- Date : 27/09/2020
- Read: 9 mins
No investment can guarantee returns that will beat inflation, but PPF and debt funds are good alternatives to fixed deposits.
In August this year, the government released data that should be a source of worry for those who have invested a bulk of their savings in fixed deposits (FDs). The reason is simple: inflation is rising so fast that such investors may not even break even! In other words, the money they have saved (or are saving) in FDs may not be enough to meet their daily expenses when the FDs mature.
Inflation is a general increase in prices in items across categories in an economy, which leads to an overall rise in the cost of living. The rate at which this price rise occurs is called the rate of inflation. Government data shows that India’s rate of inflation in July 2020, based on the consumer price index, was 6.93%. This exceeds the 6% limit that’s deemed acceptable by the Reserve Bank of India (RBI).
Why inflation matters
What is the implication of this rising inflation rate? It is this: as the inflation rate rises and catches up with the interest on bank FDs, the rate of return – the return on an FD (or another fixed income investment) minus inflation – can turn negative. As a result, earning from interest is less than the rise in prices.
And this is where the problem lies for retired people, who tend to park their money in FDs. A negative real rate of return can lead to a situation where their corpus is eroded, simply because their expenses have become higher than their income from interest earnings. As it is, the interest rates offered by banks barely manage to beat inflation.
But it gets worse when tax is deducted from the interest income – then the returns on FDs could fall below the rate of inflation. So don’t get excited when banks offer an 8% interest rate on a five-year FD; it probably won’t be sufficient to keep pace with rising inflation.
The appeal of fixed deposits
Yet, in India, FDs are one of the most popular investment instruments, scoring over market-linked investments such as the stock market, mutual funds, and SIPs. There are several reasons why FDs are so attractive, especially among the elderly and retirees. Let’s see what they are:
- Security: Unlike market-linked schemes, FDs do not depend on the market’s health to deliver the promised returns; such investments are safe even if the stock market crashes. In any case, deposits of up to Rs 5 lakh are protected under a scheme from the Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary of the RBI.
- Competitive rates: Interest rates tend to get better with longer tenures – averaging around 6.5% for the mainstream banks, depending on the tenure.
- Known returns: It is easy to plan for the future with FDs as the maturity value is predetermined due to the fixed rate of interest during the period of investment; this appeals to retirees.
- Tax benefits: Though interest income is taxable, tax deduction up to Rs 1.5 lakh can be claimed per financial year during the period of FD investment.
- Withdrawal: FDs can be withdrawn during emergencies, though banks will charge a nominal penalty of 0.50%–1% of the interest.
- Easy entry: What also makes FDs attractive to many in India is the low entry amount; at just Rs 1000, it makes investing simple for people from all sections of society.
- Zero fees: Unlike market-linked investment schemes, banks do not charge any fee for FD management.
Related: FAQs about fixed deposits
Maximising fixed deposits
As stated earlier, a fixed rate of interest means the maturity amount of an FD is predetermined. However, there are ways for an investor to target returns higher than what’s derived from back-of-the-envelope calculations. Let us consider some of them:
- Best rates: Interest rates on FDs vary from bank to bank, so it is advisable to compare rates and choose a lender that offers the best rates. Many banks offer online interest calculators; these can be used to calculate the best deal.
- Avoiding TDS: Interest earnings on FDs are taxable. But if the investor’s income is not taxable (that is, if it is less than Rs 2.5 lakh in a financial year) they can submit Form 15G (senior citizens) or 15H (general category) to avoid TDS on the FD account.
- Senior citizen benefit: Investors can also exploit exemptions granted to senior citizens; if one’s parents do not have any taxable income, FDs can be opened in their accounts. There is another advantage to this: FD interest rates are generally higher for senior citizens.
- Splitting FDs: Early withdrawals, which are common during emergencies, eat into the interest income, and banks too levy a penalty. So it is better not to put all your money in a single FD, but to split it among multiple FDs.
