Personal Finance Rule 3 – Max out all forms of PF

Courtesy: EPFO

This short post reiterates the importance of an essential debt component of any portfolio in India – Employee and Public Provident Fund. This is a companion post to the India version of Harold Pollack’s Index Card – Pollack’s Index Card: All the financial advice that you ever need – India version. While there are different types and sub-types of provident funds, this article is generic to all of them.

The essence of the rule – Treat PF as a debt product and make it part of your portfolio

Employee Provident Fund (EPF, and its subtypes like GPF, SPF) and Public Provident Fund (PPF) are the most well known provident funds in India. There are important differences between them. The most important factors common to both of them are:

They earn a specific amount of interest every year (the interest rate may vary from period to period, but it follows a steady trend)
They qualify for the most preferred tax treatment – EEE or Exempt, Exempt, Exempt There are no other debt products that tick the boxes on the second and third ‘E’s
They are long term instruments – associated with employment (EPF) or tied to a term (15 years for PPF)
They provide some level of liquidity

Point 1 qualifies them as a debt instrument. Point 2 makes them an excellent debt instrument. Points 3 and 4 put them in the basket of long-term instruments.

Any sensible portfolio needs to have space for debt/fixed income instruments. The various PFs should be in the debt part of the portfolio. In fact, one can argue that PFs + Liquid/overnight funds are all that one needs as debt instruments. There are two major mistakes that people make, and we discuss them in the next two paragraphs.

Not investing in PPF, or investing enough in PPF
Making too many withdrawals from EPF

Public Provident Fund – The Rahul Dravid of Personal Finance

Yes, PPF is not glamorous. A lot of people use it as a filler for 80(C) and balk at the 15-year minimum life of the account. But the fact is that it is one of the best debt instruments, and it is available to almost all Indians. The benefits of PPF are very well explained in this blog post. PPF investment is a must for every investor In addition to the benevolent tax treatment, long-term nature, and stability the post also mentions that PPF can serve as an excellent illustration for compounding.

Assuming that one invests the entire permissible amount – 1.5 lac – by Apr 5, and the interest rate is 8%, here is how the account grows.

Year	Fin Year Begin	Contribution	‘Prinicipal’ for the year	Interest Rate	Interest	Final Balance
1	2018	1,50,000	1,50,000	8%	12,000	1,62,000
2	2019	1,50,000	3,12,000	8%	24,960	3,36,960
3	2020	1,50,000	4,86,960	8%	38,957	5,25,917
4	2021	1,50,000	6,75,917	8%	54,073	7,29,990
5	2022	1,50,000	8,79,990	8%	70,399	9,50,389
6	2023	1,50,000	11,00,389	8%	88,031	11,88,421
7	2024	1,50,000	13,38,421	8%	1,07,074	14,45,494
8	2025	1,50,000	15,95,494	8%	1,27,640	17,23,134
9	2026	1,50,000	18,73,134	8%	1,49,851	20,22,984
10	2027	1,50,000	21,72,984	8%	1,73,839	23,46,823
11	2028	1,50,000	24,96,823	8%	1,99,746	26,96,569
12	2029	1,50,000	28,46,569	8%	2,27,726	30,74,294
13	2030	1,50,000	32,24,294	8%	2,57,944	34,82,238
14	2031	1,50,000	36,32,238	8%	2,90,579	39,22,817
15	2032	1,50,000	40,72,817	8%	3,25,825	43,98,642

From the tenth year, the interest overtakes the yearly contribution. In the final balance at the end of 15 years, almost half is contributed by accumulated interest. If you extend the account for 5 years and continue contributing, the interest at the end of 20 years would be almost 1.5 times that of the principal – 44 lacs of interest and 30 lacs of principal.

In a thread in Quora, a prolific author posted a screenshot of his PPF account. You can read the thread to get a real-life example. Why my father always recommend to invest in PPF? (Interestingly, all the people responding to the question agree with the father!) Even without the initial 80(c) rebate, PPF is still a great debt product. So the prudent thing would be to invest the maximum allowable amount every year, even if it is outside the 80(c) limit.

Employee Provident Fund – Just stop abusing it

EPF is even better than PPF, if you view it as a debt instrument.

There is contribution from the employer too. Luckily a lot of employers disregard the 15,000 per month requirement and apply EPF to employees earning higher wages too.
The interest rate is slightly higher than PPF.
Its life is tied to being employed. If you retire early, you can withdraw the entire amount.

However, a lot of the people covered under EPF abuse the provisions. Yes, abuse is a strong word to use, but it is the only way to describe the usage. Due to frequent withdrawals, many people never give their account a chance to grow and benefit from compounding.

A lot happens with EPF in India. The orgnaization accountable for the scheme, EPFO, put out this nice picture of all that happens in a typical working day.

AN AVERAGE DAY IN EPFO
(One day average based on the figures for the year 2015-16 – 248 working days)

494.64 cr. is received as contribution & 424.58 cr. is invested
200.22 cr. is disbursed to beneficiaries
6.98 lac member accounts are updated
263 establishments are registered and 78471 members are enrolled
47859 claims are settled

(Source: EPFO Annual Report for 2015-16)

The last number is very revealing. Almost 50,000 claims per day means about 1.2 crore claims are made per year. EPFO has a bit more than 6 crore active members. So about 20% of them make a claim every year – which would be either a partial withdrawal or a full withdrawal. This is a very high rate for a long-term product. If people begin to just let the account grow, they would truly benefit from this excellent product.

Conclusion

Investors in India are really fortunate to have the excellent debt products of the provident fund family. By taking a long-term approach to them, and by avoiding the typical mistakes described in this article, investors can make their debt portfolio rock solid. And a strong debt component makes the entire portfolio strong.