DTC and personal finance

The Direct Taxes Code (DTC) 2010, bill no. 110 of 2010, was introduced in parliament last month. It will replace the Income Tax Axt`1961. The major changes affecting personal financial planning and investment are required to be analyzed and assessed, so that you know which provisions are likely to affect your financial plan. Even though it is going to be implemented w.e.f. 01.04.2012, one must be rest assured before starting a fresh investment.

The basic exemption limit has been raised from 1.6 lakh to 2 lakh for individuals and from 2.4 lakh to 2.5 lakh for senior citizens. The female taxpayers are likely to lose the special privilege given to them. The income above this limit will be taxed at 10% up to 5 lakh, from 5 to 10 lakh at 20% and above 10 lakh at 30%.

Life insurance premium will qualify for deduction up to 50,000 only, compared to available deduction of 1 lakh at present. The overall limit of 50,000 as per new section 73, includes life insurance premium, health insurance premium and tuition fees paid for two children. Life insurance premium will qualify for deduction only if premium payable is not exceeding 5% of the sum assured. At present this limit is 20% of the sum assured. This will again change all the existing insurance plans next year. So be cautious, if you are buying a new insurance plan in this year.

New section 69 also provides for an additional deduction of 1 lakh to tax payer if the amount is deposited in approved fund such as provident fund, superannuation, graruity fund and also pension funds approved by the central government. It seems that government wants promote long term investment plans for the retirement benefit. The major problem in this type of plans is that they are not liquid and in case of emergency also you cannot withdraw these funds. Government should seriously think about this liquidity problem in these plans.

The following investments shall not be eligible for deduction after 01.04.2012
1) Payment of housing loan principle
2) ELSS schemes of mutual funds
3) Fixed deposits (FDs) with banks
4) National saving certificates (NSC)
5) Term deposits of post office

Housing loan interest is eligible for deduction up to same previous limit of 1.5 lakh under section 74, provided it is not let out during the year and also acquisition and construction is completed within 3 years from the end of the financial year in which loan is taken.

Section 110 provides for levy of 5% dividend distribution tax on dividend distributed or paid by mutual fund and life insurer. Life insurance cos. never pay dividend to their policyholders. Actually the fund grows in the fund opted in the insurance plan. This may be the case when the dividend is paid to the shareholders of the co. We have to wait for the further clarifications.

Capital gain in respect of equity share in a company or a unit of an equity oriented fund, where STT is paid & the asset is held for more than a year, no tax is payable. But if the asset is held for less than a year than 50% of the income is chargeable to tax. Thus you have to pay 5%, 10% or 15% of tax depending on your slab rate. At present short term capital gain is taxed at 15% flat. The individuals in lower tax slab will benefit from new provisions.

The base year for the fair market value of the investment asset shall be 01.04.2000, at the option of person for the assets acquired before such date. At present it is 01.04.1981.

7 financial planning goals you should be saving for

Author: Lovaii Navlakhi

Planning for a secure future is not easy; everybody needs to plan for tomorrow. At every income level, there are steps that you can take to make more efficient use of your assets and savings. It makes better sense to map out a plan based on well defined goals and to define strategies to turn your goals into a reality. Being unplanned to meet your goals could leave you feeling stranded at the time with unmanageable expenses forcing you to take expensive loans in order to meet them.

Funding retirement because Indians are living longer, healthier and more active lives than ever before, this means you will live a good number of years after your retirement. Many will spend as much time in retired lives as they did in their careers. If a longer, more active retirement is in the works, then you need to plan out your retirement nest egg as you would require significant financial resources. Identifying the amount you would need to save by the time you retire will help you know if you can extend your retirement by a few years in order to enjoy it with the same or better lifestyle that you have today.

Higher education continues to outpace inflation especially at a time when the need for higher education has never been more important. Since the costs involved are huge and not easily manageable by most people, it would make sense to have a good financial plan ready to meet these costs. It also allows you to identify how you can secure your children`s future goals by investing in the right insurance/ investment product to protect these goals. You may feel secure in the belief that you will always earn an income and be able to save for your children`s education needs, but a sudden change in situation can hamper your child`s dreams. 

Material Stuff we think is cool. If our grandparents or parents didn`t need financial planning, then why do we? Well, 20-30 years ago, the lifestyle was very different as compared to now. The world has changed tremendously and so has our lifestyles. Now, we have more ways to spend our money - earlier there was no satellite television, home theatre systems, mobile phones, PDAs, private medical care, internet, shopping malls, designer wear etc. The goals and aspirations of people in this generation are more ambitious when compared to the earlier generations. Achieving your goals easily would require more preparation from the beginning.

As we live longer, the total cost of medical care over a lifetime will also be more. Diseases that used to end lives are now treatable but expensive. You also need to plan for long term care after retirement. The importance of setting aside funds for healthcare cannot be over-emphasized especially as the costs are huge and can be a massive unexpected expense.

