To ensure regular income after retirement, you need to create a corpus that will earn you a particular return every month. Of course, there are a number of ways in which you can create this fund like investing in stocks or property. In India, buying endowment plans from insurance companies is also another way as you get a lump sum amount as survival benefit.
You can also go for pension schemes of mutual funds. The main feature of these schemes is that they allow the investor to accumulate money till a certain age after which they have the option of getting a regular amount each month or a lump sum after retirement.
Mutual funds offer you two options: dividend and growth. The former option is further split into dividend payout or dividend reinvestment. In the growth option, the gains made by the scheme are added to the net asset value (NAV) of the fund so that the NAV keeps on accumulating the gains and keeps increasing.
Under the dividend payout option, the investor receives the payment. In case, you have opted for the reinvestment option, the dividend amount will be used to buy further units at the prevailing NAV. In pension schemes, there is no dividend payout though the fund declares it from time to time. The amount is ploughed back into the scheme and more units are allotted to the investor in lieu of the dividend payout. The main idea behind the scheme is to increase the invested amount for the investor over a period of time till retirement and benefit from compounding.
Also, you should remember that whenever a dividend is declared the NAV will correct and the correction will also include the impact of the dividend distribution tax that has been deducted at the time of dividend declaration because these schemes qualify as a debt scheme for tax purposes.
Consider an example where an investor has bought 1,000 units of such a scheme at Rs 15 per unit taking the total investment to Rs 15,000. The investor has opted for the dividend option and assumes that Rs 15 is the NAV at which point a 20 per cent dividend is declared. The total dividend will be Rs 1,000 X 2 per unit which is Rs 2,000. After the dividend, the NAV taking into effect the dividend plus the dividend distribution tax will come to around Rs 12.72 entailing an additional allotment of 157.27 units in that year. This takes the total number of units to 1,157.27.
In the next year assume that the NAV has risen 20 per cent to Rs 15.26. The rate of return and the rate of dividend considered here are just random figures and they do not represent any expectation from such schemes. If the rate of dividend is maintained at 20 per cent during the year, then the dividend amount comes to Rs 2,314 and the NAV will fall to Rs 12.98 after the payout. This will entail an additional allotment of 178 units for the investor taking the total holding to 1,335 units. Investors also need to note that even though each year there is similar earning and payout in percentage terms, the various NAV keeps changing because of the additional dividend distribution tax that is adjusted in the workings.
This process can continue every year and the dividend will keep getting added to the corpus as more units. For example at the end of five years, the investor will end up with 2,011 units that will have a total value of Rs 28,384 against the initial investment of Rs 15,000 made at the start of the exercise.
The investor has to make the all-important decision of the option that he wants. This should come from matching your needs with the choices available. The mutual fund will act according to the instructions you give.
The writer is a certified financial planner.