March 30, 2009

Know thy pension plan

I was the audience. A pitch was being made to buy into a pension plan. The salesperson gave the keeping aside for old age spiel. In short the dynamics were like this - I was to put in a fixed amount for the first five years, say INR x per annum. From thereon, till I was fifty, this cash would grow and after I turned fifty I would get a monthly income from this kitty till my passing into the next world.

She was doing her job well until the point where I asked at what rate my cash would grow between the last installment and me turning fifty.
“15%”, came the reply.
“Will you guarantee that?”
“Well we don’t guarantee it but if you invest the money in an aggressive mutual fund you will see those returns”
“Which mutual fund? I thought this was a pension plan”
She unfolded the literature for the plan. It showed options of allocating my annual contributions towards various asset classes – the most aggressive of which (also took on the most risk) and would, assuming the world didn’t fall apart in the intervening years, assuming that Indian equity markets delivered, assuming the fund manager wasn’t a rogue, assuming the companies in which my pension money was invested didn’t blow up due to fraud, bad management, business cycles or otherwise and assuming a million other risks which my tiny brain couldn’t fathom or whose impact I couldn’t ascertain, would potentially deliver 15%! … It was getting clear now …

“So your literature says 15% return annually if I invest in this scheme and allocate my pension to this asset class (Fancy term 1: ‘asset class’ is money that is exposed to similar risks – bonds, shares, etc are examples of asset classes)
“Well on the letterhead we can mention a maximum of 10%. But you can get 15% if …”
“Why 10%? You just said 15%!”
“Well sir, on the letterhead …”
“OK. No issues, So if your letter mentions 10% I assume my cash grows at 10% in the intervening period.” … PS: whatever you may hear from stock brokers, cash growing 10% assured annually for a long time is a pretty good investment, especially for pension plans
“No sir that again would depend …”
“Then why mention 10% on the letter?”
(Uncomfortable babble) … “Sir you can choose our as your asset class. The current NAV (Fancy Term 2: NAV means Net Asset Value – the price of a mutual fund at any given point in time) is INR 4. The NAV will surely rise (?) and your pension money will grow faster than 15%”
(I smile) … “What was the offering NAV?”
“INR 10 sir”
“Don’t you think it’s a concern that it has fallen from INR 10 to INR 4?”
“It’s a five star scheme sir and they invest in AAA+ corporates” … she doodled AAA+ on the literature, possibly to drive home the point
“Is there a possibility the NAV can drop further?”
(again that uncomfortable silence)
“Never mind … I’ll take this literature and get back to you”

As I was leaving I felt a little sorry for grilling her after I came to know about the asset classes logic. I understood the plan fundamentally then but was exploring the possibility that the pension plan scheme actually had a fixed rate of return. There was none. Instead there was a hell lot of market risk. (It actually seemed a clever way to seek contributions to the company’s mutual fund schemes) It called for taking a call on the capital markets for the next 23 years. (I’m around 27, and it would be 23 years till I turn 50). Ideally I would like my pension money to be risk-free. A large portion, say 95% of it, should grow at a fixed rate and the rest in equity shares of AAA+ corporates and pension funds should see to it that the float (Fancy term 3: Float is the premium on insurance / pension contributions collected by such companies in this business) is managed in a similar way. Unfortunately the fees component from selling these products has become huge income drivers for banks. A cross-sell like this gets fees form the pension plan as well as the mutual fund. Obviously bank executives will not want to sell the safer plans which gets fees for just the pension fund.

Just to give you one example of the impact a decision like this will have, assume someone invests in this scheme (most people will eventually). Their money grows in this mutual fund based pension plan till they are 49. Just before they turn 50, we see a recession the likes of today, there is mayhem in the markets and they are left with the capital they started off with, maybe less, which over 23 years has lost its value due to inflation. Assume that this was their only safety net. Isn’t their retirement royally screwed? Where has all the hard work to support old age gone? What if there was someone with a terminal illness at home? As usual the only beneficiary is the bank manager who collected bonuses every year for growing the capital (maybe completely due to luck) till our friend grew 49 and then who gave up his bonus when the fund went under.

Unfortunately, most people are unaware of what they sign up for in such schemes. One old-timer I know very happily told me that he invested most of his savings in a fixed rate investment which is market determined (?). My attempts to explain that there is no instrument that can pay a fixed rate and at the same time be market-determined was met with a “Do you think the managers at the insurance Co are fools?” Well they were not fools, they met their annual targets and scooted off into the sunset.

Financial innovation may have got people access to investment options they never would have, which is a good thing if they understood it. But financial innovation coupled with ignorance could well be disastrous. Know thy investments!