Pass on wealth to the next generation. This is increasingly difficult because it is likely that you will outlive your assets and have little to leave to your children. In many cases, the transfer of wealth is going backwards. Therefore, it is important that you plan your retirement requirements after setting aside the corpus that you wish to leave for your children.

Buy a home, car or take a vacation. Whatever the goal you are interested in; financial planning can make it happen.

The author is a managing director and chief financial planner at International Money Matters.

The next act of `To ULIP or not to ULIP`

We look at the upcoming changes in ULIP regulations, their effect on the product, the subsequent benefits for IFAs and investors.
How IRDA was lead up this path?After the recent turf-war between the SEBI and the IRDA over the regulation of unit linked insurance policies (ULIPs), according to a majority the verdict was, `SEBI lost out!` as most viewed the ULIP ordinance passed by the government as a loss for the capital market regulator. Despite this, there are some sure signs that the insurance industry`s cash cow, often called the ULIPs will see some changes that will help everybody except the insurance industry.

Most experts turn up their noses when they talk of ULIPs and for good reason. Not only are ULIPs inefficient investment vehicles, they are also inefficient insurance vehicles (in the form that they have been till now). How can the insurer really position ULIPs? It can`t be sold as a pure risk product as there are better (term insurance) products and neither can it be sold as a pure investment product since mutual funds are cheaper, more transparent with better options and have a track record of performance. As a result, ULIPs have been positioned as a hybrid product with high distribution commission. Hence, agents and distributors push such products for the high upfront commission they generate. The fact remains however, that ULIPs sell and like hot cakes too.
Mis-selling
Another aspect that the SEBI-IRDA dispute brought out in the public domain was - the big question of mis-selling. Sure, mis-selling happens everywhere, from soaps to financial products, but it is a serious issue in financial products since they are of the `sold` variety as against the `bought` variety. `Sold` basically means financial products are not actively selected by investors but need to be pushed for sales to occur. So for an agent who is marketing financial products, the product that gives the highest commissions is pushed more as has been prevalent in the ULIPs. As the illustration alongside shows, the cost structure is such that the charges are the maximum in the first few years and as a result, beyond the initial phases, the agent has no need to pursue the investor. This is why lapsed policies in ULIPs are such a heavy chunk of the total policies. In a recent interview, J Hari Narayan, the IRDA chief, accepted that mis-selling has been one of the major concerns.

The major changesIn more ways than one, the failings of ULIPs are being addressed:

> The commission structure is being changed to become more transparent
> The guaranteed returns on certain ULIP plans are to be made mandatory
> The distribution channels are being strengthened

The question is, with all these steps and more being taken by the IRDA to tackle the problems faced by investors and the insured, how much of an effect will it have on the industry? Some suggest that September 2010 (when the regulations will come into force) will be to the insurance industry what August 2009 was to the mutual fund industry. The only silver lining is that at least the IRDA unlike its capital market counterpart is going about the reforms process in a gradual manner.

Consider the major changes in the ULIP space that are expected:

- Offer guaranteed returns of at least 4.5%
- Deter mis-selling (all literature used for marketing will have to be approved by the IRDA)
- Change in Commission structure. The charges will now be levied evenly over the term of the product, where today the bulk of the charges are levied in the initial years
- Make Life cover mandatory as part of the ULIP product
- Allow partial withdrawals only after 5 years

The way ahead
What these steps will do is to bring focus on the returns provided by the ULIP scheme, the engineering of the product will become more important, finally and most importantly, the focus on the sales force will reduce. Rumours of layoffs in the sales force in insurance companies are already doing the rounds.

The product is more important than the sales pitch. This is the basic message that the regulator has been trying to put across. An investor buying insurance and mutual fund scheme separately should make sure he/she gets the best of both worlds. The intermediaries would also benefit and it would make sure that the distributors are educated enough about both sides of the coin. Quoting J. Hari Narayan once again, ``anything done pro-investor is good``. These changes will go a long way in making the entire market environment easier for the investor. From the IFAs` point of view managing both types of products could become a task but online platforms are the best bet in such circumstances including cost-effectiveness and streamlining of service irrespective of the Assets under Management of the IFA.
DTC EffectThe DTC will come into effect essentially in 2012. However, notwithstanding the changes that could happen till then, the current provisions make it a bittersweet scenario for the ULIPs industry. The bitter part mainly is that ULIPs will give the monetary advantage as they do today over a long term (15 - 20 years). The sum assured is now a function of premium to attain favourable tax deductions (sum assured should be greater than or equal to 20 times the premium). The one advantage that ULIPs will still have is that if held to maturity they will not be taxed. Due to the earlier lock-in period of three years, which has now become five years, ULIPs were compared to mutual funds. With the new regulations and the DTC kicking in, investors of ULIPs would have to consider longer term investment horizon. Where once the ULIPs were sold a a part investment and mainly tax benefit based product, now the investor would have think twice before putting money in ULIPs and understand that they are essentially investing in an equity linked insurance plan. The other disadvantage is that the total tax exemption for insurance products will now stand at Rs. 50,000. This will include the medical and life insurance premia. T. Vijayan, the Chairman of LIC made an important comment that the new regulations will undoubtedly slow down the ULIP collections but make the product better in the long-term and draw sustainable inflows.
To a certain extent, the combination of the DTC and the IRDA regulations does address the MF industry`s concerns of having a level playing field against ULIPs.

