Tuesday, 22 November 2011

PPF interest rate increase. Ponzi Alert! Like Social Security? (Part III)

The Public Provident Fund Scheme, or PPF is arguably the most popular savings scheme currently available for small investors in India.  Literally millions of Indians, participate in this government backed scheme with the full confidence that their money is safe, and will grow over the years.  There are several detailed articles that you can find on the web, describing the benefits of the scheme, how to invest in it, and the rules and fine print for deposits and withdrawals.  You will also find every financial planner, first checking if you have a PPF account, and if not, encouraging you to open one, not just for yourself, but also for your spouse and minor children.  It is almost automatic today, for every earning adult (and in fact their minor children as well) to have a PPF account with money being stashed away dutifully every year, just like our parents did before us. 

The PPF scheme is undeniably very attractive, which is what makes it so popular for millions of small investors in India.  The government has positioned it as a must-have part of every investors portfolio, and most financial planners will tell you the same thing.  Heck, even I have a PPF account and diligently put away the maximum limit in it every year.  Let's go through some basics of the PPF scheme.

For starters, the money you invest in the PPF scheme, is pre-tax.  This is some-what similar to the 401K in the US, and by investing your pre-tax money you actually save on tax, since the money invested is deducted from your gross income.  The government sets a limit of Rs70,000 per year for investment of pre-tax rupees into the scheme (again similar to the US 401K which has an upper limit for yearly investment).  Next, any investment growth in the PPF scheme is completely tax free.  This is a huge benefit, since your money can continue to grow for the 15 year tenure undisturbed by taxation, which usually takes a huge chunk out of your investments outside of the PPF scheme.  Again, this is similar to the 401K scheme in the US.  Finally, once the 15 year term completes, you can withdraw your money completely tax free!  This EEE treatment of the scheme is unmatched in the world!  The 401K in the US is EET, with the final withdrawals from the 401K taxed at the prevailing income tax rate at that time.  However in the PPF scheme in India, even withdrawals are not taxed, making it unique and extremely attractive to investors.  This is a tremendous gift form the government of India to the people, since in effect, it means that the money invested in PPF is never taxed!

Finally the returns from your investment in the PPF scheme, are also decided by the government.  The PPF is a defined benefit scheme, in the sense that the government unilaterally announces the rate of return in the PPF account.  The PPF scheme is fairly opaque, with no clarity on how the government expects to make the rate of return that it promises.  Typically the PPF interest rate has been above prevailing market determined interest rates.  The table below shows the PPF rates since the inception of the scheme. 

Notice from the table that over the years, the government has promised and delivered a rate of interest that is much higher than the prevailing market rate at that time.  Every time the market rates have gone up, the government has been forced to increase rates in the PPF scheme, to keep money flowing into the scheme.  Again this year, as the RBI has increased interest rates to keep inflation in check, the collections into the PPF scheme have dropped significantly.  The government depends on having a strong cash flow every year into the PPF scheme, and it had to increase the interest rates for this year to keep the scheme viable.  The government from this year, has pegged the PPF interest rate to the 10year G-sec yield with a margin of 0.25%.  So if the G-sec yield is 10% for a given year, the PPF interest rate will be 10.25%  Notice again, the artificially inflated interest rate for PPF, to keep the scheme attractive to small investors.  Do you see a pattern here?

No comments:

Post a Comment