonds) losses may occur in scenarios where increase in market rates of interest will render old bonds very unattractive in case they have lower interest offering. This is when the prices of those debt instruments move down, resulting in net loss.
- Returns in double digit is somewhat misleading: If you fall for Monthly Income Plans because the agent showed you the lucrative future of double digit interest earnings, you are being misled. We learned about two types variants – one with growth option and the other with dividend payout option. Double digit interest earnings happen only in case of growth option. This is because, once the profits are reinvested, profits start growing at compounded rates. This is not what happens in payout option. Every time dividend is paid out, the NAV falls by the dividend amount. So, if NAV was 30 and it increased to INR 35, you are entitled for a dividend earning of INR 5. However, once the dividend in paid out, the NAV falls back to INR 30. So essentially, your dividend earnings never grow at compounded rates. Also, you need to keep in mind that Monthly Income Plans have high expense (as high as 2% and sometimes even higher). This expense is taken out of the profit earnings.
- You may attract capital gains tax in the short term: In case you suddenly decide to sell your units of Monthly Income Plan before you cross the 3-year mark, all that you earn by selling those units is considered as short term capital gains. They are then taxed by adding the earnings to your overall income and income tax in levied. Remember, when the capital gains are added to your income, your income slab increases and so does your tax slab.
- Long term capital gains are also taxed: Assuming that you wait out the 3-year period and then start selling your units of Monthly Income Plan, you still earn capital and this is called long term capital gains. Long term capitals gains attract 20% tax flat post indexation and there is another 3% additional cess that you need to pay. So, what really happens is that you end up paying tax, this time, it less than what you pay in short term capital gains.
- Dividend earnings aren’t completely tax-free: Don’t roll your eyes. We know that you have been promised tax-free dividend earnings. However, did the agent tell you that whatever is being paid out to you as dividend is actually a post-taxation amount. Yes, the company that pays your dividends is actually required to, according to the existing rules books, pay 15% DDT which is known as dividend distribution tax. In addition to that, the company is also required to pay surcharge and cess. Do you really think that the company is going to absorb these charges and pay out of its own pocket? No! Sorry to break it but you are gravely mistaken here. All these payments for deductions are taken out from interest earnings of the investors. So, what you are getting is actually post-tax earnings or net earnings.
Keeping these shortfalls in mind, the question that comes is, ‘If Monthly Income Plans do not offer guaranteed monthly income, what are the alternatives?’ You can go for Monthly Income Scheme of Post Office or you can opt for Bank Fixed Deposits. They both offer assured monthly income. Let us take a quick look at the comparative study of the three options:
|Key Differentiators||Post Office Monthly Income Scheme||Fixed Deposit With Banks||Mutual Fund Monthly Income Plans|
|Risk||No Risk **||No Risk **||Very Low Risk|
|Amount of tax to be paid||Depends on the tax slab you are in.||Depends on the tax slab you are in.||Selling before 3 years will attract tax as per you tax slab. Selling after 3 years will attract 20% tax flat but indexation will be allowed.|
|TDS deductions||There are no TDS deductions.||TDS is deducted.||There are no TDS deductions.|
|Monthly income assurance||Yes||Yes||No|
|Returns before taxation||8.40%||8-9% – varies from bank to bank.||7-12% – depends on market performance.|
|Limits on investment||Yes! For single account, max investment is 4.5 lakhs. This doubles for joint account. Also, there is a minimum investment requirement.||There is no upward limit but there is a downward limit||No upward limit but there is a downward limit.|
|Premature withdrawal penalty||Yes. 2% if withdrawn before 3 years and 1% if withdrawn after 3-year period.||1% reduction in interest rate||1%|
** Please note that bank fixed deposits and Monthly Income Scheme of post office are also subject to risks. In case of economic meltdown, they can go bankrupt and hence, complete loss.
So, which one to go for? Well, this will depend on your risk appetite. If you are willing to take market risks, go for Mutual Funds’ Monthly Income Plans. They are good but they don’t guarantee monthly income. If monthly income is your priority, go for fixed deposits or monthly income plans with post office. You will have an assured monthly income flow.