Conclusion
Overall, the deficit of trust between the intermediaries and the investors would do with a good deal of patching and these changes are important in this context. On the one hand, those professionals in the financial services industry who for better earnings have focused on insurance will need to sell products with their sole purpose in mind. With commissions expected to fall to around 8-10% instead of the previous range of 18-20%, the trail and upfront commissions paid by the AMCs based on the AUM will tend to be more rewarding and will benefit advice that makes money for the investors in the long run. Mutual Funds have long blamed the scrapping of commissions in mutual funds since August 2009 for the lackluster investments into schemes. With the leveling of the playing field for the insurance and mutual fund industry to some extent, one would expect that money will go where the product deserves. Noises coming from the Industry sound similar to what was heard a year back from Fund Houses. Instead of hurting one industry over the other, the value of the advisory and the positioning of products should now take centre stage.

Can you time the market?

Key Points
> A range bound stock market has left some investors on the sidelines waiting for the next rally

> We conducted a study of historical returns for the Sensex between 1980 and 2009 to test the benefits and detriments of timing the market

> Avoiding the ten worst months resulted in an annualized 26% return, versus the annualized 18.4% return for remaining invested from 1980 to 2009

> Excluding the ten worst days of performance in twenty nine years, annualized return improved to 22.4%

> On the other hand, missing out on the ten best months and ten best days gave annualized returns of 9.4% and 14.2% respectively

> Monthly returns were concentrated between -5% and 5% for a majority of the time

> The results suggest that market timing can be a risky strategy which may severely impact returns, if one misses out on the best days or months of market performance

After some heady gains from the lows of March 2009, the BSE Sensex has been trading in a range bound fashion since September 2009. Investors have seen the index `trapped` between 15,500 and 17,500 points i.e., in a trading range of about 13% over the past three months.

With this limited movement in the stock markets since the past few months, some investors may be tempted to sit on the sidelines, waiting for the next upward movement before investing in the stock market.

Is the practice of trying to time the market really the best option? Let us evaluate it!

Market timing study

We consider the historical data for the BSE Sensex to capture the numerous economic cycles between 1980 and 2009. The purpose is to monitor the stock market outperformance of an investor who has managed to avoid either daily or monthly declines in the market.

Table 1 shows the returns obtained by missing the best and worst ten days, as well as the best and the worst ten months for the entire period (end of December 1979 to end of October 2009).

The Sensex during this period has given an annualized 20.09% returns over the twenty nine year period. Thus, a rupee invested in the Sensex back in December 1979 would be worth Rs 134.53 at the end of October 2009.

Table 1: Value of Rs. 1 invested in the SENSEX since 1980 with different scenarios
	End of October 2009	Annualised Return
SENSEX	Rs. 134.53	18.4%
avoiding all negative months	Rs. 15,54,338.71	63.5%
avoiding all negative days	Rs. 13,322,431,291,963,800,000	356.5%
Source: Bloomberg, Fundsupermart.com Compilations

Chart 1: Outliers can make a huge difference!

Taking the study further, we calculated the hypothetical returns if an investor managed to avoid all negative months while investing during this entire twenty nine year period (158 negative months out of the 368 months in the period under study). Such an investor would have grown a single rupee into more than Rs 1.55 million in twenty nine years.

How about an investor who has managed to avoid all the days when the markets have ended in red while invested during this twenty nine year period? The net worth of such an investor would have stood at over Rs 13 quintillion, or a billion multiplied by a billion, an incredibly large figure (a quintillion is 1018). To put this figure in perspective, the total estimated global economic output was `just` USD 60.6 trillion in 2008, and 13 quintillion is almost 0.26 million times bigger than the USD 60.6 trillion.
Setting more realistic expectations
The results we have derived so far suggest that the investors who can successfully time the market (either by month or by each day) may become a millionaire, or even the richest person in the universe. Obviously, the catch here is that it is practically impossible to time the market on a monthly basis with perfect accuracy over such a long period of time. Needless to say, timing the market with perfect precision on a daily basis over twenty nine years is perhaps an art best reserved for the almighty.

Table 2 shows the same study with more realistic scenarios. Four scenarios were tested, which we believe are plausible outcomes for an individual investor.

Table 2: Value of Re 1 invested in the SENSEX since 1980, with more realistic scenarios
	End of October 2009	Annualized Return
SENSEX	Rs. 134.53	18.4%
missing top 10 months	Rs. 13.41	9.4%
missing top 10 days	Rs. 47.57	14.2%
avoiding worst 10 months	Rs. 812.58	26%
avoiding worst 10 days	Rs. 354.99	22.4%
Source: Bloomberg, Fundsupermart.com Compilations

Avoiding the `mines` or `potholes` obviously increased returns

Avoiding the ten worst months has increased the annualized returns from 18.4% to 26%, while avoiding the ten worst days increased the annualized returns to 22.4%. This is all well and good for an investor, but it certainly calls for the question: how does an investor manage to avoid these `potholes` in their investment journey?