- Regular renewals: Another way to earn maximum profit from FDs is to opt for short-term fixed deposits, and renew these regularly. This way, the investor can take advantage of revised interest rates.
- Risks of fixed deposits
Returns on FDs are well understood; for instance, they are still widely accepted as collateral. However, despite all these advantages, FDs also have some inherent drawbacks – such as the risk of inflation, which takes away the real value of an FD. But there are other, less obvious risks with FDs, which should be considered as well:
- Liquidity risk: Bank FDs can have maturity periods as low as a few months, but they are not traded in the secondary market. Also, breaking an FD involves paying a penalty.
- Default risk: Smaller cooperative banks are known to have defaulted on FDs. Under the DICGC scheme, some level of safety is available, but only for deposits up to Rs 5 lakh.
- Rate risk: The investor loses out if interest rates go up during the term of deposit. A fixed period of investment means the money is blocked and cannot be reinvested to take advantage of the newer, more lucrative interest rates.
- Taxation risk: This is significant because what one takes home are the post-tax returns, which can be a dampener for the investor.
- Goal risk: For an investment to fit into one’s overall financial plan or with one’s goal, it needs to be liquid, flexible and tax-efficient; FDs don’t really fit into any of these categories.
No investment is totally risk-free, but one that matches the investor’s financial goals and risk appetite can be considered the best of the lot. By this yardstick, even an FD can be the right safe choice.
Alternatives to fixed deposits
There are options similar in risk profile to FDs in terms of safety, which may even fetch slightly better returns. However, one should bear in mind that no investment can promise returns that are guaranteed to beat inflation. Let us consider two such options: public provident fund (PPF) and debt funds.
Public Provident Fund
According to a circular dated July 1, interest earned on PPF will remain constant at 7.1% in the second quarter of FY 2020–21, while it will be 7.4% for the Senior Citizens Savings Scheme (SCSS). The rates effective for the quarter of July 1 – September 30 compare well with FD returns. Its other features are attractive as well, some which are listed below:
- No age limit, and it can be opened in the name of a minor as well
- Annual contribution starts at a nominal Rs 500 and goes up to Rs 1.5 lakh
- It is tax-free
- Government backing, which ensures a high degree of safety
- Offers a fixed (steady) income
- The duration of a PPF account is 15 years and it can be extended in blocks of five years without any loss of interest. What’s more, the depositor is eligible for a loan in the third financial year. Therefore, PPF not only provides a cushion during retirement; its returns also keep pace with inflation.
Another option that conservative investors can look at are debt funds, which invest in government securities, bonds, debentures, money market instruments, commercial papers etc. These provide a regular income and also enjoy various advantages over equity investments and other fixed investments like FDs.
Debt funds can prove better than FDs if held over a longer-term (more than three years). This attracts tax at 20% with indexation benefit that takes inflation into account, reducing the overall tax outgo.
Returns from debt funds and FDs are comparable, but what tips the balance in favour of the former is the way either is taxed; debt funds are not the most lucrative in the mutual fund category, but thanks to the inflation-adjusted returns and taxation, they beat FDs in terms of gains.
Debt funds have historically given returns in the range of 7%–9% annually, which compares well with FDs. Such returns are clocked despite the risks mentioned earlier. Besides, unlike FDs which attract TDS annually, with debt funds one can defer tax deductions till redemption; this is one of the main advantages debt funds have over FDs. Debt funds also more liquid than fixed deposits.
The downside of debt funds is that since they are market-linked, positive returns are not always assured. As a result, investors are exposed to defaults and other credit issues with the entities the investment is in.
FD is the best investment avenue if the criterion is a relatively risk-free instrument. However, if inflation-beating returns is the principal consideration, an FD may not be the right choice. There are alternatives such as debt mutual funds, which are more flexible than FDs and allow the Investor to switch to other schemes without having to pay a steep penalty. Read this piece to know how to choose between fixed-income and market-linked investment avenues.
Disclaimer: This article is intended for general information purposes only and should not be construed as insurance or investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.