Is there Merit in Guarantees for Pension Plans?

Pension Plans

The markets move up or down which is why there is an element of risk when it comes to investments. This is the basic reason why an individual may ask for a guarantee on his investment.

But do they really secure your hard earned money? Before we delve into this, let’s take a quick glance at the last 35 years of the Indian Stock Market which today hovers around 22K.

The point of this is to understand how risk in the stock market works which eventually impacts your investment.

Now, 10 years ago, or in 2003, the stock market was around 3K, 20 years ago about 1.1K, 35 years ago it was at 100.

So from these figures it is evident that in 35 years the stock market has rocketed up by 220 times.

So where does the risk lie? The thing with markets is that if investments are made over a short period of time, say 0-5 years, there is a risk for losses.

However there has never been a period longer than 5 years when the market has not given substantial returns. In fact, over a 10 year period the market has given an average compounded return as high as 13% per annum.

Coming back to pensions, now these are usually long term products for retirement where investment is made for a period of 20-40 years.

If we go by the history of this product, we see that there has never really been any chance of a negative return.

Yet, today all pension products are required to provide a guarantee that an investor will not lose money. Let’s understand if this actually has any benefits for investors.

First of all, almost all companies charge a fee of about 0.5% of assets under management for the service of providing guarantee.

That is not a small percentage when you look at long term products. For example, if you pay 1Lac a year for 30 years, and get a 13% return (which is what the markets usually provide) you will pay, hold your breath, 74Lacs extra.

And, here’s the startling part. The corpus without this charge would have been 6Crore 18 Lacs, and with this 0.5% charge it would be 5Crore 46 Lacs. Such is the power of compounding and power of interest rates over a long period of time.

Let’ also speak of a situation where charges are left alone and get into the mechanism for providing such guarantees.

To guarantee you never lose money, the fund managers must ensure that if the markets start falling, they remove the money from the stocks and put them into fixed return products to ensure your return.

That sounds like a good plan, except for the fact that you are likely to miss out when the markets bounce back.

Based on my study, there is about a 64% chance that you will get just the basic guaranteed return, as 64% is the chance that the market will drop below todays prices at least once in the future. Anytime this happens, you will lose the chance to get the market return.

I’ll explain this further with an easy example. Let’s take a very simple market which moves either 30% up or 10% down every period.

So if you invest INR 100, there is a 50% chance its INR 130, and a 50% chance its INR 90. Now when its 90, in the next period it has a 50% chance of being 117, and a 50% chance of being 81.

Here is the catch. If this were a guaranteed product, you would get 100 in both cases not 81 nor 117. If you do this over 6 periods only you get the following outcome probabilities.

So over just 6 periods the following results are achieved.

Outcome Type Guaranteed Non Guaranteed
Negative 0% 1%
Guaranteed 60% 20%
Good 30% 60%
Very Good 9% 18%
Exceptional 1% 1%

Outcome Type Guaranteed Non Guaranteed

While the guaranteed products prevents the 1% chance of a really bad outcome, it also diminishes the chances of moderately good outcomes, and essentially creates an abnormal chance of just the guaranteed outcome.

The expected value of all results after 6 periods for the guaranteed product is 154, while its 177 for the non-guaranteed product. The Guarantee even without its cost destroys value.

I think the point is made. Over a long period of time say greater than 10 years, asking for a guarantee actually reduces value for you as a consumer. So just do not ask for it.

Curated from Is there Merit in Guarantees for Pension Plans?

You may also like...