But missing the best months or days severely impacted performance

Being unable to forecast the future, we believe that our study of missing out on the top ten months or top ten days may have more bearing on determining the investment approach. In the entire 368 months of study, it is surprising to note that missing out on the best ten of those months nearly halved the actual annualized return of the Sensex. On an absolute return basis, the 13,453% return of the Sensex was cut to just 1,341% as a result, a very paltry return for almost twenty nine years of investment.

Missing out on the best ten days of market performance in the entire eighty-two year period was less detrimental, but cut the annualized return to 14.2% versus the Sensex`s 18.4%. On a total return basis, this has translated to a 4,757% return.

Markets are `boring` a large part of the time

As shown in Chart 1, the monthly returns of the Sensex appear to be normally distributed, with 68% of the monthly returns in the range of -5% to 5%. These are the periods where markets are considered `boring` and often trade in a range bound fashion. However, we believe that the investors should be more excited about the positive occurrences (those on the right side of Chart 1), and should ensure that their portfolios benefit when such hefty gains occur.

Unless one is extremely lucky, the only way to ensure exposure to these positive periods of performance (just 11.5% of the months under study had a positive return of over 10%) is to remain invested in the stock market and avoid timing the market.

Staying invested is the better option

From the results, it appears that while getting market timing calls right (avoiding worst performing days or months), one can generate significantly better performance than the market return. On the other hand, missing out on the best days or months will hurt returns substantially.

Since no one can correctly forecast the direction of the market with precise accuracy, avoiding the worst periods of performance is not easy, and is sometimes an impossible task. Rather than trying to avoid the large negative-return outliers (shown on the left side of Chart 1), a task fraught with uncertainty, investors can choose to `accept` all the huge positive-return occurrences (on the right portion of Chart 1), a certainty if one stays invested in the market.

Manager selection: Why it`s relevant for individual portfolios?

Manager selection is important for institutional investors. This refers to the professional expertise offered by investment consulting firms to select portfolio managers who can optimally manage assets for the institutional investors. We believe that manager selection plays an important role for individual investors as well.
Manager selectionPlan sponsors typically hire investment consulting firms to help them select portfolio managers. Suppose a pension fund (plan sponsor) has to invest USD 50 billion in various asset classes including equity and bonds. Further suppose that the pension fund proposes to invest USD 15 billion in equity, spread across three investment styles - large-cap value, mid-cap growth and small-cap blend. The investment consulting firm`s mandate would be to select portfolio managers in each style universe.

Suffice it to know that the process is very rigorous. It involves three-steps - performance measurement, performance attribution and performance appraisal. Take the large-cap value universe. The investment consulting firm will first measure the performance of all large-cap value managers. Next, the firm will compare each manager`s performance with the large-cap value index.

The performance attribution analysis helps in explaining the factors that helped the portfolio managers generate returns in excess of the benchmark index. Suppose a large-cap value manager generated 16% return while the large-cap value index generated only 10%. The consulting firm will seek reasons as to how the portfolio manager was able to generate the excess return.

Finally, performance appraisal refers to a process where the consulting firm asks the question: Was the excess return due to luck or skill? Can the portfolio manager generate excess returns in the future as well? If the answer is in the affirmative, the investment consulting firm will recommend that the pension fund invest in the portfolio manager.

The question is: How is this three-step process relevant to individual investors?

Fund selection
Consider an individual investor who wants to take exposure to mid-cap stocks. She has a suite of funds to select from, thanks to the proliferation of funds and fund complexes in the country. The problem is more severe when an individual investor wants to buy diversified funds. How should an investor choose such a fund?

Individuals typically use personal finance Web sites that ranks funds according to their past performance; investors tend to select a fund that has been a top-performer in the last three years and five years.

The point is that past is not an indicator for the future. This does not mean past performance is not a useful measure to forecast future alpha. But buying a fund based only on its past performance may not always help the investor; for the fund may just as well perform poorly in the future.

Consider the evidence. The top-performing diversified fund over a five-year period lagged the leaders in its peer universe over a ten-year period. The phenomenon is no different for funds in other style universe such as mid-caps.

This is not all. The top-performing diversified fund over a five-year period returned 28% while the bottom in the list returned 0.50%; even the Nifty index returned 20% during the same period. This suggests that a wrong selection of fund could lead to negative alpha returns. Both these factors suggest that fund selection goes beyond mere ranking of fund returns.

Conclusion
Individual investors should strive to reduce the error of choosing an active manager who has generated excess returns through luck; for luck could well run out in the future. This is possible if investors engage in manager selection as institutional investors do. Such a process would increase the possibility of the investors achieving their stated investment objectives, through optimal passive and active exposure.

