Senior citizens need to look at diversification in financial assets

Recently, the RBI put out an interesting working paper which used a HANK model which suggests that interest rates may be low for longer than anticipated. (For those who are interested HANK stands for – heterogeneous agent new Keynesian model)

This is good as many of us have been talking about the risks posed by misaligned monetary policy since 2018 till about late 2019. That interest rates are expected to remain low also indicates the understanding that inflation will remain muted post the pandemic. Thus, lower nominal rates would be the norm going forward. As stated in an earlier article, we are more concerned with the real interest rates rather than the nominal interest rates. So, a moderation in inflation & nominal rates can still result in a higher real rate than earlier.

Rejigging investment strategy

The transition from a relatively high to a lower interest rate economy has interesting implications, more so for those who prefer bank deposits as the predominant instrument for parking their savings — or wealth. Thus, the low rates on small savings rates, fixed deposits and even saving deposits have implications — more so for those who are retired. Similarly, the low rates will also have implications for the young as they re-evaluate their strategy to manage their savings.

The difference is that for the young, there is a higher-risk appetite and thus many may end up parking a part of their money in the stock markets. This could be either by purchasing shares directly — or buying mutual funds, SIPs and/or any other such investments. These investments will give handsome returns, even as they come with a greater risk. However, given that those who are young will witness income on a recurring basis, they are willing to make such investments.

Options for senior citizens

Those who are retired may be unwilling to do the same as they depend predominantly on their past income (savings). Thus, for them, moderate, risk free return is ideal. In inflation-adjusted terms they can expect a real return of close to 0.50-1 per cent on their short-term deposits while longer duration may offer them a slightly better return. Given that a lot of senior citizens depend on interest income, parking their funds in fixed instruments that credit interest to the savings account is a good idea.

Apart from conventional fixed deposits, they can also invest in various bonds such as the NHAI bonds or other such instruments which offer a higher return, which is taxable. The advantage with NHAI bonds is that to a great extent it helps offset a part of the capital gains tax. While fixed income instruments such as bonds are a nice way to diversify the portfolio, one has to be careful about some mis-selling as was the case with the YES Bank’s AT1 bonds. For those who are tech-savvy, index or balanced funds are also a good option to store a part of their savings. Apart from financial instruments, there are always assets in the form of gold & other precious metals which can be considered by them. Invariably, some form of rejig of the existing portfolio may be needed for those looking for higher returns over the coming years.

We must realise that the conventional mechanism to provide support by offering high small saving rates is problematic for numerous reasons. The objective behind the policy of high small savings rates is to provide some form of income support to the elderly. However, interest rates are perhaps the most distorted way to provide such support as it increases the overall cost of capital for corporates, which thereby dampens economic activity. That these small saving rates must be linked with the repo rate has been long argued, and the perils of such form of welfare has been well documented.

The question is, whether state can provide support to the elderly through other policy instruments? The answer is yes, a combination of higher tax deductions and cash transfers directly into their bank account would be a better approach to provide income support to our elderly. That is, the government can simply make a tax-free transfer to all the senior citizens for the excess interest amount that they would have received in the event of the nominal rates being high. There can be a ceiling on the monthly transfer amount to discourage excess savings from being parked predominantly in small savings instruments. The total transfer amount in such a situation is easily calculable — and would allow the nominal rates to be low even as senior citizens continue to get similar returns. Moreover, this would be fiscally neutral at worse — and fiscally positive at best as the government is already spending this amount.

Shift in mentality

Ultimately, senior citizens want to ensure a decent standard of living and thus want a smooth income on a recurring basis for their retirement years. This will have to be achieved through some form of policy support combined with diversification in financial assets by the elderly. Low inflation in general would auger well for everyone. However, for those dependent on primarily interest income, a lower nominal return may push them in search of other financial instruments. Policy support can mitigate some of this and avoid a situation whereby an investor ends up parking funds in risky assets without fully recognising his or her risk profile.