Should mutual funds for monthly income be part of your portfolio

Capital appreciation and income are two primary investment goals. Mutual funds provide multitude of investment solutions for both these objectives for different risk profiles. However, in India mutual funds are mostly associated with capital appreciation. Retail investor's faith in mutual funds for wealth creation has been well rewarded, with good equity mutual funds giving multiple times returns over a sufficiently long investment period.

The main purpose of investing, for many investors, is capital appreciation or wealth creation; investing for regular income is not an important consideration for majority of investors, except senior citizens. Most mutual fund investors in India belong to the salaried class and they depend almost entirely on their salary for meeting their regular expenses. Be that as it may, monthly income, whether from salary or investments, is the most important financial need for all of us.

Let us take a typical salaried person in the mid to late thirties or early forties in the upper middle income group. Consider his regular monthly expenses - home loan EMIs, fees for school going children, utility bills, fuel bills, grocery bills, salaries of household staff etc. Most of these expenses are fixed expenses and you simply cannot wish them away. Let us now ask the very uncomfortable question. What if he does not get his salary next month? He may have enough balance in his savings account to take care of his monthly expenses for a few months.

But what if he does not get his salary for more than 6 months? He would have run out of liquidity and start redeeming his investments like fixed deposits and later mutual funds. If unfortunately the market crashes at the same time (bad luck often strikes on multiple fronts), then he will be selling his mutual funds at a low price or even at a loss. Eventually he will get an alternative employment and his crisis will thankfully be over. But during this period his investments may have depleted considerably and it may take the investor a very long time to return to comfortable levels of savings / investments, not to mention the severe mental stress, the investor and his family had to go through.

Related read: 6 important To Dos in your mid-career financial planning

Safeguarding from loss of income

How can investors safeguard themselves from such a situation? In the developed countries like USA, Canada, UK etc there are general insurance products which can provide income replacement if the insured loses his or her job, but unfortunately at present there are no unemployment insurance products in India. Investors should therefore, look for investment solutions for regular income. Fixed deposits paying monthly interest and Post Office Monthly Income Schemes were traditional investment choices for income in India. However, interest rates of these traditional fixed income products have fallen over the last 2 years and as such these products may not be able to generate sufficient income for your needs. Investors need to look at alternate income investing solutions and mutual funds provide such solutions to investors.

Before we discuss, income investing solutions, it is important to understand that income producing assets are low or moderately low risk assets and therefore, investors should not expect very high returns from these investments. Further, since the income yield is not very high, it may take a considerable amount of assets to generate sufficient income to replace your monthly salary. But investing in income producing assets is a step towards financial independence. If your investment income can meet, say 20% of your fixed monthly expenses, pressure on your other assets will be considerably reduced during the period you do not get salaries.

Who should invest in income generating assets?

There is a misconception that only retired people should invest in income generating assets. Even if you are working, you should invest in income generating assets. You should ask yourself, how much flexibility you have in expenses - a very large part of the expenses of most families are inflexible. Such families should therefore, invest in income generating assets. You should look at your financial liabilities like home loans, car loans etc. You should also look at your family obligations – school going children, dependent parents etc. Higher your financial liabilities and your other obligations, more should you invest in income generating assets.

Mutual funds income solutions

Mutual Fund Monthly Income Plans are excellent investment choices for investors looking for income and also some capital appreciation over a sufficiently long investment period. Monthly Income Plans are debt oriented hybrid mutual fund scheme where debt allocation can range from 75 to 95% and the equity allocation can range from 5 to 25%. You can choose between lower and higher equity allocations based on your risk appetite, for example younger investors can go for higher equity exposure, while older investors should opt for lower equity exposure.

Read more about Hybrid mutual funds in India

The primary objective of Mutual Fund Monthly Income Plans is to provide regular income to investors along with some capital appreciation over a sufficiently long investment. The capital appreciation can help investors beat inflation in the long term. The debt component of Monthly Income Plans lowers the volatility, provides stability and generates income for investors. The equity portion of the portion provides a kicker to returns over a sufficiently long investment horizon and can help investors beat inflation.