Go online for hassle-free tax filing!

Like the inevitable Monday morning blues, the annual tax blues are here to haunt us again. The deadline (July 31) for filing income-tax returns is fast approaching and you may be dreading that mandatory visit to Aayakar Bhavan.

Don`t you bank online? Don`t you pay bills online? Why not file your returns online?

E-filing of returns is becoming quite popular, going by statistics from the Directorate of Income-Tax. For the assessment year 2009-10, about 48 lakh returns were filed online out of which ITRs 1-4 applicable to non-corporate assesses (like salaried individuals, HUFs, partners in a firm and those carrying on proprietary business or profession) amounted to 38.5 lakhs. So save that half a day`s leave, forget the long queues and become a part of the statistic for this year.

With all the data and documents in place, e-filing is expected to take only about 30 minutes of your time. For the tech-savvy who knows a bit of taxation laws too, incometaxindiaefiling.gov.in is the Web site you should hit.

At your doorstep
For others lost in the ocean, do a Google search. You`ll find umpteen e-return intermediaries who can help fulfill your obligation to the taxman for a fee.
There`s more to cheer for corporate employees as these service providers may be available on your own premises.

``With assesses like corporate employees, we work in an online-offline model,`` says Nitin Vyakaranam, co-founder of Artha Yantra, a financial advisory firm, which runs taxyantra.com. Explaining this model further, Navin Kumar, co-founder, eLAGAAN says that one can exercise a choice between using the return preparation software ( to crunch the numbers) and then filing the returns manually or use their software and later proceed to file their returns electronically.

Once you have decided to e-file your returns, you have two options. If you have digitally signed your ITR, the process gets complete with the generation of the ITR V (acknowledgement) form.

Digital Signature
But intermediaries like Nitin and Navin don`t recommend a digital signature for individuals as it is slightly expensive, has limited validity and almost no other use. In that case, you can still file your returns electronically.

On the successful uploading of your return, you must take a print out of the acknowledgement, fill it and send it across to the Central Processing Centre at Bangalore within a specified time period after transmitting the data electronically.
The CPC will then send an e-mail acknowledging the receipt.

Electronic filing scores over manual filing in four areas. One, it helps many who go on short stints abroad (in the course of their employment) file their returns on time even though they may not be physically be present in India. Two, intermediaries may serve as a digital storehouse for your income and tax records, freeing you of the burden.

Nitin recalls cases of people who have come back to him after three years asking for copies of these statements for obtaining a loan or a visa. Three, the processing of refunds is faster for electronically filed returns.

Four, both agree that e-filing is safe. eLAGAAN boasts of a 256 bit encryption when most banks, they say, use a 128 bit encryption.

Explaining that the manual filing of tax returns done all along has anyway been unsafe as far as confidentiality goes, Nitin says that safety is not as big an issue as convenience.

Year-long facility
Finally, for those who miss the deadline too, e-filing, and hence, e-return services, is available throughout the year.

Only that a filing beyond July 31 would mean that you cannot revise your return if necessary. You would also have to pay interest in case there are tax arrears and may miss out on carry-forward of certain losses.

Five steps to financial fitness

Saving money is one of those tasks that is easier said than done. How much money will you save, how will you do it, and how can you make sure it stays there? Here are five questions to ask yourself to help you get financially fit and achieve monetary success.

What are your financial goals?
Understanding why you want to save money is a fantastic way to start. With your vision in mind it will be easier to make those tradeoffs at the till. (Is that extra pair of shoes really worth it?) Create milestones to make the path look easier and track your progress regularly to know if you need to make any adjustments to get to your goal.

Where`s your money going?
Many of us have no idea where we spend our money. In fact, as long as there is enough in the bank to cover the expenses we`re fine. Unfortunately, that`s not a great way to ensure you are making the most of your wages.

Understanding where you spend is a key step in financial fitness as it helps you determine the percentage of your money that is being spent on necessities and how much is being spent on the non-essentials.

Once you know where your money is going, you can start thinking about what changes you need to make in order to get to your desired financial state.

How much can you spend and where?
Budget. There are few words that are less exciting to hear.

We all know how difficult it is to create a budget and it`s often even harder to stick to it. But now that you know what you are saving for and you know where your money goes, it will be easier to set a budget that works for your lifestyle.

Create a list of things you are likely to spend on each month and make sure to track each rupee you spend. Give it a shot for three to four months and before you know it, you`re on your way.

Are you sticking to the plan?
Tracking your expenses is a key factor in making your budget work. Keep a tab on how much you are spending across each of your budget categories and see which ones you are overspending in.

Understand why you are overspending and make adjustments accordingly. Revisit your expenses often to be sure you are on track and don`t forget to focus on the goal.

Are you rewarding yourself?
It`s not an easy path towards financial fitness. It requires a lot of discipline and rigor. Don`t forget to reward strong performance. Every milestone you reach means a small success, so treat yourself along the way (within budget, of course!).
This will help you keep your motivation levels up and makes the exercise a little more fun.

