Options For Income Generation - And Which One To Choose

Few questions have vexed investors more over the years than this seemingly simple one: "How do I generate investment income?"

There may be times in your life (typically once your earning stops) that you'll need to have a robust income generation strategy in place. While there are several ways to generate a steady income from your lump sums investments, all of them have their relative merits and drawbacks. In order to make an informed decision, it's important to have a basic understanding of all the various options available. In this article, I will highlight a few of the top of the mind choices that most people will consider.

Rent
For many of us, the phrase 'investment income' is synonymous with 'rental income'. This, in my opinion, isn't a great idea at all. Gross Rental yields are extremely low in most metropolitan cities; In Delhi, they typically range from 2.75 per cent to 3.50 per cent. In Mumbai, they are even lower, at closer to 2.40 per cent. They used to be close to 7 per cent in Bangalore until a few years back; they are down to roughly 4 per cent now.

What this essentially means is that you can typically expect a rental income of Rs. 20,000 to Rs. 30,000 per month on a property that you bought for Rs. 1 Crore; factor in taxation (rental income is taxed as normal income), maintenance costs and the time that your property spends vacant between tenants, and you'll likely end up at a real rental yield of closer to 2 per cent per annum - a pittance!

A deeper, structural concern is that such low rental yields are often symbolic of overvaluation - so you may just be dealt a double whammy in terms of low rent, plus zero to low appreciation for an extended period of time.

Real Estate is also indivisible and relatively illiquid, so the only way to realize interim liquidity from it (for instance, in case of emergencies) is to take a LAP (Loan Against Property). Needless to say, this will involve an interest burden.

Annuities & Traditional Products
Many investors will consider the purchase of an annuity from a Life Insurance company in order to generate an income from their lump sum moneys.

Annuities are a poor choice on many counts - they are low return instruments; rarely, if ever, exceeding an 8 per cent annualized return in any scenario. The income from annuities is taxable as normal income, and the fact that they lock you into a long term commitment with (usually) a fixed, non-inflation linked payout only makes matters worse. Avoid buying an annuity at all costs.

A POMIS (Post Office Monthly Income Scheme) allows for a maximum investment of Rs. 9 lakh in a joint account. At the current rate of 7.8 per cent, this works out to just Rs. 5850 per month; and this income is taxable, to boot. The tax inefficiency and low ceiling value makes POMIS an incomplete and ineffective solution.

Reverse Mortgages
A Reverse Mortgage is a variation of a Loan Against Property, wherein a homeowner aged 60 or more can avail a loan against a self-owned property. The difference between an RM and a LAP is that instead of the borrower paying back EMI's (as in the case of a LAP), the lender pays the loan amount to the borrower in tranches (capped at Rs. 50,000 per month).

At the end of the tenor, the loan is settled by the legal heirs by liquidating the property or by paying off the loan amount. There are no repayments to be made by the borrower during his or her lifetime.

RM's have been wildly unpopular in India; primarily because in our country, a residential property is considered nothing short of a sacred asset that is usually held to be bequeathed to future generations. If that's not a constraint for you, it may be a useful option to consider. Make sure you opt for the RMLeA (Reverse Mortgage Loan enabled Annuity) option instead; this would yield a higher amount for you, and also safeguard you against the risk of outliving your savings.

Having said that, a RM is not inflation linked, and therefore isn't a complete solution. Needless to say what's worth 50,000 per month today will be worth a lot less in ten years' time.

Monthly Income Plans by Mutual Funds
Monthly Income Plans (MIP's) are a type of debt oriented hybrid mutual fund. They invest roughly 80 per cent of their assets into safe, fixed income instruments such as bonds and company deposits, and the remainder into the equity markets.

Contrary to popular belief, MIPs do not provide a guaranteed or even assured fixed monthly income. Dividends are paid depending upon the discretion of the fund manager, and are correlated with the fund's performance. A steep fall in the stock markets, for instance, will affect the 20 per cent equity part of the portfolio and therefore hamper the prospects of future dividends.

Although returns from Mutual Funds are not guaranteed, a basic thumb rule for estimating future cash flows from MIP's is this - roughly 4-6 per cent gross annual dividend, subject to 28.33 per cent Dividend Distribution Taxes, which works out to 2.75 per cent to 4 per cent net of taxes. That is, on a 1 Crore investment in an MIP, you'll likely end up receiving dividends to the tune of Rs. 20,000 to Rs. 30,000 per month. In addition, one could expect a ballpark capital appreciation of another 5-6 per cent - the capital gains will be taxed as would other debt instruments.

The tax inefficiency of MIP's, combined with the lack of assurance about future income streams makes them a poor choice.

Synthetic Income through SWP's - the best option
I'm yet to come across a better, more complete solution for income generation than the creation of a synthetic 'monthly dividend' of sorts from a well-planned portfolio of Mutual Funds.

This is how it works: decide on your target asset allocation based on your risk profile, time horizon and income requirement. Let's say you decide on a 70:30 asset allocation in favor of debt instruments. A ballpark expected return from such a portfolio could be assumed as 10 per cent (Rs. 10 lakh on a 1 Crore investment). Allocate this amount (in this example, Rs. 10 lakh) to a liquid fund and start a monthly SWP (Systematic Withdrawal Plan) of Rs. 85,000 or thereabouts from it.

At the end of the year, transfer the next years' planned SWP amount to liquid funds and repeat the process. If you would like to refine the process even further, you could start with a smaller SWP amount and inflate it by 7 per cent per annum.

The process of generating a synthetic monthly income through SWP's is relatively tax efficient, and will, in the long run, produce much better risk adjusted returns compared to any other option.