Both Growth and Dividend options are available in Mutual Fund Monthly Income Plans. Unless you have immediate income needs, you should invest in Growth option so that you can benefit from compounding. When you need income from your investments, you can switch from Growth to Dividend and start receiving regular monthly pay-outs. Investors should understand that, though Mutual Fund Monthly Income Plans aim to pay-out regular dividends to investors, mutual fund dividends are not assured.

Difference between Monthly Income Plans and Balanced Funds paying monthly dividends

Both Monthly Income Plans and Balanced Funds of many AMCs are paying monthly dividends for the last few years. The monthly dividend pay-out rates of Balanced Funds have been a few percentage points higher than that of Monthly Income Plans. However, you should understand that the risk profiles of these two types of mutual funds are very different. Balanced funds have at least 65% exposure to equities and the balance to fixed income; Monthly Income Plans, on the other hand, have only 5 to 25% exposure to equities. Lower equity exposure makes Monthly Income Plans much less volatile compared to Balanced Funds.

Let us also understand how Mutual Fund Monthly Income Plans and Balanced Funds pay regular dividends. Monthly Income Plans ideally aim to pay dividends from income accrued by investments, e.g. interest earned from debt securities. Balanced Funds on the other hand are paying monthly dividends from their accumulated profits earned through portfolio churning, i.e. buying and selling stocks and bonds. Over the years, the older Balanced Funds have paid out only a portion of their profits as dividends, keeping the rest of the profits in reserve to be paid out on rainy days. But you should understand that Balanced Funds are more affected by stock market volatility and their ability to pay dividends has market dependency. Monthly Income Plans, on the other hand, get their income primarily from debt securities and therefore, provide much greater income stability.

Dividend taxation

One of the main reasons of higher dividend pay-out rates by Balanced Funds is because of the tax advantage these funds enjoyed over Mutual Fund Monthly Income Plans. Balanced Funds are taxed as equity funds. Dividends paid by Balanced Funds were tax free, whereas dividends paid by Monthly Income Plans, which are treated as debt funds, are subject to Dividend Distribution Tax of 28.8%.

However, the tax advantage enjoyed by Balanced Funds will come down a bit from April 1, when dividends paid by Balanced Funds will be taxed at 10% by way of dividend distribution tax (DDT). Other things remaining the same, the dividend yield of Balanced Funds will go down in the future due toDDT, but Balanced Funds will continue to have a significant tax advantage over Monthly Income Plans.

Capital Gains Tax in Monthly Income Plans

Short term capital gains (investment holding period of less than 3 years) in Monthly Income Plans are taxed as per the income tax rate of the investor; long term capital gains (investment holding period of less than 3 years) are taxed at 20% after indexation. Indexation benefits can reduce the effective tax rate of the investors substantially.

Long term capital gains tax advantage makes Systematic Withdrawal Plan (SWP) in Monthly Income Plans more tax efficient than monthly dividends. However, the SWP rate should not be more than the long term average rate of return of the fund; otherwise you may end up depleting your investment and defeat the purpose of income investing. Top performing Mutual Fund Monthly Income Plans have given nearly double digit returns over the past 5 to 10 years, but in our view you should limit your withdrawal to 8% per annum. Once your corpus grows, you can then increase your withdrawal rate.

Conclusion

Your portfolio should comprise of both growth assets (for capital appreciation) and income generating assets. Growth assets will create wealth for you, while income generating assets will provide stability in difficult times. Mutual fund Monthly Income Plans are excellent income generating assets for long term investors. You can invest in Mutual Fund Monthly Income Plans either in lump sum or Systematic Investment Plan (SIP).

In Advisorkhoj, we advocate SIP as a disciplined investing mode for salaried investors. Over a sufficiently long period of time, through SIPs, you can accumulate a sufficiently large asset base, which can take care of a large part of your income needs. Investors should consult with their financial advisors if Mutual Fund Monthly Income Plans are suitable for their investment needs.