Most indian savings don't create wealth growth

Although 80% of Indian households own at least one bank account, 95% of their wealth is in gold and real estate. In a global context, Indians in the middle and richest tertiles hold more of their wealth in real estate than their counterparts in developed and other developing countries.

For the five percent of household portfolios that comprise any financial assets, life insurance, and fixed deposits are the two most prevalent. Of these households, 50% possess some form of public life insurance, 43% use fixed deposits and around 25% avail of post office savings schemes. But all other assets suffer poor uptake. Strikingly, even the Employees’ Provident Fund (EPF), a government-supported scheme for regular salaried workers that provides automatic savings and investment mechanism for old age, is used by only 12% of households.

The financial assets that Indians use the most — life insurance, fixed deposits, post office schemes — all display several weaknesses. For example, on average, life insurance payouts in India only cover 8% of what is required for a family that has just lost its breadwinner to survive. This is not including the innumerable hassles and uncertainty related to settling the claim process, all of which are amplified for lower-income households. The question then is not only whether Indians purchase insurance to cover various risks, but also if policies adequately protect them if the need arises.

Fixed deposit and post office deposit schemes have seen their real interest rates decline over the last six years — even witnessing negative returns during some months — and can continue to be beaten by rising inflation in the near term. For example, a one-year fixed deposit with the State Bank of India (SBI), the country’s largest lender, resulted in a real return of -1.5% after accounting for inflation and taxation in 2020. Assuming inflation is at 5%, post office savings accounts offer an annual return of -1%, while the returns from 1-year to 5-year fixed deposits in post offices range from 0.5% to 1.7%. It is Strivers and Risers who predominantly use these saving and investment products, which are either losing real value or barely keeping up with inflation.

Long-term government schemes do have a slightly better outlook. The provident fund scheme that was created by the government includes both the Employees’ Provident Fund (EPF) and the Public Provident Fund (PPF). Both of them afford savers three main benefits: creating a corpus for retirement, generating an emergency fund in case of crises, and using a tax-exempt savings device. In fact, both types of provident funds hold the exempt-exempt-exempt (EEE) taxation label, denoting that they are untaxed during contribution, accumulation, and withdrawal.

The EPF is a saving scheme geared toward workers with a regular salary in enterprises with more than 20 employees. Employees and employers each contribute 12% of the employees’ monthly salary, and the real annual returns of 3.5% are higher compared to most other traditional savings schemes. The PPF is available to most Indian citizens residing in the country and is considered a safe savings product. A minimum investment of INR 500 is required annually to maintain the account, and there is a lock-in period of 15 years during which funds cannot be withdrawn completely. Crucially, the PPF offers an annual real return of 2.1%.

Furthermore, the government-sponsored National Pension Scheme (NPS), which is a defined, voluntary contribution scheme that is market-linked, offers another long-term investment option. Importantly, this scheme is open to informal workers as well, in theory lowering the entry barrier for 90% of the workforce. The NPS is intended to create a corpus of wealth for old age; thus, in the case of retirement, exit from the plan, or superannuation, at least 40% of the contribution is used to purchase an annuity that provides a lifetime pension. With two main options for the NPS — Tier 1 and Tier 2 accounts, with the real annual returns ranging from 3% to 5%.

Lastly, Sukanya Samriddhi Yojan (SSY) accounts — a scheme geared to encourage saving for the education and marriage expenses of female children — manages an annual real return of 2.6%.

Government schemes do offer safe long-term returns, doing as well if not better than gold (the SBI Gold ETF averaged an annual, inflation-adjusted return of 3% over five years).

Compared to capital markets, however, government schemes afford lower returns and less liquidity to cash-strapped Indians. India’s asset management — or mutual fund — industry currently forms a small portion of household assets (with an AUM of 12% of GDP, compared to 14% in China, 60% in Brazil, and 120% in the United States). The Total Return Index (TRI) of the NIFTY 50 — the 50 largest companies by capitalization — stood at 15.3% in the five years leading up to 2021. With the annual inflation rate averaging 4.9% during this period, the mean annual real return from the NIFTY 50 was around 10.4%. Still, only about 20 million individuals, or about 1% of households, participate in capital markets directly, which have performed relatively well over the last half-decade.

Mutual funds, though, are the fastest-growing channel for marginal financial savings, having doubled to 21% of bank deposits in five years. In 2019, for example, gross household financial savings amounted to about INR 20 trillion or $285 billion, of which mutual funds attracted nearly a third.

Forty-four companies in India together manage nearly 3,000 mutual funds — typically equity, debt, hybrid, sectoral, or solution-oriented schemes. The wide array of funds often make it difficult for investors to choose the best scheme for them. While funds are numerous, they are not appropriately rationalized or differentiated. Though each company offers hundreds of funds, the vast majority of them are very similar in their strategies and portfolios — investing in the same universe of 500 Indian stocks and a relatively nascent bond market.

Nearly 95% of assets under management are “actively managed” as opposed to passively managed in index funds or ETFs. Paying more in fees for active funds does not equal better performance. Only 33% of funds delivered alpha returns in 3-years. Besides, two-thirds of investors do not stay invested long enough for alpha returns.

A major reason for this redundancy is that AMCs use New Fund Offerings (NFOs) as a sales tactic. To distribute its mutual fund offerings, the industry relies on its 250,000-strong distributor fraternity. To maintain healthy growth in AUM, AMCs issue several NFOs each month that distributors then hawk to their customers as a new or unique investment opportunity through home visits or when they come into a bank branch. Consequently, the number of funds balloon and investors typically own multiple folios each.

The major drawback of this approach is that it is bad for both the customer and the AMCs by creating a high-cost environment. Having to manage multiple redundant funds and pay heavy commissions to distributors pushes up the AMCs’ operating costs and, consequently, the total expense ratio or management fees charged to customers. Sales and marketing account for 50% of their operating costs or 3X the actual management expense. As a result, India has among the highest AMC fees as a percentage of AUM in the world.

As we discussed in our first blog post, Indians are earning more than they were 10 years ago (in real terms), allowing for a greater potential to save and invest. Yet their asset ownership serves their needs poorly: their wealth is either concentrated in illiquid assets such as gold and real estate, and the few financial assets they possess cannot beat inflation or offer significant flexibility of access. This last point is particularly important for Strivers who might need to make regular withdrawals to cope with their volatile incomes. For Risers, safer, longer-term investments that carry comparatively less risk but that beat inflation — fixed income instruments in the form of bonds, for example — could be a more fruitful strategy than relying on fixed deposits. Some of the wealthier Risers and, many Aspirers, already participate in mutual funds and riskier equity markets, but there is much greater scope for their involvement in these higher-return options to grow. Indians’ assets can, and should, count for more.