We hope that these simple tips do help you in your march towards financial fitness.

What has changed with ULIPs?

Unit-linked insurance products or ULIPs are perhaps the most widely discussed and written about financial products in recent times, and not all for the right reasons. First, there was the battle over who would regulate them, and then came a series of regulatory changes to reform the product.

The changes over the past few months have come one at a time, but in rapid succession. They have far-reaching implications for investors who are considering ULIPs. Here is a look at all the recent changes in the ULIP structure and their implications for investors.

Despite all the changes announced, these products still have a long way to go on transparency and disclosures relating to their investments. Though ``insurance`` is only incidental to ULIPs and the ``investment`` component is the key to returns, many insurance companies are unwilling to divulge adequate details on the historical portfolios and investment strategies of the ULIPs they manage.

Changes to costs

Cap on recurring charges: Their high expense structure has been a bone of contention with ULIPs.

The IRDA has sought to remedy this in two ways. First, it fixed caps on the overall costs that can be charged to ULIP investors under two slabs, one for a tenor of up to 10 years and another for tenors of 10 years and above.

It specified that the net reduction in yield (return) to investors from a ULIP should not be more than 3 percentage points for terms up to 10 years and 2.25 percentage points for ULIPs of 10 years or more, effectively capping the total expenses insurers may charge their investors. Then, this was modified, based on the experience of policies lapsing in the initial years.

The difference between the gross and net yield for ULIP-holders is now capped at 4% from the end of fifth year, and this cap progressively declines to 3% by the tenth year. This will mean a lower cost structure for investors, even if they seek exit from ULIPs after the fifth year.

For instance, if you invest for five years in a ULIP that earns a 10% gross return, if you withdraw after the lock-in period; the net yield would drop by four percentage points to 6%. These changes are effective from Jul. 1, 2010.

Surrender charges trimmed: One of the key features that curtailed the liquidity aspect of ULIPs was the high surrender charge levied by insurers for premature closure.

If policy-holders stopped paying premiums after two years, the surrender charges would amount to as much as 30-40% of the first year premium. The surrender charges would thus reduce your overall returns substantially. IRDA has now introduced limits on surrender charges to rationalize them.

If the policy is surrendered in the first year, the charge would be 20% of first year premium or Rs 3,000, whichever is lower, for an investment amount up to Rs 25,000. For an investment above Rs 25,000, the charge would be six% of the premium subject to a maximum of Rs 6,000.

The surrender charge progressively reduces to Rs 1,000 in case of former or Rs 2,000 in the latter, if the policy is surrendered in the fourth year. As per the new guidelines, there would be no surrender charges from the fifth year. The implication of this is that investors wishing to exit a ULIP after the five-year lock in would not suffer any additional surrender charges, only the overall expenses mandated by the IRDA.

Commission: The high commissions paid to insurance agents have been often highlighted by critics of ULIPs. The IRDA`s new regulations seek to address this through the cap on overall charges and also through disclosure requirements.

With effect from this month, the advisor`s commission in a ULIP will be automatically disclosed in the benefit illustration (the document that spells out the various charges deducted from the unit-holders premium and quantifies the net yield to the customer). It is now mandatory for the advisor to take the signature of the investor on this document.

Increase in mortality: The insurance component in a ULIP is usually quite small; however, IRDA has now sought to raise this component by specifying that ULIPs should carry a life cover for a minimum ten times of their annual premium (this was five times earlier).
Changes and liquidity

Extended lock-in period: All investments in ULIPs carry a three-year lock-in period. This will be increased to a five years from September 1, 2010. This will clearly weed out the mis-selling of ULIPs as short-term products to investors.

Given the buoyant equity market investors are often persuaded by their advisors to invest in ULIPs on the premise that these are three-year products.

With funds locked up for five years, only investors serious about building a long-term investment portfolio would consider buying ULIPs. Incidentally, ULIPs should be bought only that way, because of their front-ended expense structure.

Investors should also be conservative in deciding their premia as they are committed to the investment for several years at a time.

If they fail to pay the renewal premium and discontinue the policy in the first five years, no payment will be made till expiry of the lock-in period. Hence investors not sure of a regular income should set their premium conservatively.

For excess income, one can always add on single-premium policies.

This ensures that you will not surrender the policy within five years. If a ULIP is prematurely discontinued, your fund value on the date (after adjusting for surrender charges) will earn minimum of 3.5% interest during the remaining lock-in period.

Liquidity: Even while extending the lock-in period on ULIPs the regulator has sought to improve their liquidity by introducing norms for loans against ULIPs.

In any ULIP where the equity accounts for more than 60% of total portfolio, investors can be granted loans not exceeding 40% of the investment`s net asset value (NAV). Where debt accounts for more than 60% of the portfolio, the loan can be up to 50% of NAV.

Returns: While the above changes to ULIP costs may help improve effective returns to investors, the IRDA has also laid out special provisions for pension products fashioned as ULIPs.

As per the new regulation, a unit-linked pension plan should carry a minimum guaranteed return of 4.5% a year if all premiums are paid. Such ULIPs will also carry a longer lock-in period than others and no partial withdrawal will be allowed during the accumulation period.

However, on vesting date, policyholders can commute (choose to receive as lump-sum) up to one-third of the accumulated value of the fund to his credit.

Pension policy holders should ensure that they pay premium till the maturity period. In the event of discontinuation, the policyholder would be entitled for a lump-sum refund of not more than one-third of the fund value, while the remaining amount would be used to purchase annuity to ensure pension payments. You will pay tax for the pension received for your respective slab and it will bring down the net yield on the product.

How ULIPs performed

All the above measures may help lift the effective returns to investors from ULIP products. But how have equity-oriented ULIPs performed so far? Details on ULIP performance or portfolios are not as easy to come by as those for mutual funds.
However, an analysis of equity-oriented ULIPs (80-100% invested in stocks) shows that over a one-year period, 56 of 62 schemes managed to outperform such indices as BSE Sensex, CNX Nifty and BSE 100.

Over a three-year period, 21 of 28 schemes, and for a five-year period 9 out of 13 schemes, comfortably edged past BSE Sensex.

Over three- and five-year periods, the category average clocked compounded annual returns of 10% and 22.7% respectively, against the 5.5% and 19.2% recorded by the BSE Sensex (Nifty returns are 6.3% and 18.1%).

However, investors should note that their effective returns from ULIPs may be 3-4 percentage points lower than the NAV-based return (as ULIP expenses are adjusted based on the unit balance and not the NAV).

COMMON AND MUST TO KNOW TRADING RULES

• Always have a trading plan. Never trade without a trading plan (a trading plan consists of a trading system which is made of few components)
• Never trade without a StopLoss (Repeat 10 times).
• Never ever hold on to a losing position. Never average/add to a losing position. (Repeat 10 times).
• Let your profits growing. Add to your winning trades.
• Trade on Rumors and Exit at news. But be care ful while following this strategy.
• Never discuss your trading position to anyone else.
• Control your emotions. You cannot control the market but definitely control yourself.
• Never try to become a perfectionist or Best. Try to become ‘better than others’ and ‘above average’.
• Follow your trading system. Let the system prove itself right or wrong; before changing it.
• Never ever over trade (repeat 10 times).
• 
  So, what you are intraday trader, Learn basics of stock market. Learn the intermediate and long-term trend etc.
• If you are starting new or re-starting; begin with paper trading.
• Don’t think of earning regular salary/income in markets while trading. Because trading is not a job it’s a business.
• Cut the losses small and let the profits grow.
• Learn to understand the ‘general condition’ principle’ argued by Edvin Lafarve in book ‘Reminiscence of a Stock Operator’.
• Learn to both; buy-n-trade and short-n-trade. But try–More buy-n-trade in bull market and sell-n-trade in bear phase.
• Don’t be greedy. Remain reasonable. Don’t try to make killing once in every week. You can expect it only once in months.
• Clearly decide what you expect from trading.
• Tell yourself and accept the risks of trading.
• Never bet your life-savings in markets.
• Learn from the successful traders. Learn from unsuccessful traders more.
• See how successful traders do it. But note that every person has to accommodate success rules as per his own attitude and composure.
• Money management plans and risk management are as much important as much the trading system (which will decide the accuracy of your trades)
• Remain alert that you don’t slip into speculation while trading.
• Never turn a trading position into investment position because you don’t want to take mental hit of booking loss.
• Maintain proper record of your activity. Also maintain a daily diary of your progress/lessons/experience in trading.

Some cheer for individual taxpayers

Mayur Shah

The much awaited Revised Discussion Paper (RDP) on the draft Direct Taxes Code (DTC) which is meant to respond to the major concerns and comments received from various stakeholders on the draft DTC and the Discussion Paper (released on August 12, 2009) was released by the Government on June 15, 2010, for public debate and comments.

Manisha Paul, an IT professional, is wondering how the RDP would affect her salary income and correspondingly her tax liability. For those like Manisha, the following are some of the relevant changes brought in by the RDP to DTC.

The dilution of several provisions of the DTC should address many concerns of individuals and the salaried although the RDP leaves many questions unanswered, including relating to the tax rates and tax slabs.

Under the RDP, the Government has proposed the exempt-exempt-exempt (EEE) method of taxation for Government Provident Fund (GPF), Public Provident Fund (PPF), Recognised Provident Fund (RPF) and pension scheme administered by Pension Fund Regulatory and Development Authority.

Similarly, approved pure life insurance products and annuity schemes have also been proposed to be subject to the EEE method of taxation as opposed to the exempt-exempt-tax (EET) method proposed earlier.

Social security

It is pertinent to note that most countries that follow the EET method of taxation for retirement benefits have robust social security system in place. The RDP recognised that in the absence of a universal social security system in India, the proposed EET method of taxation of permitted savings would be harsh on the taxpayers as they would require some flexibility in making withdrawals in lump-sum without being subjected to tax.

Also, people may need lump-sum funds on retirement for various family obligations and, hence, continuation of the EEE regime is a welcome move. Further, the RDP acknowledges the fact that it is unlikely to have a social security system in place in the near future. Accordingly, the continuation of the EEE regime is a welcome step taken by the Government. It has also been proposed that the investments made, before commencement of the DTC, in instruments presently enjoying the EEE method of taxation would continue to be so eligible, for the full duration of the financial instrument. However, there seems to be an anomaly with regard to the tax treatment on the contributions/investments made to the financial instruments existing before the implementation of DTC, which we believe would be clarified once the DTC legislation is enacted.

However, what is not stated explicitly in the RDP is whether popular instruments such as equity-linked savings schemes and unit-linked savings schemes will continue with the EEE method of taxation when the DTC comes into force. Also, the RDP does not say either if the authorities propose to adopt the EET regime at a later date, once a solution is found to the administrative, logistical and technological challenges. Or would the EET regime be held in abeyance till universal social security system is in place, which, in any case, will take several years.

Retirement benefits

Further, the RDP also proposes that retirement benefits in the nature of gratuity, voluntary retirement scheme, commuted pension linked to gratuity and leave encashment receipts at the time of superannuation are proposed to be exempt for all employees, subject to specified monetary limits.

The tax exemption for retirement benefits is a welcome move and will mitigate undue hardship to employees as in the absence of adequate social security benefits, the social and economic norm is to use retirement benefit amounts for savings as well as for social expenditure.

The continuation of the exempt-exempt-exempt regime is a welcome step taken in the Revised Discussion Paper on the Direct Taxes Code.

(The author is Associate Director, Ernst & Young. )

Is base rate sustainable?

T.V. Gopalakrishnan

The Prime Lending Rate introduced early in 1990s and refined as Bench Mark Prime Lending rate (BPLR) in 2003 as a reference rate by the banking system has been replaced by the Base Rate effective from July 1.

What difference the base rate makes to borrower customers and the banking system and how this rate will help the Reserve Bank of India to transmit its monetary policy signals can be assessed or understood only after the rate stabilises.

Basically, the BPLR and the base rate should reflect the cost of funds, risk margin, and the rate of return to the bank but the difference lies in arriving at the cost of funds and the transparency in its computation and application. The computation of base rate is expected to be on a uniform basis and apparently leaves no scope for manipulation. It takes into account the cost of deposits, operating costs, negative carry on cost in the maintenance of statutory requirements that is, Cash Reserve Ratio and Statutory Liquidity Requirements, risk and profit margin.

BPLR and base rate

Compared to BPLR, which was basically computed on historical basis, the base rate has to be assessed more on a futuristic basis. The base rate will vary from bank to bank and should reflect on bank`s efficiency in bringing down the cost of funds and dynamism in the overall management of funds. Unlike in the case of BPLR, the banks cannot lend funds below the base rate except in certain permitted categories of lending under differential rate of interest schemes, advances against fixed deposits and agricultural advances having subvention from the Government and export credit. This is a major change and will be a challenge for banks to retain major corporate clients as borrowers as hitherto. This should also bring in some changes in the money market operations as some of the borrowers may switch over to short-term instruments such as commercial paper to raise funds at lower rates than the base rate.

Various banks have announced their base rates and they range between 7.5 per cent and 8.5 per cent. How they have arrived at the base rates, however, have not been made transparent. The rates are also much higher than the one-year FD rates, call money rates, bank rate, repo rate, and the yield on Government bonds. They are also reflective of the generally high cost of the funds. The compulsion to maintain the Net Interest Margin at 3-3.5 per cent also seems to have influenced banks in fixing the base rate comparatively at a higher level.

Struggle to retain customers

Will the banks be able to realistically assess the base rate reflecting both the past and future trends and will the rate be able to transmit the Reserve Bank`s monetary policy signals effectively are the major doubts in the minds of knowledgeable public?

Although the base rate may come down in the long-run, immediately the large borrowers, particularly good borrowers, who had enjoyed funds at less than the BPLR will have to shell out more towards interest as they cannot borrow at less than the base rate. This may naturally lead them to resort to some other means to raise funds or banks will be compelled to compensate them to retain as their customers which is not desirable.

They may go in for Commercial papers or external commercial borrowings or raise deposits from the public directly at less than the base rate. In any case, this will have an adverse impact on banks` funds management and profitability. In such a situation, banks will be forced to entertain comparatively risky borrowers adding to their non-performing loans and consequent problems.

Good timing

Although, the concept of base rate is good to establish healthy credit market and improve banks` asset liability management down the years, it may in the immediate future upset the corporates` borrowing programmes and bring some visible changes in the money market operations. In case the base rate stabilises, it may also pave way to develop corporate bond market in a big way. Present surplus liquidity situation in the economy and continued persistence of higher level of inflation, however, supports a higher base rate and from that angle the timing of introduction of base rate seems well intended and justifiable.

(The author is a former Chief General Manager, RBI)